The Merchants Trust: Lessons from history- How do long-term investors navigate market bubbles?

There can be an over self-fulfilling prophecy, a virtuous cycle that's spun too fast.

What we tried to do is just stand back from that and say, look, if everyone's going over there, there may be other areas that are being left behind.

It's great to be here, John.

Great to see you. Thank you.

Yeah. Well, I wasn't around for the railway boom, but I was there for the technology bubble. I think it can be sometimes. Sometimes I don't think it is because you see huge genuine changes in society and massive opportunities, and it's hard to know quite how valuable they're going to prove to be. But other times you see enormous investment going in, enormous excitement, perhaps over excitement in share prices. Sometimes excess leverage, cases of people who know nothing about the stock market getting involved. So there are times I think when you can see it in advance. But it is quite tricky to know quite how far enthusiasm for a theme or an idea is going to go.

I think bubbles are a natural part of financial history and the whole capitalist system. Stock markets are wonderful things because they allow a pooling of capital from a very broad range of sources. But the downside of that, the great thing is that new technologies can be funded, society can be changed by, well, if we go back to the 18th century joint stock companies, later canals, 19th century railways, then the information technology bubble, and then of course TMT at the turn of the century. You could even call elements of the great financial crisis the property bubble before then. But what we're seeing there is the flip side of a lot of people being brought together for what starts as a very, very good idea and may create lasting benefits for society. Well, absolutely the railways did in the 19th century, as did the TMT bubble, leaving this fantastic infrastructure for us. But there can be an over self-fulfilling kind of prophecy, a virtuous cycle that's spun too fast, that leads to an overinvestment in that capacity, in that new technology, an overexuberance. And markets are very, very psychological. So of course everyone starts moving in the same direction. People get left behind. They feel the need to move in the same direction and ultimately you get misallocation of capital. I think that almost every bubble looks obvious in hindsight. The really interesting point is whether they look obvious in foresight, in advance. And what's interesting when you read about historical financial bubbles is that most of them do. It's just that the participants can't really quite work out how to get off or where it will actually stop and so they get carried away with a sort of their own momentum and sometimes that means they ended up believing very, very, very optimistic analysis. Other times they're just, they're right about the change, they're wrong about the time frame. I think in the 1840s, in order to justify the investments that were being made in Britain to build the railways, you needed the industry to something like multiply by a factor of 10 in 5 years between 1845 and 1850 and in reality it doubled. Now a doubling industry is very, very exciting but that wasn't enough to generate a good return for the people putting their capital in in 1845. So it's asking almost to predict the future to sense when a bubble is about to happen and to call it, I guess, which is a tough call for frankly anybody. But a simple question to you and Andrew, let me come to you on this, why does it keep happening? You know, bubbles don't just happen occasionally, the history of them...

Right? So that's as simple as that. It's human nature. Even more powerful than greed and fear is wanting to belong, is wanting to be part of, you know, a group that's all saying something reasonably similar. We all feel it in our own lives in different ways. We don't want to stand out too much. Being a value investor is about standing out.

I think the problem is there is so much money chasing these areas that if you don't participate, that money will go elsewhere and somebody else will facilitate that. So I think what we tried to do is just stand back from that and say, look, if everyone's going over there, there may be other areas that are being left behind that might be opportunities where we can have a lot more confidence in the cash we're going to get back, the return we're going to get on investment, the dividends we're going to earn from investing in these companies, the assets we're buying on behalf of shareholders. So, you know, I think one of the great things about having an investment trust like the Merchants Trust is we've got permanent capital from shareholders. We can and a board who will back us to say, 'Okay, I can't really be sure about that area over there, there may be a great opportunity, but in this area here of the stock market, even though it's out of favor, there's some really strong businesses trading at incredibly unusual valuations. And if we buy them at those levels and hold them for four or five years, we should make a very good return and generate a good income stream.' And so we're not necessarily trying to call whether the bubble is right or wrong or whether that theme is right or wrong. We're trying to make money on the things that we understand. And so bubbles are fascinating, but often what they leave behind is opportunities elsewhere. And that was the same in the TMT bubble. There were many what were called old economy companies at the time, if you remember, most of which are still thriving today, which were being offered for well below what they were really worth.

Yes. I think if you focus on what you understand and the cash flow you're buying into and you're buying at a sensible valuation and if that cash flow is sufficiently robust and you know you understand what the businesses do and why they deserve to exist, you can keep doing that and make a good return without having to worry about an area that's actually very, very hard to analyze.