You may have seen the FCA has recently wound back restrictions on cryptocurrency investments for retail clients. Bitcoin remains the most significant of these, and I don’t have an opinion on that, or any of the others. That’s quite a strange start to an opinion piece, but in my defence, consciously not having an opinion is different to being ignorant of the issue.
Let me explain. At work at least, I believe we should stay in our spheres of competence. Mine happens to be within equity analysis. I seek to identify stocks that should be appropriate holdings and then work with investment managers to try and get the right ideas into client portfolios.
The MSCI World index contains over 1,300 stocks, and that only tracks stocks with a value of more than $1.7bn. The same provider’s global small cap index has 3,855 constituents. And these indices only track stocks in developed markets. The potential universe is vast.
We do not have the resource or inclination to have an opinion on thousands of equities. So how do we decide which ones we do cover? We try to keep things simple and have a distinct bias towards certain characteristics. We generally look for businesses that have high margins, strong cash flows and sensible balance sheets. We also hold those that have a track record of stability and good capital allocation in high regard. Not all of these characteristics are entirely demonstrable, and I don’t intend on allocating all my word count to proving these points… but by way of example the average operating margin of our buy list ideas is 27%, compared to US and UK markets, which both average around 17%.
Why does that matter? Margin is an extremely simple metric, but a wonderfully informative one. High margins tell us that products are sold for a large premium to the associated operational costs. Generally, you can only do this if there is something special about that product. Ideally, they are highly bespoke and critical to ongoing operations, as that usually gives a very high degree of operational resilience. High margins also offer financial resilience. All else held equal, a business making a 2% operating margin which takes a 1% hit loses half its profit. One that makes a 50% margin and suffers the same 1% hit loses only 2% of its profits.
Once we find businesses we like, the next thing is to think about valuation. And this is where the sphere of competence argument comes back into play. Give me a nice, profitable business with reliable revenue streams and I can construct an estimate of its current value. This might use a profit or cash flow model to project the future, or the argument could lean on balance sheet metrics. A sceptic would say projecting is just a fancy word for guessing, and as we all know past performance is not a guide to the future. This is true: projections do go wrong at times. But you’ve got a better chance of being in the right ballpark if you’re modelling a reliable business. And, as above, if you are wrong, higher margins and lower leverage reduce the risks.
Which brings me back to crypto. Regulators around the world are increasingly seeing it as a valid asset class, but I still have no credible way of valuing this thing. There are no cash flows, no balance sheet and no track record to speak of. What are we meant to be modelling to determine its value?
One thing I know for sure is that price changes don’t always reflect a change in an asset’s real value. They are just a function of the current sentiment of market participants. If there are more buyers than sellers, the price goes up. If the reverse is true, prices fall. It’s simple supply and demand. This is true for all conventional assets too, i.e. property, bonds, commodities, and equities. In the long term, valuation will prevail, but in the short term, sentiment matters. As cryptocurrencies become more mainstream and accepted, there is certainly a school of thought that this attracts buyers.
But what is the mood music in stock markets? JPMorgan’s CEO Jamie Dimon, who is held in very high regard because of his track record of correct calls on such things recently said he’s worried about a bubble forming around AI. The Bank of England and the IMF have both flagged inflated asset prices as key financial risks.
This is not surprising. We have enjoyed a period of buoyant markets and when prices rise there will always be chatter about overvaluation. Do we think parts of the market are inflated? Yes. Do we believe there are others which offer opportunities? Also yes. Is it possible that a rising tide will continue to lift all boats for at least a while longer? For a third time, yes.
But is it likely that will continue indefinitely? No. Conditions will change at some point and having a proper plan for navigating through choppier waters matters.
It is notoriously difficult to time predictions around stock markets correctly. Prices can remain irrational for far longer than one might reasonably expect – both on the upside and the downside. Therefore, I am not predicting anything about the direction of markets, especially amid the current geopolitical uncertainty. What I will say is that applying reasonable valuation logic to asset allocation, conducting diligent research on funds and thinking carefully about direct stock selection gives the best chance of success over a long time horizon.
In other words, being in the market with a sensible plan beats trying to hop in and out in anticipation of things that are very difficult to anticipate.
George Salmon – Senior Investment Analyst
FPC25545
Hawksmoor Investment Management Limited is authorised and regulated by the Financial Conduct Authority (www.fca.org.uk) with its registered office at 2nd Floor Stratus House, Emperor Way, Exeter Business Park, Exeter, Devon EX1 3QS. This document does not constitute an offer or invitation to any person in respect of the securities or funds described, nor should its content be interpreted as investment or tax advice for which you should consult your independent financial adviser and or accountant. The information and opinions it contains have been compiled or arrived at from sources believed to be reliable at the time and are given in good faith, but no representation is made as to their accuracy, completeness or correctness. The editorial content is the personal opinion of George Salmon, Senior Investment Analyst. Other opinions expressed in this document, whether in general or both on the performance of individual securities and in a wider economic context, represent the views of Hawksmoor at the time of preparation and may be subject to change. Past performance is not a guide to future performance. The value of an investment and any income from it can fall as well as rise as a result of market and currency fluctuations. You may not get back the amount you originally invested. Currency exchange rates may affect the value of investments.
