The growing popularity of passive and other forms of rule‐based investing, such as index funds, factor‐based investing, and quantitative investing is forcing investors to make some important considerations, according to PenderFund Capital Management’s CIO and Portfolio Manager Felix Narhi.
In fact, as the amount of money going into active vehicles has declined, Narhi has seen stock prices become more correlated and closely linked to organizations' characteristics, like index membership or ETF inclusion.
“As a result, companies’ stock prices have become less correlated to their own fundamentals and cause market distortions,” Narhi said. “However, it is important to keep in mind correlations between similar firms based on their characteristics break down when observed over longer durations. The longer one owns a stock, the more its returns will reflect the underlying economics of the business itself.”
It is common for stock prices to detach from their fundamentals over the short-term, and Narhi thinks that being on the opposite side of the trade from investors less inclined to consider the factors that drive long‐term returns is not necessarily a bad thing. “It is an opportunity for those investors who dare to be different, take a bottom‐up value‐based approach to investing and maintain a long‐term view,” Narhi said.
“A trade only occurs when two parties have contrasting world views, different investment strategies or other motivations for buying and selling a stock. Increasingly, the counterparties are not even human, but rather algorithms that have been programmed by humans to mechanically follow rules‐based trading strategies.”
Assessing valuation risk plays a fundamental role in Narhi’s investment process because, as he puts it: “If an investor over pays for a stock, it doesn’t matter how well the underlying business performs, the returns will likely be mediocre or worse. Prospective long‐term returns for any given stock will largely depend on whether the stock was bought at a discount to its intrinsic value and the underlying economics of the business itself.”
Looking at the current environment, Narhi believes the valuation risk for large caps listed in the S&P500 to be high. He cites a recent report by Goldman Sachs, which found the prolonged bull market across stocks, bonds and credit to have created an environment in which average valuations to be at their highest since 1900.
“Price‐to-value considerations are an important part of our investment process – we will buy a stock when we believe we will obtain more intrinsic value than we are paying for,” Narhi said. “Importantly, as a small and nimble investment firm with flexible mandates, we are not forced to look for our ideas in the S&P500 or the TSX. We are able to search for ideas outside the box. And in the absence of compelling investment ideas, we believe an investor’s default position should be cash.”
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