KEY POINTS:
James Montier is an investment strategist with a difference.
Unlike some in the finance sector Montier doesn't always think the stockmarket is cheap and frequently manages to see things from a different perspective.
His recent efforts have included papers arguing that more investment information is worse not better
and that the practice of sharebroking analysts meeting company management is a waste of time. Heretical thoughts in the investment business.
Montier works for Dresdner Kleinwort in London and tends to focus on the behavioural aspects of investing rather than just the numbers. In February, he published an analysis of investment risk that is relevant to Mum and Dad investors.
Montier kicks off by arguing that risk is one of the most misunderstood concepts in finance and, despite the theory which says you measure risk by calculating the standard deviation of returns, insists that one thing risk is not is price volatility.
Real people don't worry when prices rise, it is downside risk, the risk of losing your money that is the real bogeyman for Mum and Dad.
Montier's approach breaks risk down into three different types: business risk, financial risk and valuation risk.
Business risk is defined as the possibility that the business you buy (via owning a share) will go broke or suffer a permanent loss of competitiveness or profitability.
The legendary investor Ben Graham (who taught Warren Buffet) wrote: "Real investment risk is measured not by the per cent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earning power through economic changes or deterioration in management". On this basis Telecom NZ, which has a standard deviation lower than Contact, has proved quite risky as its business model is under threat.
Montier's second category of risk is financial risk - the risk posed by leverage or borrowing.
When the stockmarket falls, all things being equal, companies with lots of debt fall by more than the average. Leverage comes in many forms - one of the favourite ways of speculating on the stockmarket is by buying options over a stock whereby you can own a share for a short period of time for less money than it would cost to actually buy the shares. Options, like debt, tend to magnify the effect of any change in a company's fortunes. Feltex had quite high levels of financial leverage which, when combined with high operational leverage, proved terminal.
Montier calls the last risk category valuation risk and his view is that this is the most important of the three. It is all about a margin of safety - if you buy something that is very cheap you have a reasonable degree of protection should things go wrong. When a lowly valued stock disappoints it tends to marginally underperform the market but when a stock with a high valuation disappoints the results can be ugly. One factor affecting this characteristic is that lowly valued stocks often have higher dividend yields which tend to offer support to the share price when sentiment is bearish.
One might also observe that the world stockmarket with next to no dividends and prices close to historical highs doesn't offer a great margin of safety right now.
Montier's interrelated trinity of risk captures the aspects people should consider when they are thinking about the risk of an investment position.
They certainly seem to be a better guide to risk than the relative price volatility so beloved by risk managers and classical finance.
But there is another way of looking at risk from Mum and Dad's perspective: while investment risk is well documented, people who choose not to invest and keep their money in the bank, or under the bed, are taking on another variant of risk. They run the risk that buying an investment portfolio producing income and growth becomes more expensive.
Investing for retirement is primarily about buying future cashflows. If prices rise and yields fall, the amount of cashflow one gets for one's money declines - which means less to spend in retirement.
The US listed property market provides a good example. Back in 1999 we could buy prime office, retail and international property real estate investment trusts (Reits) which were producing an income of around 8 per cent on cost. In hindsight it was a gift: for every $100,000 invested you got $8000 in income plus more growth than the stockmarket.
The bad news is that since February 1999 the Reit index has risen by 339 per cent so that Mum and Dad buying today only get $3500 of income from their $100,000.
On this definition of risk Mum and Dad with a long-term investment horizon and a medium-risk profile who leave their money in the bank are the real speculators. They are betting that short-dated bond yields are going to stay sufficiently high to sustain their income needs and/or that the property/sharemarket is going to get cheaper. That's a big call, first because since 1900 stockmarkets have got progressively more expensive and second because in New Zealand we have got a negatively sloping yield curve whereby longer-term bonds yield less than short-term ones.
These factors are, of course, part of the reason prudent investment institutions around the world own diversified portfolios.
Incidentally, lower yields are not only a feature of the US property market but part of a long-term worldwide trend - since 1926 the dividend yield of the US stockmarket has fallen from 6.5 per cent to barely 2 per cent today.
Rising stockmarkets are all very well but a side-effect is that the cost of retirement has risen dramatically. In the last 20 years buying risky assets like shares and property has paid off handsomely but the flipside of the Triumph of the Optimists is lower returns in the future.
* Brent Sheather is a Whakatane-based investment adviser.
