Uncertain times require a focus on the basics
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2012
Tue
17
Jan
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By Nic Andrew: Head, Nedgroup Investments
Negative news headlines, enormously complex macro-economic issues, extreme market volatility and often contradictory comments from the experts… There are an almost overwhelming number of factors influencing the market. These range from the US fiscal deficit and bungled dealing of managing the debt ceiling by Washington, to S&P downgrading US government debt (the “ultimate” risk free asset for so long), to Greece’s expected default, the knock-on effect on the rest of Europe and the impact that would have on confidence and longer-term economic growth.
The combination of factors and their inter-connectedness aggravate the situation and further muddy the outlook. Although experts normally differ in their opinion (as that is what creates a market), one has rarely seen such extreme and often opposite views as are being currently expressed. An example of this is the inflation debate where there seem to be very compelling arguments for both deflation (slow growth, unemployment, excess capacity and austerity measures) and inflation (loose monetary policy, excessive stimulation and higher food and commodity prices).
Amidst all the uncertainty what should we investors do?
· Focus on the long-term
It is near impossible to predict short-term market movement and it is easy to be unsettled by extreme volatility. There are significant advantages and opportunities to astute and patient investors who are able to look through the short-term noise and to retain focus on their long-term goals and overall plan.
When assessing performance of one’s investment, we recommend measuring equity investments (high growth objective) over rolling 7 year periods, balanced investments (medium growth objective) over rolling 5 year periods and lower risk investments (capital preservation objective) over rolling 3 year periods.
· Diversify
There are few free lunches in investing and diversification is one of them. At times like this when the range of potential outcomes is so wide, it makes sense that to diversify one’s portfolio by investing amongst assets that are not highly correlated.
For the South African investor this includes having a reasonable offshore allocation. Our asset allocation solutions such as the Managed, Stable, and Flexible Income funds take advantage of their wide mandates to ensure they are well diversified.
Similarly if one appoints a number of different managers, it makes sense to appoint managers who are different and themselves provide diversification benefits.
· Focus on Valuation and quality
Many studies have shown that the price one pays for an asset is the most important determinant of your end result. The most successful investors are able to ignore short-term market turmoil and momentum and identify opportunities where assets are driven below their fundamental value.
A focus on value provides an important anchor that helps prevent panic selling of existing holdings which may be driven below their fair valuation and provides the conviction to invest when all are selling.
Another characteristic of market declines is that indiscriminate selling often means little distinction is made for individual company characteristics. The result is that high quality companies (which normally and rationally trade at premiums) are sold down with the market to very attractive levels. Purchasing these high quality companies at attractive prices has typically proved to result in very satisfactory investment outcomes. Currently, where mandates allow our managers have found some excellent opportunities of purchasing high quality global companies at very attractive valuations.
· Awareness of the danger of emotions
It is completely natural for investors to feel the emotions of fear and panic. Investors are well served to be aware of the dangers of re-acting emotionally and put in place the structures and framework to manage their natural re-actions.
A good understanding of the principles outlined in this article should assist in developing and sticking to that framework. Many of the best investment managers are well aware that they too are at risk of behaving emotionally and apply disciplined processes to ensure that they stick to their well thought out plans and philosophies.
· Manager selection is important
There are a number of principles we look at when selecting investment managers to manage our client’s monies. We assess a manager’s performance over the full market cycle, as we are well aware that no manager will consistently out-perform over short periods. Our research suggests that top managers have historically produced the bulk of their out-performance (up to 80%) in poor market conditions.
Most of Nedgroup Investments’ Best of Breed™ managers have exceptional long-term records and much of this out-performance has come as a result of their specific focus on protecting client’s capital.
· Expectation management of returns and volatility
Few commentators would deny that the issues facing the global economy are material and that the environment is significantly less benign than it was for much of the latter part of the twentieth century. Many of the previous tailwinds such as long-time leveraging, political stability and capital market friendly legislation have now turned into headwinds.
For South African investors the experience of the last decade has been above average returns (the average general equity fund has produced about 17% per annum and those investors fortunate enough to be in top performing funds such as the Nedgroup Investors Rainmaker fund have enjoyed returns of almost 22% per annum for ten years).
Investors should prepare and expect lower returns than the last decade, and in all likelihood with continued high levels of volatility.
· Understand the risk of not taking risk
Despite the expectation of lower returns going forward, this does not mean that investors should not take risk. With interest rates (both nominal and real) at low rates, investing too much of one’s portfolio in cash seriously increases the shortfall risk or risk of running out of money. Our longer term expectations are still that quality growth assets (such as well-run companies, with high returns on capital, strong barriers to entry and high cash generation) purchased at current levels will reward patient investors.
Investors undoubtedly face challenging circumstances. Applying these principles should assist them in navigating the choppy waters and ultimately achieving their investment goals.
Source: Epic Communications (Pty) Ltd
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