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Beware the disappointment of great expectations

Siboniso Nxumalo, Chief Investment Officer, Old Mutual Investment Group

“It’s your own expectations that hurt you. Not the world you live in. Whatever happens in the world is real. What you think should happen is unreal. So people are hurt by their expectations. You know, you’re not disappointed by the world, you are disappointed by your own projections.” – Jacque Fresco

“Expectations are the root of all heartache,” declared William Shakespeare.

With the year well underway and investors eagerly anticipate the unfolding of the months ahead, this sentiment holds true in the investment realm too, as we continue to see a barrage of investment outlook views, each professing to unveil the mysteries of the market’s future.

If the past two years has taught us anything, it’s that nothing is certain, not even when buoyed by expectation.

This issue of expectations is particularly relevant currently, particularly when we consider current uncertainty around SA and US market outlooks and the question of the sustainability of the extraordinary performance we saw from the Magnificent Seven tech stocks in the US market last year.

So, instead of reading the current litany of investment outlook notes that have been doing the rounds since the year kicked off, I decided to go back in time and read past outlooks, and then compare them to the actual outcomes.

This was an eye-opening exercise which led me to completely understand why John Kenneth Galbraith said: “The only function of economic forecasting is to make astrology look respectable.”

The future truly is unknown and unknowable. This is demonstrated in the sufficient evidence when looking at past economic and financial outlooks; as investors we simply do not know what the future holds.

Embedded expectations

So where does that leave us as investors, given that investing, by its nature, is an attempt to grow clients’ wealth over the long term, which is dictated by the said unforecastable future?

In 2001 Michael Mauboussin and Alfred Rappaport published a book titled ‘Expectations investing: Reading Stock Prices for Better Returns’.

Coincidentally, the book was authored during one of the biggest stock market bubbles in modern times and was published in September 2001, near the end of one of the largest market corrections in living memory.

The premise of the book is that most investors act as if their goal is to figure out a stock’s value and then compare that value to the price. The book’s approach reverses this mindset.

Investors should start with the only thing we know for sure — the price — and then assess what has to happen to realise an attractive return.

The authors assert that “The most important question in investing is what is discounted, or put slightly differently, what are the expectations embedded in the valuation?”

At its core, expectations investing revolves around the profound idea that stock prices are not arbitrary movements but rather reflections of investors’ anticipations.

However, high expectations wield a double-edged sword, laying the groundwork for potential disappointment and diminished returns. The market often extrapolates current success indefinitely, leading to overvaluation.

When reality falls short of these inflated projections, share prices are left to bear the brunt of investor disillusionment.

Legendary investor Benjamin Graham succinctly captured the essence of market fluctuations tied to expectations when he said, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.”

This voting mechanism—driven by expectations—can spur euphoria and inflated valuations during periods of exuberance, only to be corrected when the weighing machine of true value prevails.

Conversely, low expectations can create fertile ground for astute investors.

Companies facing temporary challenges or undergoing restructuring may witness depressed stock prices, presenting an opportunity for substantial gains when sentiment rebounds.

Balancing expectations with price

Deciphering the intricate link between expectations and share prices requires a nuanced approach.

Analysts and investors alike must not only evaluate a company’s current performance but also assess the sustainability of its growth trajectory.

The ability to discern whether expectations align with reality or veer into overly optimistic territory is a skill that distinguishes successful investors from the crowd.

Let’s go back to 2008, to be more precise to the global financial crisis. A crisis that originated in the United States of America but whose contagion spread globally to a devastating effect.

Back then, while the US market was in free fall, very few were thinking of investing, let alone deploying, clients’ capital in the US market in anticipation that this particular correction would present one of the most attractive investing opportunities for investing in the US market.

Exhibit A below illustrates that late 2008 to 2009 was the perfect buying opportunity of US assets.

The chart illustrates the US return versus the rest of the world. Clearly the place to be since 2008 has been in the US.

Chart 1: US return versus rest of the world

Source: MSCI, Factset

In the midst of market panic and fear the expectations of the US market were extremely low, yet what followed (spurred by a deluge of market stimulus) proved to be exceptionally profitable.

Consider the same chart, but this time I have included the Price Earnings (PE) ratio (as a reflection of market expectations) in the version below.

The US market has been rewarded since 2008 and a material part of those rewards has been driven by underlying fundamentals.

US companies (driven by the dominant tech names) have grown earnings faster than the rest of the world.

A closer look, however, also shows that half the return came from a PE re-rating – so given the multiple relative to the rest of the world, it might be fair to say that the US market (unlike 2008) now carries very high expectations.

Chart 2: US return versus rest of the world

Source: MSCI, Factset

It is worth noting that these lofty expectations rest increasingly on the shoulders of the dominant tech performers that have collectively become known as the “Magnificent Seven” companies.

Expectations are high, they depend on the performance of a few – albeit exceptional – companies.

These lofty expectations do not in any way mean these companies can’t continue to deliver strong growth, but it does mean that should they fall slightly short of the lofty expectations investors could stand to lose a material amount of their capital.

Our investment performance has been lacklustre of late.

Towards the end of 2022, increasingly tighter market conditions were driven by global central banks.

The FED interest rates climbed faster than they had in four decades.

These tight conditions usually herald a market correction with a high probability of a recession.

In anticipation of these market risks we thought it prudent to reduce our client’s exposure to risk assets, position clients in the more defensive names.

We however completely underestimated the resilience of the US market and consumer.

We underestimated the excess savings consumers had gathered during the covid stimulus, which was able to help them weather the tighter market conditions and higher inflation.

So where do we stand today?

South Africa’s troubles are well telegraphed.

Eskom, Transnet, politics, exceedingly high unemployment, anaemic growth… and you can keep adding to the list.

The fact that these issues are being widely reported on implies that the market is familiar with them, thus the “expectations” for South Africa represent all these fears and concerns.

2024 is an election year & recent polls paint a scenario that the ruling party could lose its three-decade majority and thus thrust the country towards national governance by coalition.

Against this anticipation, the reality is that the South African market has fittingly derated by over 40% since 2015.

It now trades at record discounts relative to global and emerging markets, paving the way for rising investment opportunities.

Chart 3: MSCI 12m forward PE

Source: MSCI, Factset

Global markets, at the time of writing, showed that the MSCI ACwi’s PE was 19x with expected EPS growth of 10%, MSCI emerging markets PE is 13x with expected EPS growth 17%, while South Africa is trading at a multiple of 11 for earnings growth of 17%.

Based on this data, global markets seem set up to disappoint under the seemingly enormous weight of lofty expectations – unlike the 2008 scenario – which is once again an indictment on the perils of putting too much emphasis on inflating forecasts at the expense of share prices.

In the world of investing, fortunes are often made not amid euphoria, but in the quiet corners of low expectations, where the seeds of opportunity sprout far from the crowd’s gaze.

For a boy who grew up in a township I really enjoyed English as a subject in high school, more specifically I enjoyed studying Shakespeare.

There is a scene I recall from one of Shakespeare poems which is aptly named “All’s Well That Ends Well” in Act 2 scene 1 Helena ushers the following words translated into modern English) , which I will conclude with.

Often, our expectation fails exactly where we think success most likely to happen, and often we get what we prayed for where hope seems weakest and it seems to make the most sense to despair.

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Siboniso Nxumalo, Chief Investment Officer, Old Mutual Investment Group


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