By Bob Homan, Chief Investment Officer, ING
Storytelling plays an important role in our lives. There are even philosophers who say that the ability to tell and transfer stories separates human beings from animals. No wonder that stories, or narratives, are playing an important role in investments as well. In fact, investment analysts and strategists usually spend more time writing and talking about their views, ideas and recommendations than analysing or executing their calls.
The aim of the storyteller in the investment world is usually to explain, interpret, predict, persuade or guard. We all know the stories about which investments will perform well, in which direction the market will move, or whether markets are cheap or expensive. But you can also think of stories with the message to stick to your investment plan, especially when markets are volatile, or stories that try to guard investors against making irrational decisions.
With lots of stories coming around in investing, it may be hard for investors to distinguish good stories from bad stories and fairy tales. So let’s start with a valuable real story that every investment professional needs to tell his or her clients.
Stories to prevent irrational behaviour
Storytelling, with the aim of guarding investors against making irrational decisions, is very important, in my view. It is one of an investment advisor’s most important tasks, as many investors have a strong tendency to let emotions take control. We all know the cycle of investors buying at high price levels, when all is faring well, and selling at low prices, when they’re disillusioned and scared of prices falling even further. In this way, investing is mainly leading to disappointment, and the risk that an investor takes is not being rewarded with a return. The advisor, or actually the whole investment industry, should do everything to avoid investors falling prey to this cycle. They need to explain that price fluctuations and market volatility are part of investing and that there is no escape from the peaks and troughs of the market. Investors need guidance in controlling their emotions of fear and greed. History teaches us that this story is very helpful. What also helps is to engage the investor in the story of your investment decisions if you, as his investment professional, are managing his assets. And that brings me to the next example of a valuable story.
Stories that explain
Substantiating your investment decisions with good stories serves multiple purposes. First, an investor has the right to know the rationale behind your choices. Consequently, he’ll get to know how you think as an investor and if your ideas align with his own thoughts. And if they deviate too much, he may choose to go to another investment manager. Second, writing down the rationale behind a decision has a disciplining effect for a manager. By doing so, you’re forced to weigh all of the opportunities and risks and make a well-considered decision. This storytelling also supports the behavioural aspect mentioned above. If an investor understands more about the companies or the strategy, it’s easier for him to see the silver lining when it’s cloudy. And investing may be even more fun when you’re aware of what you’re investing in. This is certainly the case if you invest in sustainable assets, which may give you the feeling of contributing to a better world. It’s important not to confuse these explaining stories with a worse kind, viz., stories to persuade.
Stories to persuade
It’s not that strange that the investment industry is always looking for new stories. In the end, it’s a commercial environment in which you compete with other players. Returns are the most important factor in attracting customers. An investment fund with a track record of strong returns will attract new clients, but it has its limits. A fund can eventually grow too large and become a victim of its own success—or, being the “smarter” choice, closed to new entrants. So, the industry needs larger-scale stories to persuade clients. They come up with stories about interesting themes and opportunities in which to invest. Which is all fine with me. But it gets worrisome when storytellers become too persuasive and try to make you feel stupid if you’re not willing to invest in their ideas.
Even if you don’t invest at all, you’re not irrational by definition. Stronger than that: When you have enough money to fulfil all of your dreams, why take any risk? Some years ago, asset managers marketed factor investing as the new paradigm. Focusing on factors such as value and small caps was supposed to give you superb returns with less risk, because these stocks were undervalued. The support from academic research made it almost impossible to neglect these investments, especially for professional investors. My advice is: Always keep thinking for yourself. In this case, I’ve always asked myself: How can undervalued stocks give superb returns if they’re still undervalued? You can guess how factor investing has performed in the last few years. I wouldn’t be surprised if the next storybook heroes will be found in illiquid assets, such as private debt and private equity, offered in a liquid solution. So, don’t believe in fairy tales, because if something seems too good to be true, it usually is. And that brings me to the next topic.
The song remains the same.
Equity, as well as bond returns, has been a very good story in the past couple of years, especially with the savings rate close to zero. Will this story be just as good in the forthcoming years? The best predictor for future bond returns is simple: just take the 10-year yield, and you know what to expect. Predicting equity returns is somewhat more difficult. Most investors know that the stock market is not the economy, but certainly this year, the disconnection between equity markets and the real economy is huge. As a consequence, equity-market valuations have skyrocketed. The MSCI World Index’s valuation, measured by the price-to-earnings (PE) ratio, has doubled since 2009 and is back at levels last seen in 2000, which was the highest ever.
Does this make the equity market overpriced and thus unattractive? I don’t think so. Valuations are only one part of the story. Interest rates have plummeted globally in the past few years; in Europe, they’re even negative. It’s no wonder that equities have become expensive. If interest rates fall, the yields of all other asset classes also fall as a consequence. This happens when equity prices rise, thereby adapting to these lower yields. For equities, this means that expected future returns have declined strongly. The expected return of 8 percent, which is often used for both historical and future returns, is no longer justifiable. But at the same time, the story doesn’t change. Just like in the past, you can combine the interest rate and risk premium to calculate the long-term expected equity return. The only difference is that in the past, the interest-rate component was a few percent, but now it’s around zero.
The equity-risk premium is clearly less volatile than the PE ratio. This suggests that the interest rate plays an important role in the PE ratio, while the interest-rate component is excluded from the equity-risk premium. At the moment, the equity-risk premium is around 4 percent, which is historically around average. So if the interest rate is around zero, the equity return is 4 percent. This is, in my view, also what you can expect as an average annual return on your equity investment in, let’s say, the next 10 years.
The graph shows the PE ratio and risk premium for the MSCI All Country World Index. The risk premium is based on the average 10-year bond yields of the United States, Germany and Japan.
Thus, the song remains the same, but unfortunately, the result is somewhat lower. Also, when you look at other measures to estimate long-term equity returns, such as the normalized PE or Shiller PE or the market cap relative to national income, the outcome of long-term expected equity returns is around 4 percent. Of course, that is an average, and you have to take the volatility around that average into account. So the investment story has adapted to the low-yielding world. The story is still good, but the outcome isn’t comparable with the past anymore. I think it’s better to accept this outcome than to chase higher returns by adding risk. And with the warning I gave earlier—keep thinking for yourself—I’ve come to the final topic: Which stocks to buy today? Unsurprisingly, this also has a link with stories.
Investing today: Buy the story, not the fairy tale.
Once again, investing is all about stories, and today even more than ever. On a stock-specific level, companies with compelling stories have performed very well and offer double-digit returns this year. On the other hand, stocks without a story, or should I say with a sad story, have performed poorly. This has been a common phenomenon for several years now, with a climax this year. This is not that strange if you bear in mind that all of the long-term trends on which most stories are based have accelerated as a result of COVID-19. With interest rates near zero, the promise of profits in a faraway future is almost as good as profits now. In the past, companies without a good story or with a sad story had a revival or kept their prices because of their dividends or due to “being cheap”. This doesn’t seem to apply anymore. Good-story stocks this year are, not surprisingly, related to the pandemic—for example, remote work, online shopping and delivery services. Or renewable-energy stocks related to structural themes such as climate change. And although, after we get rid of COVID-19, a temporary move into cheap, sad-story stocks is possible, the good-story stocks will keep the upper hand. If I may give the sad-story companies that are worried about their stock prices a suggestion: Come up with a compelling story. For the down-beaten oil stocks, alternative energy seems like a good opportunity. As far as real estate is concerned, redevelopment, such as a shift from office to residence, reads like a good story. For other sad-story stocks, like those of our own banking sector, I find it harder to come up with a good story. I’m curious if you can make up a good story for financials, apart from hoping for higher interest rates.
Combining all of the above-mentioned stories, here’s mine: Investing in equities will give you lower returns than in the past, but these returns are still relatively attractive. To fully take advantage of these returns, storytelling is very important in order to avoid behavioural traps. The market likes good-story stocks. Keep thinking for yourself, and don’t buy every story!