This article was originally published on Citywire.
Investors live with uncertainty, and we should be rewarded for the risks that entails. But sometimes conditions ahead looks so obscure that it is like driving in thick fog – and that means the risks grow.
If you were on the M1 (as I often am on the way to my favourite holiday destination – Bournemouth) and hit fog, your natural response would be to reduce speed. When you are investing and run into these patches – when, as the saying goes, ‘the future is not what it used to be’ – it makes sense to give yourself a margin of error. There are a number of ways you can do that.
Begin by focusing on valuations. A low starting valuation gives you a margin of error if earnings forecasts turn out to be wrong. History would also suggest that over long time periods a low starting valuation tends to correlate with a higher real return, so you could think of it as stacking the odds in your favour.
All of the portfolios I manage have a price/earnings ratio below that of the UK market, which itself is at a discount to many overseas markets. The FTSE All-Share Index is currently trading at around 12x earnings. This compares with the US, where, despite recent falls, the S&P 500 is still trading at around 20x earnings. That may encourage you to revisit your asset allocation.
Of course, just because something is cheap does not guarantee it is worth buying, as anyone who has ordered clothes from the Chinese online platform Shein will testify (I am told)!
For me, buying individual equities within a portfolio, balance sheets become more important than ever at times of stress. I recently had this illustrated on a call with a management team where, because their balance sheet was relatively geared and earnings were under pressure, on a refinancing they were looking at an interest rate into double digits. If and when that financing gets agreed, it will effectively put that company on the back foot on any end market recovery as they will be lumbered with these onerous costs. This served as a good reminder for me that its often the strong that get stronger at times like these.
Another element to consider is positioning and sentiment. Think about where the next buyer is coming from. If you are starting with an asset class that has been in favour for a number of years and is therefore well held, who is left to buy? Often people become anchored to where weightings and valuations are now and forget the historical context. Returning to the US, it has gone from 45% of the MSCI All Countries World Index in 2011 to 65%1 now. Could the tide turn?
Don’t ignore dividend yields. Many companies are now focusing on share buybacks, but, as an investor, if your starting point is an attractive dividend yield that you view as sustainable – for example, the UK market pays a dividend yield of 3.9% – this can go some way to generating a good total return. In some sectors the starting dividend yield can be considerably higher – for example, life insurers such as Phoenix Group often pay a high-single-digit dividend yield.
Experienced management teams can shine at times like this. A team that has already steered effectively through Covid and the spike in inflation that followed Russia’s invasion of Ukraine will be used to volatility. It will know, for example, what levers to pull in the business to flex costs at times of end-market weakness. I like this quote from Sainsbury’s CEO on its recent results call. He said: “When we think back over the last four or five years, it feels like in every year we’ve had unprecedented events to navigate – and this year is going to be no different.”2
Don’t forget diversification. When the outlook can change so fast, it is important to invest in a blend of companies that can perform well in different environments. For example, you might want to own some sectors (like banks) that should see better returns generated in a ‘higher for longer’ interest rate environment, while others (like housebuilders) might see a demand benefit if interest rates fall further. This can also apply to currency moves. Some of the multinationals we invest in (such as consumer staples and pharma companies) will likely see some earnings pressure on a weaker US dollar, while other more domestic businesses (the likes of clothing retailers, for example) should benefit from lower sourcing costs. This might sound like a lack of conviction, but we see it as the portfolio equivalent of not putting all your eggs in one basket.
Finally, I am challenging my own assumptions where investment cases were built around potential corporate actions – selling off a division, for example. Potential buyers of these assets are, for understandable reasons, often choosing to sit on their hands or negotiate hard on price. One company we invest in is DCC, a specialist distributor of energy, healthcare and technology products. It is in the process of simplification and has agreed a sale for its healthcare division – but at a lower valuation than some in the market were expecting. Examples elsewhere include Reckitt Benckiser (not held), where some investors are questioning the pace of the company’s Essential Home disposal in light of more challenging trading conditions.
It is a good time to go through your portfolio and check that the investment rationale for buying remains strong enough to carry on holding. Drive carefully!
Source
1. MSCI ACWI – Development of the Country Weighting
2. J Sainsbury plc Preliminary Results 2425 Transcript
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