The Curse of the Benchmark

So Xstrata shares have fallen below £6, down from a peak of just under £45 barely 5 months ago. Having been wrong for so long on commodities (or rather seen the bubble carry on going) I do at least derive some satisfaction from having got something right in this market, even if some my firm’s funds have been burnt badly with the recent commodities blow up.

What I find most interesting about this recent price action is not so much the speed of the collapse but the size of it. With the Xstrata shares at less than £6, one has to ask the question, how could the bubble possibly have gone on for so long? Unless the market is currently seriously mispricing the shares (which is certainly a possibility which I’m currently investigating), it defies comprehension that people could have genuinely believed the shares were undervalued at £45.

Another interesting question is whether or not I was actually correct to be bearish. And here it depends entirely on your timeframe. When I interviewed for my current job back in June 2006 (it feels like a lifetime ago now!), one of the arguments I made was that the current commodities boom was an investment fad, based on a false extrapolation of Chinese growth rates out into perpetuity. For sure I was not denying that China was going to carry on growing. Rather I was suggesting that it would become more efficient in its use of inputs and that supply would respond to the growing demand. After all, over the very long run (past 250 years), commodity prices have not risen at all in real terms, so why should we suddenly expect this to change?

While this now appears to have been the correct position to take, if a little early, the fact remains that had I actually been in a position to implement my belief within a portfolio, the results career-wise would have surely been catastrophic. Lets imagine a parallel universe where, upon joining the firm, I was immediately given a high profile portfolio to run. The previous manager had been massively bullish mining and commodities. Performance was fantastic and the clients were all happy.

So I immediately sell down all the mining and commodity related positions, only to see, to my horror, that Xstrata – the previous manager’s biggest overweight position - more than double in value again! Performance falls apart and clients start leave. Then toward the end of 2007 the CIO (who is also a commodities bull) gives me a stern warning that such underperformance will not be tolerated for much longer. But being a value investor I argue my case and stick to my guns. Finally mid way through 2008, management have had enough and I get the boot. Assets under management have collapsed due to poor performance, so my services are no longer required. Of course the next week the collapse begins, but it is too late.

This is what I call “the curse of the benchmark”. You can be absolutely right about something fundamentally, but if you are too early then the benchmark will kill you. I really dislike this side of professional fund management. I do not think that a fund manager should be obliged to hold stocks that he or she thinks are overvalued just because they make up a big chunk of the benchmark. If I would not buy something with my own money then I should not buy it for my investors. Thankfully for me this is only a hypothetical story, but for many it has no doubt been a reality.