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Volatility is back! It’s time to find your inner Spock…
McCoy: “It's worse than that he's dead, Jim; dead, Jim; dead”
Spock: “Well it's life, Jim, but not as we know it; not as we know it”
The Firm, “Star Trekkin”, 1987
At Ravenscroft, clients are the centre of our universe. As you would imagine, much of our time is spent meeting you, discussing your investment objectives while ensuring that our investment strategies are aligned with your wants and needs. Typically, clients have quite long investment horizons: a minimum of three years. This isn’t surprising when one takes into account that many people have one eye on events such as retirement or perhaps children’s (or grandchildren’s) school and university fees. It goes without saying that we all seek to safeguard and enhance family wealth.
In our view, having a clear objective and timeframe is vital: it underpins the planning and creation of an investment strategy, which, in turn, helps us to navigate through market movements. As in life, the tricky bit is committing to a plan and sticking to it – especially when stock markets determine to test one’s resolve!
Sadly, we all have strong emotional drivers. Accordingly, when markets come under pressure – and investments suffer – our biases kick in. It’s not surprising: we’re talking about the ability to retire, pay for our children’s education and fund inheritance for generations to come. This is no small beer.
Throughout the first three months of this year we have witnessed the return of volatility – arguably a reflection of the market’s emotional angst.
Volatility has, apart from the odd blip, been glued to the floor in recent years. Despite all sorts of potential economic and geo-political threats, investors have remained emotionally subdued. But, in 2018, it feels like volatility is waking up from some sort of Rip "Vol" Winkle slumber – and investors have moved from worrying about very little to worrying about almost everything…
We have discussed many of these concerns over recent years. From the US$ 9 trillion of negative yielding sovereign (government-backed) bonds to the political backdrop now dominated by Trump (or more often his Twitter rants) and Brexit. This, coupled with parts of the equity market trading at a historical premium, creates a fragile environment – susceptible to even the smallest changes in investor sentiment. Ultimately, this can only be reflected by market behaviour.
In January 2018, the MSCI World Index (in GBP) rallied by 3% before falling 6% through February. This trend was then repeated with the Index staging a brief rally before falling through March and finishing the quarter down approximately 4.5%. Volatility (and investor angst) is back. More importantly, this is where our resolve as investors will truly be challenged. We know our long-term objectives; we have divined our investment strategy. Will we be able to withstand the emotional stress?
Emotion has its place, but purely emotionally-biased investment decisions tend to result in dismal results over the longer term. Buy at the top and sell at the bottom, anyone? We need equilibrium. We need to balance our Dr McCoy with our Mr Spock. After all, given the historical outcomes of long-term investing into equity and bond markets, such angst is largely misguided. My colleague Bob Tannahill recently undertook an exercise where he used several decades of data to look at the odds of loss where one had invested at a random month in history and then held for different periods of time.
In the top left of the table, below, you can see that investing in global equities for a year at random in the last 40 years would have had a relatively high chance of loss – something like one in five. On the other hand, holding those equities for 10 or 20 years makes the odds look much better. In fact, in over 40 years of index history, he couldn’t find a single 20-year period when investors lost money holding a broad portfolio of global equities. That is not to say that it isn’t possible, just that the odds are very low.
Bob has repeated this exercise for a variety of bond/equity mixes below. The results, whilst unsurprising, provide data from which we can channel our inner Spock and thereby calm our emotionally-biased concerns. As with all backward-looking exercises, it is important to remember the old adage "past performance is no guarantee of future results"; however, it does provide us with a reasonable start-point and sensible foundation for our decision making.
We continue to believe that it is important to remain focused on your investment objectives. Depending on time horizons, we can guide you towards appropriate strategies that will reduce the risk of failure. While none of our portfolios – even at the lower-risk end of the spectrum – are immune from sharp bouts of volatility, remaining focused on investment timeframes helps us to keep our emotional impulses in check and thereby increase the odds of meeting your long-term objectives.
As Warren Buffet notes:
"Success in investing doesn't correlate with IQ once you're above the level of 100. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people in trouble..."
Cautious Portfolios: Lower Risk
by Bob Tannahill
Objective: The Cautious Portfolio’s objective is to increase its value by predominantly allocating capital to fixed-income investments. The portfolio can also invest into global blue-chip equities with strong cash-flows and progressive dividend policies. A neutral position would be a 75% bond/25% equity split and the maximum equity-weighting of approximately 35%. The cash generated can be re-invested to provide capital or taken as an income stream.
The first quarter of 2018 has been an unpleasant one for cautious investors. Over the period, the Strategy lost (including changes in both capital and income) around 2.7% on a total-return basis.
This was driven by an alignment of factors that act as headwinds to the Strategy’s investments. The big idea was that the global economy is finally past the recovery stage and is now into full expansion mode. Accordingly, the risk to markets (in this consensus view) shifted from recession to overheat – with inevitable implications for asset pricing.
Within equity markets we saw investors rotating out of the more dependable dividend-paying stocks (which we own in the cautious strategy) towards more volatile companies with greater sensitivity to the economic cycle. This rotation saw the consumer staples sector sell-off by nearly 10% while technology stocks, which would normally underperform staples in a falling market, lost less than 3%. Against this backdrop, our equity positions were, on average, down around 6.5%, which, while painful, was better than we might have expected given the sectors they own. If we had invested passively in this space, then we would have expected to be down around 7%. We were pleased to see our active managers adding on the downside, albeit only modestly.
On the bond side of the Portfolio, rising concern about future inflation caused bond yields to rise and so prices to fall. Over the period, core government bond-yields rose by around a third of a percent and corporate bonds, which we focus on, largely followed suit. This meant that at the end of the quarter our bond positions were generally down between 1% and 1.5%. While the sell-off was quite broad, we did see our more defensive bond positions behaving as we would expect. Schroder’s Strategic Credit Fund, which we topped-up last summer, has been getting increasingly defensive recently in response to rising valuations. As a result, we were pleased to see it perform well on the downside; it is our least volatile, and second-best-performing, fund over the quarter. In addition, our government bond allocation, which sold off initially due to rising bond-yields, rallied in the last part of the quarter as the equity sell-off gathered pace. It was good to see it maintaining its equity counterweight behaviour despite the sell-off being initially triggered by bond markets.
Finally, currency has also been a headwind. As regular readers will know, while we take various steps to manage currency risk, such as hedging and diversification, there is unfortunately no silver bullet in this area. The Strategy’s main currency exposure is to the US dollar, due to its large contribution to the global economy. While, in the longer term, currencies tend to have limited net effect, in the short term they can act as either a headwind or tailwind. Over the quarter, sterling gained over 4% versus the US dollar which translated into a small hit to the value of the Portfolio. Here again, we were pleased to see the steps that we took in the wake of the Brexit vote working to reduce currency impacts, even if they can’t offset them entirely.
Looking forward, while quarters like this are painful, they do occur from time to time and are an unavoidable, if unpalatable, part of markets and investing. As we spoke about in our recent client event (the video of which is on our website) markets are best viewed in terms of probabilities or odds. In the short term – and a quarter is very much the short term – the odds of winning or losing are pretty close, if slightly biased to the positive side. As the timeframe extends, however, the odds get better as the underlying profits of companies begin to drown-out the noise of markets. At present, nothing has happened to change our fundamental view that the Cautious Portfolio is well constructed for the current environment and, therefore, should provide clients with a high probability of meeting their goals over the longer term. Of course, we constantly test this position and make changes as and when they are required… which brings us neatly to the two recent changes of note.
First, we made two changes to the UK corporate bond exposure within the Strategy. We replaced the M&G Corporate Bond Fund with the TwentyFour Corporate Fund. We believe TwentyFour should outperform M&G going forward thanks to its smaller size, which allows it to operate a more focused and nimble portfolio. We also added a new fund to our stable of managers in the form of Rathbone’s Ethical Bond Fund. Bryn Jones, who runs the Fund, has an impressive knowledge of the fine detail (an attribute we like) that he uses to go off the beaten track in the UK corporate bond market in order to seek higher returns.
Second, we increased our equity allocation by 2.5% during the sell-off on the back of significantly improved value in the space. While, as Mark notes above, some areas of the equity market do look expensive some of the more conservative areas have been hit quite hard this year and are starting to display some value. Tobacco is one area that was particularly badly hit, with a number of FDA statements over the period around areas such as reduced-risk products, which were taken badly by the market. While the sector does face change, we considered the reaction significantly overdone given the solid fundamentals. Some shares in the sector fell so far that their price-to-earnings ratios dropped under 10 times – a level that is rare to see for any large company shares outside of a major crisis. It has been some time since we could say that we were seeing value in absolute, as opposed to relative, terms. As such, we decided that some dry powder could productively be deployed within our global equity income funds.
Going forward, we will be keeping a close eye on the market valuations in the context of a world where inflation could be a rising risk and, as ever, seek to focus the Cautious Strategy on assets where there is a margin of safety.
Balanced Portfolios: Lower-to-Medium Risk
by Tiffany Gervaise-Brazier
Objective: The Balanced Portfolio’s objective is to provide capital appreciation through a balance of fixed income and global equities. A neutral position is a 50% bond/50% equity split and the maximum equity weighting is 60%. The cash generated can be re-invested to provide capital or taken as an income stream.
After fifteen months of equity markets grinding steadily higher, we all have been somewhat spoiled by the smooth upward rise. The corollary has meant that investors have had a lot to digest after the recent flurry of headlines and events – trade fears and tighter monetary policy being the focus.
During the quarter, particularly in January, we saw notable market reaction to the move in the US dollar exchange rate. Such weakness impacts the Strategy relatively negatively due to effects on the price of our dollar-denominated investments when rebased to sterling. On the other hand, the truly diverse revenue streams of the global businesses we own mean that a weaker dollar can quickly provide a more favourable environment for US companies selling their products or services to an international customer base. In the midst of dramatic headlines and ensuing panic, this is often overlooked. As part of our investment process, we continue to monitor our currency exposure (based on where the companies’ revenues are derived from – not where they are listed) and we remain comfortable with the Strategy’s current positioning.
Rest assured that despite trade wars, hikes in interest rates, an Italian election or any other political or economic event, the core of all of our portfolios is made up of global companies that we consider the best in their respective sectors – and consumption. Market falls have almost no impact on your desire to continue to brush your teeth, buy deodorant or feed your Rover (four-legged version). Having said that, we understand that witnessing your hard-earned capital fall (by any amount) does not make for easy watching. The simplest way to overcome this is to distract yourself from focusing on short-term (erratic) price movements by focusing on the knowledge that you still own world-leading, long-term-outperforming, companies. Given the environment we have experienced over the last few years, it has become all too easy to forget that volatility is a normal phenomenon when participating in financial markets.
The Strategy fell approximately 2% over the quarter. The big question on investors’ minds is whether this is short-term correction or the start of something more sinister. For us, as ever, it’s about valuations.
Whilst these are cheaper than they were three months ago, and there are pockets of value, more broadly they are not yet attractive enough for us to increase our equity exposure. For the time-being we are maintaining a more cautious stance.
Growth Portfolios: Medium Risk
by Mark Harries
Objective: The Growth Portfolio’s objective is to provide long-term capital appreciation by investing predominantly into global equities. A neutral position is a 25% bond/75% equity split and the maximum equity weighting is approximately 85%.
Over the quarter markets have weakened, largely thanks to fears of trade wars between the US and China; specifically, the latter’s response to Trump rhetoric in early 2018. Perhaps what has held markets back even more is the fact that equities simply aren’t cheap and whilst there are pockets of value (as highlighted in Bob’s Cautious commentary), stocks are, on the whole, trading towards the higher end of their long-term valuation range. Given this backdrop, it is unsurprising to find that markets, like our portfolios, have bounced around a bit. Ultimately, they have sold off and there have been few places to hide. In particular, the Consumer Staples, Telecommunications and Energy sectors have been hit hard – all recording double-digit declines in the first quarter.
Of course, it is sectors such as Technology and Healthcare (two of our investment themes) that are at the heart of mankind’s ability to keep prospering. In our view, it is this (not US or Chinese rhetoric) that will drive innovation and social change – and, ultimately, growth and stock market performance. Although we would admit that valuations in these sectors are currently looking on the expensive side, these themes will remain core holdings in our growth portfolios. As ever, it is difficult to look through the noise and focus on what will actually drive long-term growth. It is even harder to accept that there will be periods of low returns and no returns as well as periods of negative returns. Unfortunately, Madoff et al aside, investing for long-term growth doesn’t come in a consistent stream of monthly returns. However, history does teach us that growth is a pretty persistent beast: one that can be ridden by investing in the stock of some of the best managed, most productive, businesses in the world. We continue to search out these companies and ways to invest into them. After all, it is very likely that they will still be pushing forward and continuing to grow long after the current politicians have disappeared from the scene.
Our growth portfolios have demonstrated a level of protection against falling markets in early 2018, but it does not give us much pleasure in reporting capital losses – even if they are only about half that of the global equity markets. We enter the second quarter of 2018 defensively positioned; slightly underweight neutral positions in equities in order to soften the impact of any potential further sell-off. This may herald a better valuation point at which to add some monies back into the markets.
Global Blue Chip Portfolios: Medium-to-Higher Risk
by Holly Warburton
Objective: The Global Blue Chip portfolio invests into approximately 25-30 global blue chips that are in line with our long-term investment themes. The aim is to invest into such companies at an attractive valuation and hold them for the long term. The cash generated can be reinvested to provide capital growth or taken as an income stream.
It has undeniably been a challenging start of the year for equity investments. Throughout February, and March especially, we have witnessed a level of volatility not seen for some time. Although it can be difficult to observe these negative fluctuations in asset prices, it is more important than ever to focus on the long-term prospects of the underlying companies and their fundamentals. Market movements are not always a true reflection of the progress the underlying companies are making and, although uncomfortable, markets will inevitably ebb and flow even if the broader direction is an upward trajectory.
Looking more closely at the performance of the individual sectors; there really was nowhere to hide, with not one positive performer. Consumer Staples stocks were the worst hit, particularly in January, as investors rotated towards higher growth areas of the market. Investors and regular readers will know that, due to our thematic approach, it is our preference to own these types of business; however, over this short period this stance has negatively impacted performance. That said, throughout March, when the sell-off was more general, the Portfolio held up favourably.
This is not to say we have been complacent – far from it.
We have reverted to the core objectives of the Strategy and reaffirmed the underlying fundamentals of the companies we invest into and the Portfolio as a whole. The aim has always been (and will continue to be) to own a selection of high quality businesses which have well-established, global market positions and proven competitive advantages – multinationals that operate in a growing opportunity set, driven by our preferred long-term trends and themes and generate high rates of return on invested capital; building shareholder value over time.
The table, below, is a snapshot of the Global Blue Chip Portfolio illustrating that our selected companies, in aggregate, are more profitable, generate higher levels of cash and are less indebted than the broader market – making them less susceptible to financial pressure. In our view, these characteristics put them in an incredibly strong position for long-term growth, regardless of the market’s short-term biases and preferences. With regards to valuations, quality has always come at a price and this is reflected in a slightly higher valuation than the general market. Nevertheless, the premium you have to pay for quality is the lowest it has been for some time.
Looking forward, we have a bench list of equally high-quality stocks that we would like to own but consider simply too expensive at this price point. Volatility might just provide an opportunity to initiate a position.
Fund in Focus: Squeezing Lemons
by Bob Tannahill
Corporate bonds are, admittedly, not the most exciting part of most people’s portfolios. They provide modest returns but do so in a consistent manner which makes them a welcome anchor to returns in a volatile world. It also means that they rarely feature heavily in investment commentaries like this. This quarter we thought we would break this mould by looking at some recent changes we have made to our selected bond funds because we believe they will help our clients squeeze a bit more return from this under loved foundation stone.
We began reviewing the UK corporate bond space some months ago in order to answer the question of whether we could derive a bit more return from the area by looking for a smaller and more nimble fund. While our incumbent in the space was a large fund it does invest as we would want. We therefore took our time with this search as the last thing we wanted to do was chase higher returns at the expense of our core investment principles which are the bedrock of how we control risk.
We are pleased to be able to report that this search has proven fruitful and in March we began the process of replacing the M&G Corporate Bond Fund with TwentyFour’s Corporate Bond Fund in our balanced and cautious strategies. Chris and Gordon who run the TwentyFour Fund have a strong track record and joined TwentyFour in 2014 attracted by the prospect of a specialist bond house that are keenly focused on delivering performance for clients. A good example of this commitment to performance is the line in the sand they have drawn, upfront, on fund size. The team believe that the optimal number of positions is around 100 and that the maximum position size to ensure liquidity is around £20 million. This suggests a maximum fund size of £2 billion and the team have stated that they will aim to restrict the access of new investors as the Fund approaches this size. We took additional comfort in this area from the fact that TwentyFour have limited other funds when they approached their limits.
We met the team on several occasions during our due diligence process and came away very comfortable that they represented a "safe pair of hands", which is exactly what we are after for this type of stable core allocation.
During this process we also came across another fund that, although unsuited as a direct M&G replacement, did peak our interest. The Rathbone’s Ethical Bond Fund caught our attention as something a bit different in a sector where many funds look very similar. Bryn who runs the Fund has a clear passion for the minutia of lending to companies via the bond market, which was very evident when we met him. The team use this passion and the resultant deep research ability to venture off the beaten track in order to provide a genuinely different bond portfolio. While this strategy comes with a modestly higher risk profile, and we have capped the position size accordingly, it does represent a rare pocket of value in a broadly expensive world. In order to take advantage of this we have introduced a small allocation to the Fund within the bond allocation in the Cautious Strategy.
Our aim with these changes is to allow the fund managers within our bond allocation to add more value through the stock selection work. This type of work might not be glamorous but in a world of expensive valuations and potentially rising bond yields we believe active management will be a vital part of navigating the next stage of the cycle and these changes should contribute to that.
Stocks in Focus
by Ben Byrom
Instead of doing our usual deep dive on a particular stock, we thought we’d change tack and do a round-up on the most interesting news pieces on our Blue Chip holdings.
We kick-off this quarter’s ‘Stocks in Focus’ with the revelation that all processing chips had a flaw that made computing devices vulnerable to exploitation from hackers. The news sparked a brief sell-off in chip manufacturers, including industry incumbent Intel. Analytical opinion brushed over the discovery, suggesting that upgrades would provide a boost to sales. Chipzilla’s response was to play down the situation, but we decided to halve our position, anyway, since valuations looked full. We will get a better hold of any financial implications when the Company announces its Q1 results in April.
Swiss luxury designer Richemont announced plans to buy the remaining stake of Yoox Net-a-Porter (YNAP) it didn’t already own. Reconciling the logic is difficult given the differences in products. The online retailer specialises in selling fashion garments and beauty products, while Richemont’s offerings lend themselves more to being seen-and-touched prior to purchase. Nonetheless, more transactions are being done online. Perhaps Richemont sees YNAP as an opportunity to expand into fashion or to build-out its online retail offering – or both. YNAP is certainly a better alternative to Amazon, where luxury companies have suffered collateral damage to their brands due to the online retailer’s rock-bottom-price-promise undermining their cachet.
The pharma sector is getting all drugged-up on M&A; the end-result may be a prolonged period of cold turkey. Sanofi’s string of announcements in January hints at a change of fortune for Olivier Brandicourt, the Firm’s CEO, after his Company missed out on cancer treatment specialist Medivation in 2016 and Swiss biotech Actelion last year. Sanofi’s share price soured after the announcements as investors feared the Company was overpaying for Bioverative, a haemophilia-treatment specialist and Ablynx, a Belgium biotech firm specialising in nanobodies and experimental blood products. However, the businesses fit Sanofi’s areas of expertise in rare diseases and both have potential ‘game changers’ in their lockers. Sanofi’s existing infrastructure will certainly boost the new acquisitions’ commercial prospects. The antidote for drug-fuelled good times will come in the form of seamless execution and an undemanding valuation. Sanofi has the latter and Brandicourt will need to deliver the former.
Brandicourt hasn’t been the only drug chief cutting deals this quarter. In just a matter of weeks after taking the helm at Novartis, CEO, Vas Narasimhan, decided that the Company’s 36.5% stake in a consumer healthcare JV with GlaxoSmithKline was surplus to requirements. Novartis agreed to sell its stake to its UK partner for $13bn – and investors took note, sending shares higher. New sheriffs often come with new plans and Mr Narasimhan would like to focus more on drug innovation. Speculation is rife over what he will do next – Alcon (the troubled eye care business) and a $12bn stake in fellow Swiss drug-maker Roche are now being viewed as pools of untapped capital that could fund acquisitions and innovation-driven growth. If this is indeed the plan, we will wait to see at what cost the growth comes.
And, finally, it would be remiss of us not to highlight Unilever’s intention to simplify its legal structure to just one head office – and for it to be based in the Netherlands and not the UK. The Company said the decision was not Brexit-related, but based on a design to improve the Company’s ability to make acquisitions using its stock. This fuelled rumour about potential M&A activity, with Estée Lauder and Colgate mooted as potential targets. Nonetheless, Rotterdam has benefits we can’t ignore. An EU presence keeps open an important market that accounts for over 20% of revenues at a time of great uncertainty. In contrast, sales in the UK make up just over 5%. Dutch companies also enjoy stronger powers to fend off unwanted takeovers. Thankfully, our investment rationale isn’t predicated on where a company is headquartered, and we welcome news that the Company is simplifying its business model to improve flexibility.
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