Investment philosophy during sell-offs

This article is authored by Matthew Campbell CFA, a Director in our Discretionary Portfolio Management team.

For investors, the modern-day interconnectivity of global markets and economies, means that current events in Eastern Europe have ramifications across the world. Moreover, the escalation in Ukraine adds another (albeit more tragic) layer of uncertainty and volatility, after an already-bumpy start to 2022.

At the time of writing (25 February 2022) financial markets have endured their first period of weakness in almost two years since COVID-19 roiled the global economy in early 2020. We understand that for our clients, many of whom invest a substantial proportion of their wealth with us, any such period of weakness may be cause for concern and discomfort.

Whenever there is market volatility, the most important thing to grasp is that volatility, particularly in riskier asset classes such as equities or high yield bonds, is in no way out of the ordinary. In fact, the broad multi-decade uptrend in markets has been punctuated by regular drawdowns of 10% or more, which generally tend to occur once every 18-24 months.

Each of these corrections had a different catalyst and while these often felt profound at that specific point in time, it is a truism that global companies and economies learn to adapt to their new circumstances (if the catalysts of these events had any lasting impact at all).

The predictable unpredictability of life

Taking the past decade as a relatively short case study, and we have seen significant negative market reactions to COVID-19 (and new variants thereof), US election jitters and the storming of the Capitol, US-China trade wars, several inversions of the yield curve, changes in monetary policy (most notably in recent months and in late 2018), a wage inflation scare in early 2018, Brexit, the mid-2015 ETF flash crash, the Chinese yuan devaluation, the downing of Malaysia Airlines flight 17 and subsequent imposition of sanctions on Russia, geopolitical tensions regarding Crimea and various iterations of the European debt crisis.

This is clearly a long list of high profile events and it is important to note two things:

1. These developments all have a tendency to be highly unpredictable in nature; and
2. The MSCI All Country World Index posted a return of 224% over that 10-year period (equivalent to an average 12.47% per annum) despite these events having happened.

The point we are trying to make here is that while each of these events feels profound at the time, there is a larger force at play which is the gradual improvement in wealth, health, productivity and technological advancement that gradually but unrelentingly marched forward over time.  

Furthermore, these advancements tend to be a constant feature of the progress of society and often tick along in a non-newsworthy fashion, month by month, year by year, unlike the negative events which are both less predictable and also tend to feature more heavily in the news. In turn, we believe that by focusing on important yet gradual developments over the long term, then we have a much better chance of delivering meaningful investment performance (than by focusing on near-term market volatility).

In our opinion, investors in general allow near-term news flow to clutter their investment thinking and in doing so miss this bigger picture – the core of our philosophy is to de-emphasize current news flow and to keep our main focus on our long-term goals.

How do we view markets?

As we alluded to above, we do not consider it a worthwhile exercise to view financial markets through a short-term lens. To do so would result in us trying to gain an edge in timing markets against unpredictable events and news flow, where our ability to add value to your portfolio is very minimal, not least because new information is discounted in asset prices extremely quickly and investors have appeared to become much more short-term focused over time.

By instead focusing on the long-term, what we aim to achieve is a decluttering of the mind to focus on questions we think we have the best chance of finding the right answer to, and which may have a much bigger bearing on long-term investment performance. In other words, we want to understand things such as:

• What type of companies are best placed to create shareholder wealth in the long term?
• What parts of the economy are likely to offer the most investment opportunity?
• What types of assets provide the best diversification in portfolios?
• Will central bankers raise rates by 25 or 50bps at the next meeting?
• What is the election of a certain political party going to mean for the economy or certain industries?
• Where will geopolitical developments next flare up?

What does this mean in practice?

Ideally, investors would build portfolios which offer both durability in terms of the securities owned, and flexibility in terms of ability to make adjustments to asset allocation as unexpected events develop.

In practice this results in multi-asset portfolios being structured in a ‘barbell’ fashion which means that within the higher risk⁄more volatile parts of a portfolio, investors are running a modest overweight to equity markets but underweights to high yield bonds, investment grade credit, certain types of liquid alternatives strategies and commodities (ex. gold), all of which have a tendency to correlate positively with equities. On the less risky⁄less volatile side of a portfolio, it typically involves running an overweight to cash, government bonds and gold.

Equities really form the core of the long-term capital appreciation within multi-asset portfolios by allowing investors to benefit from the growth of a business over time. Furthermore, the heterogeneous nature of the asset class means that out of the thousands of equities one could reasonably invest in, one can narrow this down to a small number of names that offer a better potential outcome than the average company.

That said, while equities tend to offer the prospect of higher long-term returns, they do so at the cost of higher short-term volatility. This is where the diversifying asset classes such as cash, government bonds and gold come in. The reason for using a blend of these risk- mitigating asset classes is that they can each behave differently in different market environments, and therefore there is value in some diversification across these diversifiers. We believe that not only does this assist with offering a broader ‘airbag’ against short-term market weakness, it also means that there is a broader store of value to lean upon if we feel the need to raise funds to opportunistically buy riskier assets.

Quant. vs. qual. dynamics

The portfolio’s security selection also complements the barbell stance and makes a profound difference to the way in which portfolios are run given the focus on owning equity in high-quality businesses.

Quantitatively, we define high-quality companies as those able to demonstrate high rates of cash return on capital, that ideally have a significant runway to reinvest those cash flows at similar or higher rates of return on capital and provide the basic building blocks of long-term wealth creation and which also have limited debt which reduces the risk to the business in recessionary times.

Qualitatively, this definition includes but is not limited to selling mission critical products, strong management teams often led by a founder, a lack of capital intensity, strong supply chain management and distribution, globally renowned brand names, highly engaged workforces, deep customer embeddedness and irreplaceable scale.

In the very long-term, a surprisingly small number of companies generate most of the wealth creation within stock markets and they all have a tendency to demonstrate some or all of the above characteristics. Not only do they tend to be durable enterprises that we hope can survive a multitude of different economic environments, they can often gain share from weaker peers in such times, and this gives considerable comfort in times of great uncertainty such as now to grit our teeth, and use periods of market weakness to trim some of the cash, government bonds and gold to top-up some of these great businesses at decent prices, and to do with a level confidence we would struggle to have if we ran an equity book stocked with lower quality⁄value stocks.

There is of course a trade-off here as the broader market also recognises quality and therefore assigns a premium valuation to these companies and in some environments (such as recent months) that means that the stock of these companies can underperform in the short term.

In summary, how do we deal with selloffs?

1. Maintain a long-term⁄3 year + view as to where the best risk adjusted returns may lie;
2. Do not kid ourselves that we have a unique or special insight into why the market is selling off or how the market may behave in the short term. Instead rely on a balance of well understood, simple but effective portfolio diversifiers to attenuate drawdowns alongside high quality equities with a view to owning them longer term;
3. Do not try to time the bottom as that will only ever be clear in hindsight, and instead capitalise on the situation as it presents itself by making small rebalancing trades as often as required to average in; and
4. Remember that periods of uncertainty are surprisingly frequent and a normal, if uncomfortable, fact of life as far as investing goes.

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