Are you a renter or an owner? These days an increasing number of people are renting rather than buying a home.
There is a parallel in the stock market between ‘renting’ a share and buying one, with a greater number of short-term traders renting shares, rather than owning them.
It is possible to distinguish between investors who ‘buy’ shares, with an expectation that they will own them for years into the future or into perpetuity, and those who ‘rent’ them, typically for a short period, with the expectation of moving on, into another share, in due course.
Warren Buffett is one of the best-known buyers of shares. He has held many investments for decades, and he often buys whole companies, with no expectation of ever selling them.
At the other end of the spectrum could be a short-term trader, who looks for certain characteristics of a share when investing. He or she may look at characteristics such as valuation, volatility, price momentum and earnings revisions, but may not care about the company’s name, its competitive position, or even the industry it operates in. Such traders could be labelled ‘renters’.
There are some interesting parallels between the housing market and the stock market. If you are buying a house, you want to make sure that it not only meets your needs today but that it will also suit you into the future. You want to be sure that it is structurally sound, in a good area and not vulnerable to changes in the local environment, which could threaten your future utility, such as the construction of a new airport.
When you buy a share, you need to think about its competitive position, the industry environment and any technological or other threats to its long-term future. However, if you are renting a property (or a share), with the expectation of moving on in the near future, these longer term factors are far less critical.
Another issue to think about would be maintenance. For example, property owners would normally prefer a pitched roof, which can last for several decades, rather than a flat roof which may need repair or replacement every ten years. Renters would be less concerned about this, as the costs will not fall to them and they will have moved on in any case. For companies, an owner will be very concerned about the efficiency of the business and all its costs, whereas a renter may be less concerned about this.
One specific aspect of companies worth considering is return on capital employed (ROCE). If you rent a share, this may not seem important. It may be possible to buy a bank share at half its book value and sell it at 0.75x book value, to make a 50% profit, even if the bank earns a very low ROCE.
However, if you are buying a company for the long term, the ROCE becomes far more critical. Each year, a company retains part of its earnings and invests it for the future. Those investments compound their returns at the company’s ROCE.
Over a long period, more and more of the shareholder’s return will come from the ROCE of the business, rather than whether the shareholder bought in at a particularly cheap or expensive price.
In the bank example, if spread over 25 years, say, the 50% revaluation gain would only add about 2% a year, to the low returns the bank generates on its retained earnings. Conversely, if you own a high return business for 25 years and, crucially, it continues to earn a high ROCE, then you should make good money out of it, even if you buy it at a high price and sell for a lower valuation multiple.
So what kind of investor am I? My investments typically fall into two camps. Most would be long-term rentals, to use the property analogy. I look for value. I aim to buy companies below their long-term worth and I am typically looking 3-5 years into the future.
Over that timeframe, I am absolutely focused on the quality of the business, its competitive framework, whether it can maintain or improve its ROCE, and structural or cyclical risks and opportunities. I want to make sure it has a pitched roof, as I may end up “living there” for longer than I originally plan, and I also expect that the next owner will pay more for a house with a pitched roof when I come to sell. However, I don’t expect to own shares for ever. I am prepared to sell, even high quality businesses, if they reach a price that I believe is too high, and from where I would expect investment returns to be disappointing.
I also look for another type of situation, which in the property world could be labelled a development opportunity. In the stock market, these are usually called recovery situations. At the moment, there are many interesting recovery situations, trading on modest valuations.
Recovery situations could include, in property terms, an old, run-down house in a good location, which can be knocked down, rebuilt and sold on for a big profit. Alternatively, they could be decent properties in an up and coming area, where the value will rise in the future.
The parallels in the corporate world are restructuring opportunities; where businesses with valuable physical or intangible assets need to be turned-around, and cyclical recovery situations; where improvements in the economic cycle or the specific industry cycle should lead to superior shareholder returns in due course.
Simon Gergel is manager of the Merchants Trust and chief investment officer for UK equities at Allianz Global Investors.