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Quotidian Investments Monthly Commentary – October 2016

November 4, 2016

For the third time this year investor’s patience was put to the test in October by yet another period of relentless negativity in global stockmarkets.  From 7thOctober onwards equity markets were marked downwards day after day with just the occasional pause for breath. Whilst the FTSE100 retained a mythical level of serenity, the mid-cap and smaller companies end of the UK market took another hit and negative contagion spread through all the major world markets.

The trigger point was attributed to Theresa May’s keynote speech to the Conservative Party conference following which the term ‘hard Brexit’ was invented. Of course, Mrs May did not coin that phrase nor did her speech make any aggressive reference or intent towards forthcoming negotiations with the EU.  Quite the reverse in fact.  What she actually said was quite benign:

“The Britain we build after Brexit is going to be a global Britain.  Because whilst we are leaving the European Union, we will not leave the continent of Europe.  We will not abandon our friends and allies abroad and we will not retreat from the world”.

However, as is becoming ever more blatant and ever more tedious, the ‘hard Brexit’ phrase was created by those with an axe to grind and vested interests to serve (either commercial or political) in newspapers to sell, television schedules to fill and fear, discord or nuisance to stir up.  As a result, equity markets around the world were rattled.

Simultaneously, and adding fuel to the prevailing negative tone, the third quarter earnings season also began this month and analysts were quick (much too quick) to predict profit declines based on a very small sample of early results.  After just a handful of early reports (from less than 5% of the entire S&P500) had been disappointing Wall Street analysts pressed the panic button and simply extrapolated those early negative releases as a template for the entire earnings season.

As their past performance indicates though, market analysts generally and Wall Street analysts in particular have a near-perfect track record of missing the point.  They continually underestimate actual results and are often way off the mark with their forecasts.  Despite that, they do influence the short-term direction of stock market valuations.

Towards the end of October that assertion on the efficacy of analysts gained credence and support from a surprising quarter.  In a statement on 25thOctober the Governor of the Bank of England, Mark Carney, acknowledged that current market action may be based on ‘mistaken’ analysis of the state of the economy.  Such an admission from one of the leading lights of Project Fear is most welcome and better late than never.

In fairness, corporate management also contributes to the forecasting problem in that it has a tendency to under promise and over deliver and so analyst’s estimates are frequently too pessimistic.  Companies and the analysts who cover them effectively “conspire” to set the bar too low in order that companies can surpass it with positive earnings surprises and so keep shareholders happy.  Equity valuations that have been artificially suppressed then rise again to more realistic levels when actual results turn out to be better than dubious expectations.

In fact, over the past four years actual corporate results have, on average, beaten analysts estimates by 4.3% according to research by FactSet.  And so it has proved again this year as the results season has progressed through October.  As I write, 61% of the S&P500 results have now been released and, of these, 78% have produced positive upside earnings (profits) surprises.  Thus what has been marked down on unjustified low earnings assumptions and self-fulfilling pessimism must come up again on the reality of higher actual results.  There is good reason for optimism that these better than expected earnings will now be reflected in a belated but warranted uplift in share valuations.

Lurking in the background and adding to the October gloom has been the US Presidential election, now entering its finishing straight.  Markets abhor uncertainty and although in recent weeks the contest seems to have swung towards the Democratic party there is still a very real possibility for the result to reflect the opposing views held by very many disaffected Americans living outside the left-wing ‘bien pensant’ and media-savvy bubbles of New York and California.

On 31st October the FTSE 100 closed at 6854.22 (a rise of +0.80% for the month and +11.40% for the 2016 year to date).  However, the mid-cap and small-cap indexes have not done nearly so well thus far this year.  Many of the companies in the Footsie index have a substantial part of their earnings denominated in US dollars or Euros and so have benefited from the depreciation of the pound since the Brexit vote.  This is a currency-driven short-term boost simply because the pound is trading on politics not on the economy at the moment.  By comparison, the Quotidian Fund’s valuation at the same date shows a markdown for the month of October of -10.06% and for the year to date the Fund is now -17.11%.

US capital markets are still considered the most liquid and safest markets on the planet and that is why our portfolio has a major bias towards the American markets. Although the Federal Reserve is likely to raise US interest rates in December (if for no other reason than just to save face) the Fed is not going to tighten nearly as much after that as the market currently seems to think.  In our view it could be another six to nine months into 2017 before they move on rates again.  The fact of the matter is that the global economy is just not strong enough yet to absorb a normal round of monetary tightening at this stage.

On a lighter note we have been amused by the childish posturing of various politicians in Europe who are trying to give the impression to their own people that negotiations with the UK on Brexit will be tough and uncompromising. Of course, neither Merkel nor Hollande will still be in office when the real negotiations are in full swing next year.

The suggestion by one Eurocrat that negotiations will only be held in French was particularly laughable.  I understand that discussions are now taking place to employ Brian Blessed to lead the UK’s negotiating team in order that we at least have someone to shout loudly at them in English!

Finally, I am obliged to two professors at the London Business School for research going back as far as 1955.  It shows that investing in UK smaller companies over the past 60 years has achieved an annual return of 15.4%.  That, of course, is why we also focus a large part of our efforts in the small caps area.

There is a catch, however (and a rather obvious one).  Although this performance track record over such a long period is very attractive (and the sector tends to be overlooked by the majority of investors) the 15.4% return did not, of course, come smoothly year after year. In some years’ smaller companies powered ahead by 30% or even 40% but in several other individual years between 1955 and the present day they also fell by similar amounts.  As we all appreciate, volatility is inherent in equity market investment; it’s the overall medium to long result that counts.

Falls of this magnitude so often cause private investors holding UK small caps to make the mistake of giving up in fear, crystallising their 30-50% loss and then never investing in the stockmarket again.  This is a much more costly error than enduring periods of volatility.

We invest in good, reliable companies and hold them through these market cycles (often building up our holdings at attractive low prices).  We are long on stoicism and strongly believe in the proven benefits of riding out periods of volatility and times when temporarily muted valuations have been based on institutional group-think and over-pessimistic analysis.  Patience is particularly relevant in this current period of lacklustre investment returns.

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