23rd January 2013
Issues include large fluctuations in GDP growth, volatile sovereign debt yields, rising unemployment, austerity versus stimulus debates, Balkanisation of banking activity, the fiscal cliff and unprecedented central bank policies, to name a few. There has been widespread comment that this economic volatility and uncertainty has forced asset class correlations to converge, and therefore macro views have been driving returns – the so called “risk on, risk off” strategy
We think the idea of cranking up and down the “risk” in a portfolio within short periods of time is closer to speculation than investing. The implications of using a “risk on, risk off” strategy goes against our core approach to investing. Here are three reasons why:
1. Risk on, risk off implies high portfolio turnover and a short time horizon.
When considering investing in a company, sensible value investors do so on the basis that the valuation discrepancy they are seeking to take advantage of may well take more than two or three years to come good. Market fear and confidence can fluctuate many times over this period, as we have seen over the last five years. Moving in and out of stocks with every lurch in the market would simply create extra trading costs which erode your return over time.Our portfolio turnover is low; in 2012 we only sold three positions and bought four. This is a consequence of our sensible investment time horizon.
2. Risk on, risk off implies you believe you are good at market timing.
Market timing is more luck than anything else. Given the short time horizons implied by the risk on, risk off approach, market timing is very important for it to succeed. You need to feel confident you know when the inflection points are coming. When we have decided we a like a company’s valuation we get on and buy it without trying to pick the perfect moment. In addition, our equally weighted portfolio construction means we don’t have to be too precise in choosing our moment to invest. The act of rebalancing the portfolio means we sell down a small proportion of our winners to invest in the companies that have underperformed and therefore have become cheaper. This allows us to improve our average purchase price.
3. Risk on, risk off implies you are able to make good economic forecasts.
Statistical studies of expert predictions of future events show that they are not very accurate. Philip Tetlock looked at the predictions of 284 experts over a 20 year period. He analysed the resulting 28,000 predictions and found that these experts’ predictions were about as good as a dart-throwing monkey. Despite all the hugely confident predictions we hear from economists in the media, in fact they aren’t much better than chance. That isn’t to belittle the work of economists; considering different scenarios, the effects of political decisions, shocks, etc. is clearly valuable, but relying on specific predictions can be dangerous.
What should investors focus on instead? Economics is top of the agenda, and it’s hard to ignore the headlines; we’re more likely to discuss our Mediterranean neighbours in terms of their debt than their excellent restaurants
Instead of trying to guess the future, we think investors are better off looking for companies that can handle whatever it might throw at them. Look at companies from a bottom-up perspective and consider how they will perform in different economic environments. If you can find companies that have delivered growth in numerous economic climates,you can be less concerned with predicting the specifics of how the future will turn out.
One effective indicator of continuing success is cash generation, specifically cash flow return on investment (CFROI). Persistence is the key. High CFROI (over 10 per cent) for a whole decade – far longer than the average business cycle – is a rare achievement. But you need to be patient. This shareholder value creation is independent of what price the market will attribute to company shares at any point in time, but youcan receive a proportion of this value creation each year in the form of dividends from a portfolio of cash-generative, dividend-paying companies.
In short, instead of focusing on forecast-based or unquantifiable macro factors to shape their portfolio, we think investors should look for companies that consistently generate high returns on capital and therefore consistently create shareholder value year-on-year.
Outlook for 2013
The mood in the market at the beginning of 2013 certainly appears more upbeat than it was at the beginning of 2012 and perhaps closer to that of early 2011. In a poll of fund managers at a recent conference we attended, the least popular equity class was defensive companies, with most favouring cyclicals (although the Energy sector remains out of favour). Perhaps we should expect a continued “risk on” rally in shares of companies with less sustainable business models at the expense of those with recurring and steady profitability. Or perhaps macro concerns will again come to front of mind and it will be the opposite. This is all just short-term noise, really. We believe the demand for equities that offer a relatively safe and rising dividend is likely to remain strong for some time, driven by exceptionally low medium-term yields on bonds and cash and the long-term demand for income from shifting global demographics.
The blue chip stocks that looked exceptionally good value in the summer of 2011 are no longer the bargains that they were but we still think quite a few continue to offer good value. We did reduce our exposure to blue chips by selling Pepsico, which was looking expensive, but we can still identify plenty of value within our high quality investable universe outside of the blue chips, H&R Block being a good example of this.
We sold our position in Pepsico in October when it failed one of our Universe criteria with its debt to equity ratio going above 1 after it took on more debt. The share price had performed well over the course of the year, yet earnings expectations were declining and consequently the valuation was starting to look stretched. The business still seems in fairly good shape but we concluded the risk-reward profile had shifted somewhat and decided to take a profit. We used the proceeds of this sale to buy a position in H&R Block, a tax service provider where we see significant value within a strong business model. The company is highly cash-generative and has recently refinanced a debt facility which has strengthened their balance sheet. The dividend is well covered and offers an attractive yield of over 4%, particularly in the context of a long corporate history of paying dividends. The company is not well covered by the analyst community and short-term investors will be put off by the seasonal nature of its business, which gives some explanation to the attractive valuation.
We’ve also bought Arthur Gallagher, the insurance broker, and the Italian integrated energy company ENI. Arthur Gallagher has grown its business largely through acquisitions and has been disciplined and successful at integrating these businesses and finding cost efficiencies. Typically the company focuses its acquisitions on niche groups such as marine, energy and aviation. The company has been growing its returns on capital for the last 20 years and has a very strong balance sheet with net cash. ENI has lagged the broader energy market in recent years. We see the company as offering good value both in terms of earnings and based on the value of their a
ssets in the ground. The company is undergoing a step-change as it divests its holdings in SNAM, the gas transport group, and moves towards selling down its stake in Galp, the Portuguese energy company. This will leave the group with a greater focus on exploration and production and better able to grow production in the future, a feat it has struggled to execute in recent years.
Our Global Equity Income portfolio starts 2013 in a very similar shape to where we started 2012 in terms of its geographic and sector exposures. The Fund also remains good value, trading on a price/earnings multiple of 11.6x 2013 forecast earnings, which is very similar to 12 months ago and is a reasonable discount to the MSCI World Index of 13.2x.
We do not spend too much time worrying about how the global economic environment will fare in the near future but instead we will continue to focus our time and thoughts on our process and on identifying high quality companies and including the best value opportunities in the portfolio.
Dr. Ian Mortimer and Matthew Page are the c0-managers of the Guinness Global Equity Income Fund