Emma Wall: Hello and welcome to the Morningstar Investment Conference in Europe. I am Emma Wall and here with me today is Daniel Needham, Chief Investment Officer for Morningstar. Hi, Daniel.
Daniel Needham: Hi, Emma.
Wall: So why is valuation important to be a successful investor?
Needham: I think valuation is important because it has such an impact on the returns that you get from owning asset and asset classes. So, Warren Buffett has got a great quote, 'Price is what you pay and value is what you get.' I think when you think about an asset, normally what you are buying is series of cash flow to be received in the future, and so the return comes from those cash flows.
But if you overpay for those cash flows and what that means is that, you are likely to see much lower returns than what you'd get from the cash flow themselves. So, we think valuation influences individual companies; it influences bonds, individual bonds; it influences asset classes; and so we think of valuation-driven investing is much as a philosophy as an approach.
Wall: We just heard you speak at Morningstar Investment Conference in Europe, and you showed this fantastic graph, which shows that if you take a value approach, you outperform one that is equally weighted. However, you also made the very pertinent point, which is backward looking is, not always an indicator of what happens in the future. If we had to look at the U.S. stock market, last five years have been fantastic, that’s not necessarily what was going to happen in the next five years, though.
Needham: That’s right. So there is two points to your question. The first point is that, when looking back through time to assess what we think fair value is, we know what happened. We have history and hindsight on our side. So you know hindsight makes prediction a lot easier and that's why I guess, forward side is so difficult.
So, on the first point, so you can go back and assess what you should have done, but that's very different to what you would have done because you don't know what happened. And so what we've tried to do within the presentation was look at what somebody could've produced or how one may have invested with the information that they only had at the time and showed that you can actually produce superior returns than a static portfolio. But, again, it's with the benefit of hindsight.
The more important point I think out of that one is, less about the fact that the strategy did better. It's more to take advantage of the opportunity required investors to do things that would have been very difficult at the time, that is, not holding U.S. stocks in the late 90s. Incredibly difficult thing for anybody to do even very experienced equity managers. So that’s one of the key points.
Then the second point is, looking at equities in the last five years, effectively, it would be extrapolating those returns, which is probably the most dangerous behavior that any investor can partake in. That's one of the good things about valuation-driven investing is that, when you've had a good five-year period, the valuation gets high assuming that the returns have outstripped the cash flows, such that the prospective return will actually be lower and that's the case I believe at the moment within the United States, at least based of our guess of the future.
Wall: And you touched on it, then you said that if you follow the value approach, there were 51 months in the run up to the tech bubble bursting, where you would have been – you would have to not hold U.S. equities, which would have probably got you sacked or dumped by their private investors. So what can retail investors do to sort of take those blinkers off and not be herd it with the crowd.
Needham: That’s right. Well, this is one of the – let’s call it, the dirty little secrets of asset management is that individual investors have a huge advantage over institutional investors, and it's something that Warren Buffett calls the institutional imperative and Seth Klarman calls the short-term relative performance derby. Institutional investors have to perform over a short period of time and being different to the crowd and underperforming can mean that you can be fired.
So the research that I did was more to illustrate the fact that – to really take advantage of the strategy in a kind of a, let's call, it theoretical way. You would have had to have been out of U.S. stocks for over 50 months and that would've been being out in about early '96 and not getting back in until 2001, which for an institutional investor is effectively just not possible; for an individual investor, that is possible.
Wall: And looking then at the market now, just using the value concept, where the best opportunities?
Needham: Well, I mean I think that that equities overall are overpriced. But within equities, I think there are places that still look relatively attractive and – but it's fair to say this is not a fantastic investment environment on a prospective basis. I think generally asset prices have risen a lot everywhere; generally bond yields are low' cash rates are zero; arguably that’s being engineered by the central banks. So right now most asset markets are priced to give you low returns. So, I don't think that's actually a brave forecast. I think that’s actually probably a reasonable prediction of what will happen.
So what that means is that investors probably have to hold an unconventional portfolio. So, probably, the opportunities here in European equities or Japanese equities and emerging market equities, and probably in emerging market bonds, and places where many people are may be more concerned. So, effectively, when investors invest for safety, that – the cost of safety often comes at the realisation of low returns. And so, where investors are avoiding, that often means whilst they are risky, you can get a better return if other investors are not willing to buy.
Wall: Daniel, thank you very much.
Needham: Thank you.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
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