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‘Market volatility and the proverbial gift horse’

Horses' gums recede as they age making their teeth appear longer, hence the term, "long in the tooth”. Inspecting the teeth of a horse given as a gift was therefore considered ungrateful. It would mean that recipient is trying to see if the horse is old and therefore undesirable, or young and more desirable. Hence the meaning of the phrase, “never look a gift horse in the mouth” is not to question a gift too closely. I wonder whether this old English proverb is pertinent to the current stock market volatility.

I have always told myself to respect stock market price action so the significant increase in market volatility over the last few weeks has been a reminder that successful investing is rarely pain free. I have also been struck by the absence of a coherent narrative to the sell-off: the correction in the US has focused on fears over the valuations of some high growth technology and biotech companies; whereas in Europe - by contrast - domestic value stocks have been most vulnerable to profit taking. I have never believed, however, that the market is always correct or rational, at least in the short term.

Our investment process is based on the belief that earnings revisions – not growth or value - move share prices. If we can find stocks which over the next few years will earn considerably more than analysts are forecasting, then the market value of those companies will almost certainly increase. Conversely, stock prices of companies which will earn less than the market is forecasting will, more often than not, move down. Valuations do matter, but only when using the correct profit forecast and the forecast profit number is nearly always wrong. Therefore rather than take the consensus profit number and determine an appropriate valuation, we think we add more value assessing the validity of earnings forecasts. Moreover, because of our belief that earnings revisions are the prime factor behind stock returns, we always want to construct portfolios with stocks with superior earnings momentum. This is not a factor risk, in our opinion, that it is ever desirable to vary our exposure to or diversify away.

When share prices begin the move in the opposite direction to earnings revisions our process stops working. At this point we cannot simply reinvent ourselves as mean-reversion day traders. We have our investment religion. Adherence to a tried and tested process in stock selection is what differentiates the professional investor from a monkey throwing darts. We also believe that our “earnings momentum” investment process works more consistently than its “growth” or “value” alternatives. But it does not always work. When it doesn’t work, rather than invalidate the process, this is the irrational moment when the market offers an abnormal opportunity. In my experience, markets where there is a profound disconnect between corporate earnings revisions and share prices do not endure for long.

Share prices will of course anticipate earnings revisions before they are confirmed by the company or analysts covering the stock, notably at macro-economic inflection points, which can befuddle the pure stock analyst. But recent macro-economic momentum in Europe, particularly in the periphery, continues to be robust. If the ECB’s recent comments on potential for unconventional monetary policy have any validity, monetary policy is about to become more – rather than less – accommodative.  Events in the Ukraine would seem like another red herring. Economic dependence on a rogue Russian state is mutual, in fact almost certainly a bigger issue for Russia, given that gas is difficult to store and her pipelines point west.  Despite the tendency of the investment world to over-estimate the wisdom of perpetually bearish commentators, “black-swan” events, which would justify elevated risk premiums, are by their very nature uncommon.

Our conviction in the fundamental narratives behind our positioning remains very much intact. As economic growth returns to the continent, we continue to be genuinely excited by the potential for a multi-year recovery in domestic European corporate profits, particularly in peripheral economies, from the current depressed levels. We are also genuinely impressed by the refreshing focus on shareholder value (cost cutting, allocation of capital) from the management in many of the companies that have survived the six year economic crisis in peripheral Europe. We will go on record as saying that we are closer to the beginning than the end of a bull market in on the bourses of the countries formally known as the “PIIGS”.

Although it always feels more comfortable buying an asset that never seems to go down in price, the best investment opportunities come at moments when investors fold weak hands for no reason other than stocks are cheaper or there are unrealistic expectations of performance versus volatility. So whilst I question the legitimacy of my analysis when stocks appear to behave in a manner I find irrational, I have come to accept that there are also times when the market simply offers investors the gift of buying good stocks at cheaper prices. Those looking for a rational explanation behind the recent volatility risk looking the proverbial gift horse in the mouth.

Barry Norris
Argonaut Capital
April 2014

This document has been provided for informational purposes only solely for Professional Clients as defined by the FCA and does not constitute investment advice. Information and opinions expressed in this material are subject to change without notice and to the best of Argonauts knowledge are correct at the date of producing the document. They have been obtained or derived from sources believed by Argonaut Capital Partners LLP to be reliable but Argonaut Capital Partners LLP make no representation as to their accuracy or completeness. The writer of this piece may have conflicts of interest as may have personal holdings in the companies mentioned.