Stock picking: deciphering what’s signal and what’s noise

Investment markets are forward looking.

Wednesday, June 5th 2024, 4:09PM

by Octagon Asset Management

Public markets (traded daily like equities and fixed interest) absorb all new information today and try and instantly work out what that means for future interest rates, share prices, commodity prices and just about everything else that can be valued. Private markets like art, classic cars and watches move more slowly and there can be large gaps in pricing from one pricing event (usually an auction) to the next. The concept of ‘price discovery’– knowing the value of an asset– is one of the major goals of a well-functioning public market.

To the casual observer, some of these moves seem quite dramatic for assets that are meant to be around forever, like a listed company. In fixed interest there are well telegraphed long term targets around inflation that should steer the market on what to expect. Deciding when to react to these moves is a key skill of active managers – can we separate the important signals from the distracting noise?

Looking back over the past 18 months, we can see some large shifts in sentiment and consensus views, especially last calendar year, and their subsequent impacts on assets prices. The consensus is an average view, meaning there are always opinions counter to this. Holding those non-consensus, or contrarian, views, based on deep expertise and experience is often the way active investment managers like Octagon add value to their client’s portfolios.

At the start of 2023, there was a broad consensus that central banks had raised rates enough to slow demand and more than likely create a recession - an unfortunate but necessary step in bringing inflation back to long term targets. In March 2023 it appeared that this consensus was playing out in the mini-banking crisis triggered by the failure of Silicon Valley Bank (SVB) in the US. Equity markets fell nearly 10% and interest rates fell even more (boosting the return on fixed interest assets). Swift action by global central banks restored faith in the banking sector.

Around the middle of 2023, a resilient US economy with falling inflation saw markets move towards pricing a more benign outcome – slowing inflation and growth, but avoiding a recession. Historically such a benign outcome is rare and both interest rates and equity markets responded positively.

Three months later the market began to question whether the world economy, driven by the US, was too strong and inflation might not fall as far or as fast as needed. Interest rates rose materially based on the expectation that inflation would stay higher for a longer period, and equity markets fell over 10%, as the equity market took the view higher rates must eventually slow consumer demand and cause company profits to fall.

Fast forward another two months and data on inflation confirmed a downwards path; central banks noted that the hiking cycle was probably over, with the next move to be a rate cut, sometime in 2024. Both fixed interest and equity markets rapidly reflected this new “consensus”, delivering excellent investment returns from fixed interest and equities in the December quarter.

As active managers, Octagon looks to formulate long term views on asset valuation – be that for an individual company or fixed interest investment or the overall value of a market. We then use short term market movements away from this long term view to decide whether to buy or sell an investment. But we don’t want to make decisions based on the noise. We only want to react to very strong signals, believing our investors benefit from long term exposure to attractive asset classes.

Over 2023, there was lots of noise – only the really large moves are summarised above – but in many active manager’s eyes, only two clear signals. Having deciphered the ‘signal’ from the noise, we chose not to chase short term wins with the risk of poor outcomes, instead focusing on delivering growth for investors over the long-term.

Tags: Octagon Asset Management