Worried about a pickup in market volatility in 2015?

06 January 2015

After years of accommodative monetary policy and with the Federal Reserve looking to rein in liquidity as early as this year, equity investors around the globe ponder whether this will imply increased volatility for economic growth, earnings and consequently equities in the year ahead.

In fact many market participants focus on an even shorter time horizon than a year to assess their performance as an increasingly quant-driven and globalised market structure obsessed with monthly performance updates meets increased global complexity in the real world at a time of heightened (geo) political uncertainty. All of this can result in significant divergence of investment returns across industries and countries within global equity benchmarks at any given point in time. For the active investor, a concentrated equity portfolio with the flexibility of a longer term investment horizon offers one way to exploit these market inefficiencies while avoiding at this juncture the herd of investors hiding in bond markets.

Time to revisit Keynes in a time of “heightened uncertainty”: the importance of competitive advantage and financial health

John Maynard Keynes is famously quoted saying “In the long run, we are all dead.” This suggests he understood better than most the importance of taking into account one’s time horizon when making any statement – investment related or otherwise. Keynes was a visionary, well versed in economics and politics. He predicted as early as the time of the Versailles peace talks, shortly after World War I, how punitive fines on the losers would eventually contribute to World War II. He gained fame for his contribution as economist but he also became one of the most successful investors of his time, increasing the value of his infamous Chest Fund five-fold over a period of eighteen years (1927-1946) during which period the UK equity market actually declined.1

In a way, Keynes’ investment style in the first half of the last century epitomised many traits that we associate with investing successfully for a longer term time horizon today. He eventually focussed on making large investments in individual companies with solid balance sheets which he researched thoroughly and whose long-term value he found fundamentally mispriced. He promoted “concentrated balanced” investment portfolios2consisting of a limited number of companies from different industries to reduce his speculation on economic cycles.

While Keynes’ lifetime as investor spanned a time of great economic and political turbulence including the Great Depression and the build up to World War II3, the current global economic and political environment could also be described as unprecedented in many ways. After experiencing a bond bull market for the last thirty years, rates are at historic lows with the limitations of monetary policy starting to become apparent. At the same time, after a six year equity bull run, equity markets are coming to terms with potentially lower trend growth and equity returns from here (although still superior to the bond market’s prospects) as valuations have generally recovered since the Global Financial Crisis. Meanwhile, as Europe is facing the political consequences of austerity with extreme parties in both Greece and Spain gaining ground, the potential for unintended consequences echoes an old proverb: “History seldom repeats itself but often rhymes”.

In a time of heightened uncertainty, which implies an increase in the range of potential outcomes of any investment, we believe it is advisable to focus long-term equity investments on strongly positioned global companies of high quality and strong financial health that benefit from a sustainable competitive advantage rather than being solely dependent on a continuation of a supportive economic outlook. The resulting flexibility of these globally leading companies to reposition and take advantage of volatility in economic activity over time is a key factor in creating long-term shareholder value likely to be appreciated by the market.

In a time of heightened uncertainty, which implies an increase in the range of potential outcomes of any investment, we believe it is advisable to focus long-term equity investments on strongly positioned global companies of high quality and strong financial health.

Back to basics: the rules of concentrated plain vanilla investing for the long-term to exploit the market’s behavioural biases

Rule #1: Be clear about the investment objective

One way to cope with the increased complexity of global equity markets and the rise of several passive strategies that in turn compete with active funds of different varieties is to go back to basics and return to the objective the investor actually wants to achieve. The market today is a collection of all different objectives of all market participants at any given point in time. In this zero sum game it pays to know what you are looking for, both in terms of capital and income requirements over time as well as the willingness to risk capital.

Rule #2: Stick to what creates shareholder value

To achieve compounding total returns over the cycle, a concentrated portfolio of plain vanilla equities with a long-term investment horizon – and consequently a low turnover and cost approach – still offers a minimum amount of diversification but suggests the selection of the individual equities is the most important driver of returns. Consequently, it pays to stick to those style factors within equities that in the long-term make the difference in creating shareholder value: strong market positions, quality of management and solid financial health is key in building sustainable competitive advantage that results in a company’s ability to return more than its required cost of capital and to grow these excess returns consistently ahead of the market.

Rule #3: Avoid the herd. Over a long time horizon, mispricing of fundamentals matters more than momentum

If you invested in global bonds during 2014 you were not alone. During the year, credit and bond inflows led asset flows as investors chased yield to historically low levels and bought bonds that after a 30year+ long bull run might only provide them with meagre potential returns over the next decade, even when assuming lower trend growth and a likely continuation of the recently popularised “disinflation” phenomenon for some time to come. Investors with a longer term investment horizon should beware of the herd and resist the temptation to follow too late because in the long-term, the valuation and implied magnitude of mispricing of an asset tends to be more important for future returns than short-term momentum or asset flows.

Equities at current levels look to offer higher potential returns than bonds

Source: S&P 500, Bloomberg, Ashburton

Rule #4: Stay the course, monitor continuously and put performance in a longer term perspective

Given the equity industry’s obsession with monthly and quarterly review meetings to assess performance it is worth bearing in mind that any active portfolio, even one with a long-term investment horizon, will have to be monitored continuously to ascertain whether the investment case for any holding has changed. However, a strong investment discipline should be adhered to in terms of resisting the temptation to react to short-term performance, either good or bad, as long as the original investment rationale still holds.

1 2014, Keynes the Investor – www.maynardkeynes.org

2 1938, Keynes – Manifesto for Sound Investing

3 1951/1982, H. R. F. Harrod – The Life Of John Maynard Keynes