Resources – So high it calls for an oxygen mask!

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By Adrian Clayton

Regular readers of the Alphen Angle will know that we have written many times before on pockets of market mania, our observations go back as far as 1999 and have included IT bubbles, developed market bubbles, emerging market bubbles, undervalued rand scenarios being driven by a mania for offshore investments, small cap bubbles, preference share obsessions and now, for the latest, the commodity feeding frenzy – possibly not yet a bubble!

Many of these historic euphoric episodes, that in some cases evolved into bubbles, were identified by various market watchers. The most likely reason why they were noticed is that they all contained common characteristics and today we will reflect on some of these. What can usually be observed is:

Very powerful and accelerating price trends for “in-vogue” companies, sectors or asset classes.
To understand this, consider the performance of the Nasdaq leading up to its apex in March 2000. In 1996 the index was at 1 000 and by year end it was up 28%; in 1997 it gained 21%, in 1998 39%, in 1999 86% and for the first three months of 2000, about 18% equating to an annualized return for that year of 118% – which did not materialize as the market began to collapse. The Nasdaq reached over 5 000 by early March 2000 and at current levels of about 2 270 it is at levels last seen in 1998 (excluding touching 2 270 as it fell off its highs).

Share or asset valuations that increasingly diverge from current reality and begin to rely more and more on future optimistic outcomes which are completely uncertain.
Meteoric share price valuations need real “believers” or converts that blindly accept predictions of a euphoric future. At the time, these people are often referred to as ”visionaries”.

To understand this point, think back to the newly listed IT companies in the late 1990’s. These were companies with super confident yuppies boasting futuristic ideas and riddled with untested management teams that felt the world was their oyster. New age teachers tried to convince the market that technology would be the ultimate driver of economic activity in the future. For those buying such stocks at the high prices at the time, it demanded a blind faith in this “secular” thesis.

As it turned out, resource companies, the very part of the market that was shunned by asset managers and investors in the late 1990’s and regarded as “old world”, became the most important investment theme for portfolio managers as we entered the “new world” of emerging industrialization and hip “new age” IT stocks have been completely commoditized and were proven to be bum investments.

Managers that are not index huggers but utilize a fundamental investment research approach are made to look like idiots by trending markets.
The most notable South African example of this was the terrible underperformance of Allan Gray in the mid and late 1990’s when they refused to participate in the IT and financial sector listing bonanza. This became critical to the local Cape-based asset manager to the point where asset outflows were seriously affecting their businesses viability, but as we now all know, this fundamentalist investment approach proved exactly the correct call and those who stuck with their Allan Gray investments have been well rewarded for their loyalty.

At present we are seeing an enlarging group of dissident managers that refuse to partake in the latest commodity mania and, as was the case with Allan Gray and IT in the 1990’s, these managers are currently being marginalized. Time will surely tell if they will be right.

The concept of “risk” and the way it is defined in the industry is distorted during periods of market mania.
One would think that, logically, risk should be all about preventing clients from losing money and should also be all about ensuring clients don’t under-perform over the long-term.

Unfortunately, this normal and logical understanding of risk no longer applies when markets trend, and instead risk is perceived as underperforming competitors that are willing to “go with the flow”, willing to take on huge risk irrespective of the consequences. One needs only look at which managers presently hold large resource exposures to see where the hot money is flowing. Asking such a manager to justify fundamentally why commodity exposure is held is most likely to be met with a response that little “bottom-up” justification can be offered, it is solely a top-down macro call. This is no different to a simple trend prediction!

Asset managers stop making calls based on research as they struggle to deal with waves of criticism that besiege their everyday activities.
It becomes a case of investors and the press and even other industry players incessantly insisting on one course of action that defies everything the manager has learned over time. What emerges is that managers who are under pressure from (short-term orientated investors and advisors) begin to capitulate, and inevitably decide to swim with the tide and ignore common sense.

New theories are birthed
During boom times, it is quite common for tried and tested ways of valuing a company or asset class in order to understand its intrinsic value or “real worth” to be neglected. Instead, radical “new“ methods of valuing companies that are “in vogue“ become common place.

A trending or euphoric market generally continues for much longer than expected, captures more capital than ever expected and bursts or implodes in a much more ferocious and damaging fashion than any of the trending-supporters could have predicted
We cannot think of any market bubble that has ended without creating much more damage and pain than anyone had ever predicted.

Asset managers who capitulate are the ultimate losers.
Those managers that finally capitulate and, instead of educating investors, decide to appease them, more often than not end up with their reputations in tatters.

This point rests on the fact that trends change as sentimentality shifts, but fundamental research usually leads to sound investment decisions.

In conclusion, the resource surge might or might not be a bubble. This we usually only establish after the event, and quite unpleasantly if it bursts. What is clear is that many market participants are ignoring most of the JSE and focusing their attention (and investment monies) into a handful of resource companies. This is an untenable situation and holistically such a microscopic interest at the expense of everything else usually ends in tears.

Source: Adrian Clayton, Alphen Asset Management, March 5, 2008.

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