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Thursday, May 28, 2015 - 02:16
In the eye of…

The sharp recent slide in the oil price and the accompanying fall in global oil producer share prices have served a sharp reminder of the pervasive ‘assumption risk’ that all investors are constantly bearing. The painfully memorable demise of African Bank, as well as the fall in the iron ore price (both events also occurring in the second half of 2014), are additional reminders of how often it can be a single factor or input that will disproportionately affect an investment outcome. However, Perpetua Investment Managers notes that a key difference between the slides in the iron ore price compared with the oil price was that the market was expecting a correction in the iron ore price to occur, while on the other hand, it was expecting the oil price to remain elevated.

Comments Delphine Govender, chief investment officer at Perpetua Asset Management, “This central aspect in investing, being that of the market’s expectations (based on specific assumptions on a case-by-case basis), which is ultimately manifested in investor sentiment and behaviour, is a topic Perpetua continually finds intriguing. Within South African markets, the company believes the investor sentiment phenomenon is undoubtedly at play and is partly a reason why Perpetua sees an opportunity within the resource sector. The market consensus view is different to Perpetua’s view.”
However, as the majority of the market prefers to remain infatuated with the beauty of what they believe are quality industrial companies, whose prices have re-rated sharply in the past three to five years, and because of this, consensus opinion is that they continue to expect these shares to outperform.
“To understand investor sentiment, one must also understand why changes in sentiment occur,” she says.
The ‘conventional wisdom’ of the herd changes largely when the herd expects the conventional wisdom to adjust, not when the fundamentals suggest it should.
• How is it then that the market has reacted as negatively to the decline in the iron ore price, given this was largely expected and therefore should have already been priced in?
• Or how is it that the market has reacted so negatively to the (largely unexpected) decline in the oil price, notwithstanding the strong arguments for a higher long-term oil price?

Famed economist and theorist, John Maynard Keyes, offered perhaps the earliest explanation in 1936 for investor behaviour in an analogy comparing this behaviour to the judging at a beauty contest. He said: “It is not a case of choosing those [faces] that, to the best of one's judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees."
“Changes in investor sentiment in 2014 were in Perpetua’s opinion driven not solely by a deeper assessment of accompanying and relevant fundamentals, but to a greater extent what investors thought other investors were thinking.”
So, what is driving current investor sentiment and behaviour? Govender says the relative pricing of industrial shares, compared with resource shares and with financial shares reveals the extreme disparity between the relative pricing of these three key sectors (one of the widest in close to 60 years).
“On one end of the scale, the market is evidently willing to pay ever more for quality/sustainable growth industrial businesses that arguably might have structural advantages. However, the extreme market optimism is as much fuelled by the belief that other investors will continue to pay up for these kinds of businesses and therefore the risk of over-estimating the growth rate or the ability of a quality company’s moat to persist, heightens even further.”
On the other end of the scale, particularly with respect to resource companies, where news flow has been bleak and the outlook apparently opaque at best, market sentiment is even worse than the fundamentals imply it should be. Investors such as Perpetua, which singularly pursue value discovery, have uncovered clear investment opportunities at current prices within these neglected sectors. The company knows too though, that as the market obsesses about price discovery in the short term, it will be value discovery (what a company is fundamentally worth) that will ultimately prevail.
In his November 2001 note titled “You can’t Predict. You can Prepare”, Howard Marks writes: “Success carries with itself the seeds of failure and failure the seeds of success.”
Having gone through a period of success in the earlier part of the decade, resource companies invested heavily into feeding the dragon, and therefore sowed the seeds to current failure. Perpetua is now of the view that the efforts of the sector and the individual efforts of some of the operators are sowing the seeds of future recovery and success. Paradoxically, the investment company thinks that in some cases the beauty of some industrial shares has been borrowed from future returns.

Copyright © Insurance Times and Investments® Vol:28.5 1st May, 2015
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