Investors should look upon overvaluation and bankruptcy as the two biggest threats to their equity portfolios, according to Dan Rasmussen, founder of asset management firm Verdad.
On the first point, Rasmussen warned it is not important what you think about markets, but what you think relative to what is priced into markets.
“Investing is not a game of analysis but meta-analysis,” he said.
For example, he asked which market out of China and the US would you have backed in 1995 had you been armed with the knowledge that the former’s annual GDP growth would dwarf the latter’s over the following decades?
“You would say China, obviously,” he said. “If you know with certainty China’s GDP will grow at 10 per cent a year, why put money in the boring old US, which will grow at around a quarter of that?
“But it turned out China was massively overvalued in 1995 and the US was really cheap – and so, despite the hugely different growth outcomes, you made a lot more money from the US than China over that period.”
As a result, Rasmussen said that it’s always worth taking a step back when it comes to an emerging trend.
“I may believe electric vehicles are going to become more popular than they are today, but what is priced into markets?” he asked.
“Is it that they’ll get a little bit more popular or a lot more popular? Might they become both massively more popular and massively more profitable? What am I betting on? What are the odds?”
Rasmussen said investment is driven by narrative and thematics, but if investors ignore the meta-analysis, they could be missing out on huge gains or suffer heavy losses.
The simplest way to carry out meta-analysis is through working out valuation multiples, such as price-to-book or enterprise value-to-EBITDA (earnings before interest, taxes, depreciation or amortization).
“They will tell you roughly what percentage of a positive or negative narrative is already priced into a stock at the time you buy it,” he said.
However, he conceded that meta-analysis can also be applied to narratives and trends.
“Of course, you could also say, I think the electric vehicles narrative will get more, not less, popular and I want to ride that trend – and that is a reasonable way to invest,” he said.
“There is a lot of evidence for momentum or trend-based investing, so I’m not averse to that – but you have to know what you are doing.”
Rasmussen added that the belief in a trend or theme can become redundant if the mood of the market shifts and other investors rush for the exit. Again, this shows how important it is to understand what is priced into markets before you bet on your own analysis.
He also acknowledged that meta-analysis, like value, has had a bad run since the global financial crisis.
“Let's be honest, what has worked up until March of 2020 has been analysis, not meta-analysis,” he said. “It’s been find whatever the hot thing is and bet on it – basically go long tech and, the bigger and more ‘momo-growth’ the tech company, the better.
“One of my friends calls it ‘the dentist portfolio’ – as in what does your dentist own? Well, he owns Facebook, Amazon, Netflix and Google and he throws in a little Bitcoin and Ether because he heard about that from his buddy.
“The sad thing is, that portfolio has just crushed all of us professional investors and the dentist is looking like a genius for now.”
Scylla and Charybdis
To illustrate the two great threats to an equity portfolio, Rasmussen compared overvaluation and bankruptcy to Scylla and Charybdis, the sea monsters of Homeric mythology.
“Both of these can have the same kind of impact on the stocks you own,” he said. “And just because you haven’t seen one or the other be penalised, it doesn’t mean it’s not a risk.”
Market history has shown that overvaluation is a major threat to portfolios and can damage long-term returns.
“Yet, over the past five or 10 years, overvaluation has been rewarded,” Rasmussen noted. “The more overvaluation risk – and it is risk – that you took, the more money you made.
“So what does that drive people to do? They take even more esoteric overvaluation risks. They buy Dogecoin instead of Bitcoin. They buy Chinese venture capital instead of US venture capital. They trade off – taking higher prices while accepting less revenue, lower profits and less visibility.
“That may have worked in recent years, but it doesn’t mean it is riskless and it’s a big and ever-increasing risk to long-term portfolio success.”
He said that it is a similar story with bankruptcy risk.
“Lots of people are worried about moral hazard,” he concluded. “If we keep lowering rates and deferring the default cycle, are we rewarding risk-taking in leverage?
“Again, for now, that hasn’t been punished, but it doesn’t mean it’s not a very serious risk and just because you have been getting away with it, it doesn’t mean you can stop taking it into account.”