The 2018 financial year was a difficult one for Forager. You can read all about our year of underperformance in the 2018 performance report. It was also a tough year for value investors in general. Cheap stocks, defined as those trading on low earnings multiples and at low multiples of their book value, have underperformed so-called growth stocks for a number of years now. In the past 12 months, the difference has been stark.
In short, the hot stocks have become hotter and the unloved sectors have remained unloved. Europe and the UK dramatically underperformed the US. And an S&P measure of “value” on the ASX underperformed “growth” by 13.6 percentage points.
Forager has flexible mandates and there is nothing forcing us to own stocks that are superficially cheap. We don’t pursue value investing as a religion. We pursue it because there is an inherent logic to buying businesses that are going to generate high returns on the capital invested over a long period of time. There is nothing in that equation that says a business needs to trade on a low price to book ratio or low price to earnings ratio. In fact, our most successful investments have not featured either of those attributes. Service Stream was loss-making at the time we bought it and hardly has any tangible assets. Lotto24 made its maiden profit in 2017 and today trades at 140 times historical earnings.
Sometimes assets and earnings are a good guide to the future. Other times they are not. The key is to be able to predict a potential stream of cashflows with some degree of accuracy and buy that stream at a price that gives you an adequate return and a margin of safety.
Fundamentals Ignored by Many
Investors in many of the momentum stocks that have performed well in recent years are ignoring both facets of that equation. They are paying enormous prices for businesses where the pathway to profitability is at best difficult to define. And, even where future profitability can be discerned with some confidence, they are accepting prospective returns that will only seem attractive if interest rates stay at current low levels forever. As long as prices keep going up, don’t expect too much rationality to be applied.
There is good news for Forager investors in all of this. Some groups of stocks have become substantially cheaper over the past year despite generally rising markets.
In last year’s performance report we lamented the fact that everything was rising together:
“It might seem strange to complain after the year that was, but we hate markets that ascend smoothly and consistently. We much prefer yin and yang over time, and look forward to a bit more pessimism in future.”
– Forager 2017 Performance Report
Today, relative to the US, European stocks are trading at the lowest valuations in more than a decade.
We have deployed a significant amount of cash in the International Fund and have a particularly prospective list of opportunities. Even in the Forager Australian Shares Fund, where we are still cashing in a number of mature investments, several new names have recently made their way into the portfolio. As long as most of the market remains focused on momentum, there will be plenty more to come.
This is an extract from Forager’s most recent quarterly report.