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28 Jul 2020

Investing Through the Noise

Uncertainty levels always feel sky-high when financial markets suffer bouts of extreme stress. It is natural for people to lose confidence in their understanding of how things should work when paradigm shifts occur. Portfolio manager NICK BALKIN presents five investment strategies for dealing with risk and uncertainty.

The understanding and management of risk is core to the Foord investment philosophy. Our favourite definition of risk is Elroy Dimson’s: ‘More things can happen than will happen.’ It most certainly is not ‘what has happened’. We therefore take a forward-looking approach and make investment decisions today that aim to protect investor capital across an array of future possible outcomes, knowing that most of those possible outcomes won’t happen.

Because we are dealing with potentially many futures, we cannot build a portfolio for only one possible outcome. This applies whatever our conviction of that outcome’s probability of occurring. We will also often be wrong in our views and forecasts. We must therefore have balancing positions that we think, on average, will achieve the investment objective, regardless of how the future transpires.

In dealing with uncertainty, we find it useful to map out scenarios and assign probabilities. We try to be flexible enough to change our views as new information becomes available. But there is a lot of noise — most new information is a red herring. Instead, we rely heavily on the facts as we see them while paying special attention to critical secular trends such as demographics and the internet-of-things.

Here are five strategies that help to sift through market noise and segment the risks and opportunities for portfolio construction:

1.  Beware the dinosaurs

Dinosaurs are companies compromised by flawed business models or industries in structural decline, also known as sunset industries. They become easily recognisable if you take an appropriately long-term view. Examples include the paper industry as the world goes digital; office space with falling demand as people work increasingly in virtual spaces; and the platinum sector as fossil fuel burning internal combustion engines increasingly make way for greener electric vehicles.

2.  Ride secular trends

Invest in segments of the market that are riding structural tailwinds. These are companies and industries supported by long-term secular themes that might accelerate because of the global pandemic shock. Examples include accelerating insurance sales in underpenetrated, fast-growing markets (Asia Pacific) as the dangers of being uninsured stay fresh in peoples’ minds and companies in the broad internet sector that have benefited from “lockdown era” changes in consumer behaviour.

3.  Short-term pain, long-term opportunities

These are opportunities where companies suffer short-term dislocations but their medium to long-term prognosis is unchanged. This is where the long-term investor’s time advantage becomes acute. Most market participants want instant gratification and will sell on bad news and come back when the news changes. That strategy carries price risk and will underperform one that stays invested.

We love these opportunities, but they are not risk free. The balance sheet must be sufficiently robust to endure short-term stress. Examples include a few quality names in the beverage, restaurant and hospitality industries.

4.  Support perceptive management teams

No one has a crystal ball, but there are some secret weapons that can help long-term investors manage uncertainty — management, diversification and time. Good leaders will make strategic business decisions and implement them well as market dynamics change. Original investors in Naspers bought into a newspaper business. If they didn’t sell, they became owners of an excellent SA pay-TV business. These investors have now become owners of a global internet giant.

5.  Manage the known unknowns

Known unknowns include a series of emerging trends and behaviour shifts that can profoundly affect societies and economies in the long term. These risks are identifiable today, but difficult to predict with certainty. Examples include potential unwinding of the globalisation trend of recent decades; changing consumer behaviour patterns affecting the way people live, work and play; the human employment consequences of accelerating trends in use of intelligent technology and machines; and socio-political shifts like increased radicalisation. Dynamic scenario analysis and probabilistic thinking are critical in managing these risks.

In conclusion, uncertainty has always been central to the investment management landscape. We must avoid extrapolating into the future the things we are feeling and thinking in today’s seeming chaos. While market inflection points kick up many risks, they also provide the best long-term opportunities for those who can best navigate the noise while dealing with uncertainty.

 

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