INTRODUCTION

In my January 2012 edition of From the Desk of the CIO (Strategy Thoughts), The lure of fundamentals, or what value is value?, I agreed that valuation is a useful tool for investors, but only over very very long time periods, and only when it is used to establish the secular position of any market or asset class. Long-term trend changes from a secular bull market into a secular bear market occur at incredibly high historically valuations; similarly extremely low valuations are seen at opposite reversals, which occur only once every decade or two. Unfortunately, most investors seek the comfort provided by the precision of a valuation measure over far too short and inappropriate time frames. In From the Desk of the CIO (Strategy Thoughts) I attempted to highlight the futility of relying upon stock market valuations to discern where markets may move over time frames of possibly less than ve years and certainly less than ten years. Yet the most frequently heard comment as to why a market or stock is attractive now, for the next week, month, quarter or even year, is usually its valuation.

What is more remarkable is the e ort deployed establishing the estimates of earnings that are then used to establish a measure of valuation, which in turn is employed as a rationalisation of why a particular investment decision should be made.

Movements in markets of less than ve or ten years (cyclical moves) are not driven by fundamental factors such as valuations, as I wrote in From the Desk of the CIO (Strategy Thoughts):

Cyclical moves are driven by behavioural factors that manifest themselves in observable changes in investor mood and psychology. These factors are hard to measure but even a poorly measured sentiment shift is more instructive than a very accurately measured P/E ratio.

This has long been known. However, the di culty in measuring mood or psychology has resulted in the majority of investors succumbing to the comfort of several behavioural biases, particularly herding. The result is that the majority of investment commentary revolves around economic forecasts, earnings forecasts and so valuations. It is investor psychology, sentiment, mood and particularly expectations that drive cyclical moves in markets.

The extract below is from the abstract of an article by Leonard Zacks in the Financial Analysts Journal over thirty years ago, March April 1979, titled EPS Forecasts Accuracy Is Not Enough.

Many investors select stocks on the basis of companies earnings prospects. Since an e cient market will already have impounded these prospects in share prices, such investors will not outperform the market. The authors derived forecast earnings per share growth for 1976 and actual EPS growth for 260 of the S&P companies for which the IBES service provides institutional earnings forecasts. Using the di erence as a surrogate for change in the earnings forecast, they compared price performance over this period with both the magnitude of the original EPS growth forecast and the magnitude of the change. They found no relation between forecast EPS growth and actual price movement. On the other hand, portfolios of companies whose consensus forecasts underestimated actual earnings growth outperformed the market on the average, whereas portfolios of companies whose consensus forecasts overestimated actual earnings growth underperformed the market. These results suggest that, if the objective of stock selection is achieving abnormal portfolio returns, selection must be based on anticipating changes in the consensus, rather than changes in earnings.

From the Desk of the CIO, ANZ PrivateSTRATEGY THOUGHTS AND OBSERVATIONS: January 2012

Accuracy is not enough.Anticipating surprises could be!

Kevin ArmstrongChief Investment O cer

The paper illustrates that it is not the level of earnings that matters; it is how earnings compare with expectations. The same can be said of economic forecasting. The most perfect forecast of every aspect of any economy is only useful to an investor if that investor has some perception of how that perfect forecast compares with consensus expectations.

Markets dont reverse and start to fall because earnings suddenly start to fall. Markets reverse because eventually earnings fail to exceed what by then have become overly optimistic and extravagant expectations. Similarly, markets dont peak because economic numbers start to deteriorate. Markets peak amid great newsjust not as great as the majority hope. And markets bottom amid lousy newsjust not as bad as has by then become generally feared.

This behaviour has been seen many times at the cyclical turning points, as we have seen a number of times over the last decade.

It is clear that attempting to do the same thing as the vast majority do, only better (i.e., forecasting earnings, measuring valuations and pin pointing the economic future) not only borders on extreme arrogance, but is also of no value whatsoever unless one has an insight and an appreciation of what the majority are expecting. Successful investing does not come from being a more accurate forecaster of earnings or the economy; and it certainly does not come from doing the same thing as everyone else, no matter how comfortable it feels. It does come from stepping out from the herd, being uncomfortable and attempting to anticipate surprises.

Now I know that last phrase is an oxymoronby de nition one cant anticipate a surprise, (it wouldnt be a surprise if you could!). But successful investors must continually attempt to identify in which direction the biggest surprises to the most people may lie and position their portfolio to bene t from that positive or negative surprise. This is obviously uncomfortable and can leave an investor looking quite di erent from the rest of the market place for some time. However, it is the only way superior results can be achieved. Being the same as everyone else does provide comfort, minimises any risk of regret and is perhaps understandable in the world of institutional fund managers. It is almost certain, however, to fail to deliver the return that the underlying investor seeks.

James Montier, in his Global Equity Strategy paper, CAPM is CRAP (or The Dead Parrot Lives!) from 16 January 2007, discussed the obsessive focus amongst institutional fund managers of relative performance and tracking error. He quoted two legends of the investing industry. Firstly, Bob Kirby of the Capital Group, who wrote in a 1976 paper:

Performance measurement is one of those basically good ideas that somehow got totally out of control. In many cases, the intense application of performance measurement techniques has actually served to impede the purpose it is supposed to servenamely the achievement of a satisfactory rate of return on invested capital.

He went on to lament the increasing infatuation with shorter and shorter-term performance, a trend that has only become more obvious in the thirty- ve years since!

In addition to short-termism, Montier also quoted Ben Graham and his concern regarding the increasing obsession with relative performance rather than a longer-term satisfactory return. At a conference after hearing a fund manager state that if the market collapses and my funds collapse less thats ok with me. Ive done my job., Graham responded:

I was shocked by what I heard at this meeting. I could not comprehend how the management of money by institutions had degenerated from the standpoint of sound investment to this rat race of trying to get the highest possible return in the shortest period of time. Those men gave me the impression of being prisoners to their operations rather than controlling them.

Investors who are obsessed with relative performance naturally succumb to herding, they dont want to be too di erent from the rest, unfortunately the result will generally be disappointing. Perhaps institutional fund managers dont feel that disappointment if their tracking errors are low, but the disappointment will be felt by their underlying investors.

Investment success comes from continually questioning what seems comfortable and appreciating that it is everyone involved in a market that make a marketit is their collected expectations that are e ciently and perfectly re ected in that market at any moment. But the expected doesnt drive markets, it is surprises that do.

Perfectly forecasting a GDP number or corporate earnings number will not tell you how a market will move; successfully anticipating where the surprise to the majority lies will.

I continue to believe, as I have for the last seven months, that surprises in the current market are most likely to be disappointments, and that the rallies that have been seen in equity markets with each successive x out of Europe are evidence of the hope to which investors continue to cling. The slide down the slope of hope doesnt end until such hopes have evaporated.

Finally, in the last two editions of From the Desk of the CIO (Strategy Thoughts), I have commented that the current period of market activity has many similarities to that endured through May, June and July of 2008. This similarity extends beyond just the share market. Gold peaked in late August this year, four months after the S&P500 had peaked, and by the time gold had rolled over the share market was already down almost 20 per cent. Three and a half years ago, gold rolled over and began what would turn out to be a 30 per cent bear market. This peak came six months after the S&P500 had peaked and by the time gold hit its high the share market was already down about 20 per cent. History never repeats itself exactly, but it does provide us with rhymes or echoes, which can be foolish to ignore. Many have forgotten that in 2008 gold was not a safe haven; it may well prove to be disappointing in the next cyclical downdraught.

ABOUT THIS PUBLICATION: We o er ANZ Private & Trustees clients a compilation of informative literature showcasing our intellectual capital, insights and forward-thinking perspectives in support of clients wealth management decisions.

This paper, written by Kevin Armstrong, Chair of ANZ Privates Regional Investment Council (RIC), contains the authors thoughts and views and is designed to generate debate and discussion at the RIC meeting each month.

ABOUT THE AUTHOR: Kevin is the ANZ Private Regional Chief Investment O cer (CIO) and the Chairman of ANZ Privates Regional Investment Council.

A graduate of Magdalen College, Oxford University, with a Masters in Physics, Kevin joined Merrill Lynch in London on the U.S. Institutional Sales Desk in 1981. Kevin spent 16 years with Merrill Lynch, eventually running their U.S. institutional equity business throughout Europe. Kevin became CIO for the National Bank Private Banking in New Zealand in 2001 and subsequently, when ANZ acquired National Bank, he became the CIO of ANZ Private.

Kevin writes extensively on investment markets globally and regularly provides investment commentary in a variety of media.

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1ASX October 2010 2APBC Benchmarking Survey (September 2010)