Active vs passive: Which one works better?

So where are we today?

Which brings us to 2019, where, in our view we are again witnessing some fairly large price distortions and anomalies in the current sharemarket. It is a time when, not surprisingly, many are once again questioning active value managers, like IML, and questioning why IML is holding onto what seem to be many pedestrian and out-of-favour companies.

IML is underperforming and, justifiably, we are again being questioned by some as to whether the best times for active value managers are behind us. As has been the case through many of the previous booms referred to above, the current period of effervescence has been supported by ultra-low interest rates and easy monetary conditions worldwide.

These current low interest rates are forcing investors further up the risk curve into companies with perceived high growth, or a higher than average yield. This is evidenced by virtually every REIT in Australia trading well above its Net Asset Value (NAV). Many investors chase REITs because they pay an attractive yield when compared to cash or bond rates. As the share prices of these REITs rise, they become a bigger part of the index, meaning that index funds have to buy ever increasing amounts of them with every inflow.

In addition, many locally listed technology stocks of often dubious quality are trading on PE multiples in the hundreds and have collectively become a significant part of the index, as investors extrapolate current earnings growth as a certainty well into the future. This often happens when up-trending market sectors or stocks capture the imagination of momentum investors or speculators and are bid up and chased aggressively. Once these stocks’ market capitalisations make them large enough to become a part of the index, then passive/index buying tends to automatically follow despite many looking irrationally priced and overvalued. This pattern creates a vicious cycle until the music stops.

'In many ways, the danger with the recent rise in popularity of passive and quantitative strategies is that it is legitimising certain irrational behaviour'

In many ways, the danger with the recent increase in flows into passive strategies is that it legitimises certain irrational behaviour in the market. Thus, stocks with little to no earnings, often with questionable fundamentals yet with perceived growth, are finding good buying support by the overwhelming shift to passive or quant-based strategies as their share prices rise and they become a larger part of the index.

This is occurring because by their nature, index/passive strategies do not use any qualitative factors to select securities for their portfolios.

The more money that flows into these strategies, the more the bubble in certain sectors of the sharemarket gets inflated as these stocks become a higher weighting in the index, thus attracting more buying from index/passive funds. It’s a cycle that continues unabated to direct money into the most overvalued stocks with some momentum – until some sort of reality check occurs. Then, momentum will work the other way, i.e., the more these overvalued stocks correct, the more their index weight will decline and the more selling they will attract from index/passive strategies.

Where do we see signs of irrational pricing emerging?

Several sectors seem to have plenty of blue sky priced in, with little or no regard for fundamentals. While technology stocks around the globe have performed exceptionally well in recent years, led by US success stories such as Facebook, Apple, Amazon, Alphabet, Microsoft and Cisco Systems. These companies are well established, very profitable, cashed-up tech leaders with formidable business models and a well-recognised global presence.

In sympathy with the appetite for these established tech stocks, Australia’s nascent tech sector has also been caught up in this exuberance. Many companies, such as Wisetech, Nearmap, Afterpay and Zip Co Money, have soared in value. Stocks such as these are now collectively valued at tens of billions of dollars despite their business models being largely unproven. It is fair to say that an investment in these companies is a very different proposition to investing in the US tech companies listed above.

We are also seeing several biotech or early-stage pharmaceutical companies like Avita Medical, Pro Medicus and Nanosonics soaring to billions of dollars of market value, putting these stocks on very frothy and, often, very unrealistic, valuations.

Many investors continue to pay massive multiples for a slice of the action which, as highlighted above, is further supported by the wave of passive and quant-based funds buying shares in these companies simply because they are starting to represent a larger part of the index.

At IML, we look for a number of characteristics in any stock we consider for one of our portfolios – competitive advantage, recurring earnings and quality at a reasonable price.

In our view, the valuations of many of these types of companies have lost touch with fundamentals. Yet, investors seem happy to pay earnings multiples well into the hundreds on the view that a company might be the next big thing.

While it is possible that one, or perhaps even two, of these types of companies in Australia may one day in the future end up justifying today’s sharemarket valuation of billions of dollars by earning hundreds of millions of dollars in profits in the next decade or two, the truth is that the vast majority of these types of stocks – and there are many dozen in Australia which have stretched fundamentals – will not fulfil the promise of the huge profits implied by today’s share prices and large market capitalisations.

Another good indicator that market exuberance is nearing a peak is the rising percentage of new IPOs in the US being listed with little or often negative earnings. As seen in the chart below, the last time we saw this percentage was in 2000 at the peak of the dot.com boom.

Source: Topdown Charts, Jay R Ritter

The valuations of some of the hot sectors of recent years are also beginning to be questioned, possibly indicating the bubble will soon deflate. Thus in the US, we’ve seen ride-sharing companies Uber and Lyft close recently at record lows, dropping 36% and 23%, respectively from their very recent IPO prices. In addition, many ‘unicorn’ companies which had, until recently been highly valued in the private market are now falling significantly in value as they approach IPO – office rental company WeWork, which was recently valued by SoftBank at US$47 billion, failed to get listed on the Nasdaq despite the IPO valuation being reduced to US$10 billion.

History has shown that when sharemarket corrections occur, the stocks and sectors in which the most blue sky has been priced in are always the most impacted.

Hence, in our view, it pays to be very careful of many of the stocks and sectors in the Australian sharemarket referred to above.

In the large-cap space, we are also seeing several sectors today trading at very toppy valuations as investors chase yield almost regardless of the underlying fundamentals. As previously mentioned, if one looks at REITs, for example, many are trading well above their Net Tangible Asset (NTA) base. While we acknowledge that many REITs have solid business models, with many of the attributes we look for in companies such as recurring earnings, in our opinion, many REITs are trading today at very toppy and hard-to-justify valuations.

From the charts below, we can see that the share prices of two well-known REITs are trading at significant premiums to their underlying assets.

Source: FactSet as of 30 Sept 2019

Dexus’ price to NTA rose to 1.35 in the last quarter

Source: FactSet as of 30 Sept 2019

While some may argue that listed REITs should demand a small premium to their NTA given the accessibility to investors, does paying a huge premium above NTA simply because the asset is listed on the exchange make a lot of sense?

This is akin to buying a property on the open market at an auction, listing it on the stock market and getting REIT buyers to pay 30-40% more for it simply because it is listed – does this really make sense?

Much of this comes down to the current ultra-low interest rate environment and the thirst for yield, almost regardless of value. Despite the significant premiums to NTAs that many of these REITs trade on, they remain popular with many investors as they offer a yield of around 4%, which is well above that available in the bond and term deposit markets.

In recent months, we have also seen a strong rally in the banking sector – a sector we have been cautious on for some time. Commonwealth Bank of Australia (CBA) shares recently reached a PE of 17x and above levels seen before the start of the Royal Commission. Once again, as the RBA cuts rates, many investors are flocking into shares like CBA because of the attractive dividend yield of the stock vs cash.

Source: FactSet as of 4 Oct 2019

This big rally in CBA has come despite pressure on CBA’s net interest margins and forward earnings as interest rates fall and credit volumes decline. Meanwhile, the impact of the Royal Commission will also mean extra costs for the banks in areas such as compliance, while the risk of further customer-related remediation charges in the years ahead has been elevated by the Royal Commission’s findings.

As a disciplined value manager, we have been prepared to step back from this hunt mania for what seems to be ‘yield at any cost’. In our opinion, the REIT sector looks highly susceptible to a significant pullback at some stage while we have used the rally in the Banking sector to trim our exposures. We remain very ‘underweight’ and very selective in both these sectors.

So to conclude, which strategy is better for investors?

In summary, while passive strategies will always ensure that an investor captures all the upside when markets are trending higher, their indiscriminate buying based solely on index weights also means that these strategies will end up ultimately holding many overvalued stocks and sectors when markets turn and become more rational.

On the other hand, active managers, such as IML, will go through periods of outperformance and underperformance depending on the market cycle. However, one would expect a well-resourced active manager with a proven process to be in a position to create value for investors vs the index over the longer term as they identify mispriced securities to hold over the long term or avoid in irrationally priced markets.

At IML, we remain disciplined and committed to investing in good quality companies trading on attractive valuations that we believe are well-positioned over the next 3-5 years – and in companies that we believe will do well in more rational markets.

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