Here are two investment ideas for you. Number one, Bellamy’s Australia. This Tasmanian organic baby food company has a good business and strong brand name in Australia. But the growth is coming from China. China’s burgeoning middle class doesn’t trust home-grown food, with some justification, and it is to the southern hemisphere they turn. Australian and New Zealand foods are perceived as high quality and Chinese consumers are prepared to pay a premium. With a population of more than 1.3 billion and a recent relaxation of the country’s one-child policy, Bellamy’s is almost certain to grow for many years to come.
Investment idea number two: Whitehaven Coal. This barely profitable coal miner has just opened a giant new mine in NSW, adding more than 12 million tonnes of coal per annum to an already oversupplied international market. The industry as a whole is already losing money and with a global shift away from fossil fuels, particularly the dirtiest of them all, analysts are warning of billions of dollars worth of “stranded assets” – decades of developed fuel reserves the world no longer needs.
Made up your mind yet? One or two?
You can probably save yourself the trouble of dusting off the ethical filter. The Chinese consumption growth story is a compelling one, even for those (like me) that have serious concerns over the country’s overall GDP growth. And the global coal industry is in a pickle.
But do you get better investment results buying the Bellamy’s of the world and selling the Whitehaven Coals? You would have done so 18 months ago, but I’m going to suggest that today you are better off doing exactly the opposite.
A compelling narrative is a very powerful thing. Our brains are wired to jump to quick conclusions rather than nut problems out over hours, and a narrative helps us do that. In The Black Swan, Nassim Taleb labelled this phenomenon the “narrative fallacy”.
The narrative fallacy addresses our limited ability to look at sequences of facts without weaving an explanation into them, or, equivalently, forcing a logical link, an arrow of relationship upon them. Explanations bind facts together. They make them all the more easily remembered; they help them make more sense. Where this propensity can go wrong is when it increases our impression of understanding.
Often the link is that because a company has good growth prospects, it has to be a good investment. Which is why a compelling narrative, especially one that is on the front page of the newspaper, can make some stocks very expensive and others very cheap.
On 10 February this year, Whitehaven’s share price hit a low of $0.365, giving it a market capitalisation of $362 million. On that day you could have bought the entire company three times over with the market capitalisation of Bellamy’s Australia (it closed at $11.55 per share, giving it a market capitalisation of $1.1 billion).
Even in this depressed price environment, Whitehaven should generate $1.2 billion of revenue this year. Bellamy’s is expected to generate $260 million. Whitehaven’s balance sheet shows $2.9 billion of net assets, Bellamy’s has $63 million. Even in this most recent reporting season, an annus horribilis for the mining industry, Whitehaven managed a profit, albeit half as much as Bellamy’s.
None of this is to diminish Bellamy’s prospects. The company looks to have a very bright future. Nor to downplay the risks in a highly indebted business like Whitehaven. But, to me at least, three Whitehavens for one Bellamy’s didn’t make a whole lot of sense (the ratio has since changed to 1.5 times with a doubling of the Whitehaven share price).
There is academic evidence* that you can buy the unloved en masse and beat the market. Simple strategies like buying the lowest quartile of stocks ranked by price to earnings or price to book ratios have historically delivered a few percentage points of outperformance.
My preference, however, is to assess each individual situation on its own merits. Some stocks really are cheap for a reason, and we have been able to determine which is which with some degree of success.
But it is important to recognise and resist your brain’s desire to grab hold of a narrative. And remember the words of Horace, reprinted on the first pages of Ben Graham’s seminal Security Analysis:
“Many shall be restored that now are fallen and many shall fall that now are in honor.”
*Search for “value effect definition” on Google or another search engine and you will find many articles on the topic.
This article was published in the Smart Investor section of the AFR on 15th March 2016. You can view the original article here
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