Asset management: the foxy normal

2012-02-09 14:01

Clem Sunter

It is apparent that many of the rules of the game have changed for managing a portfolio of investments, whether it is your own money or it belongs to a pension fund or a company. Everyone from laymen to market experts alike is agreed that it is now much tougher to make money with money. Returns for the first decade of this century have been nothing like what they were in the last two decades of the previous century. The crash of 2008, from which most stock markets have largely recovered, obscure the fact that the noose has been tightening for much longer.

Here is my list of rules to bear in mind when investing your own or someone else’s money:

1. Markets are unpredictable but scenario dependent.

Who knows where the world and the markets will be in six months time? But what one can say is that if this or that global economic scenario is in play, this is how the market will be behaving. In other words, while short term rises and falls in market indices can be heavily influenced by emotional swings caused by greed or fear, longer-term patterns are determined by the hard economic data being generated for the world as a whole, for trading regions within the world and for individual countries. Hence, the methodology of formulating different economic scenarios, attaching flags to each of them and assessing the probabilities based on the disposition of the flags is about as good as you can get in analysing future stock market trends. Obviously, to be consistent, you need a model which links the behaviour of the market to each scenario. Then investment decisions are made on the balance of probability of the economic scenarios and the movements in stock, bond or property prices they can potentially trigger.

2. Individual companies can buck market trends.
 
For a variety of reasons, individual companies can be winners in hard times and losers in good times. Their share price usually reflects this, rising in a falling market and falling in a rising market. The skill is to spot the winners and losers before they buck the trend: buy into the one and get out of the other. For example, during the recent recession companies offering value for money like e-books and other online shopping services have done well whereas some banks and other financial services companies have done exceedingly badly. This feature puts an immense premium on doing in-depth research into individual companies and being a stock-picker. The last strategy to adopt nowadays is to diversify across the market as a whole where your portfolio remains flat because the losers average out the winners. Buying the market indices in the 1990s may have been a smart move but it is less and less so as the gap between the winners and losers widens. For example, the S&P 500 index in America has declined by 12% since the beginning of 2000.

This rule can apply to whole industries which either offer exciting new alternatives for consumers or are becoming technologically obsolescent. It also applies to countries which outperform the global economy or disappear from the radar. The range of national stock exchanges you should be prepared to invest in has become a real issue and very much depends on the performance of the individual governments in spending taxpayers’ money and balancing the books. The mobility of capital means that reward and punishment are swift. Hence, the need for flags too on countries and industries, which provide warnings of imminent change.

3. Look for value in shares.

Low P/E companies have outperformed high P/E companies for any 10 year period chosen in the last 100 years. P/E stands for Price/Earnings ratio. This rule is why the underlying philosophy of one of South Africa’s leading asset managers is to look for value which the market is not appreciating and which is therefore reflected in a low share price. Of course the risk in this strategy is that the share is cheap because the company is a real dog. Thus, you require the ability to tell the difference between real dogs and stars with the appearance of dogs because their light has been temporarily dimmed.

4. Dividend yield really counts.

One statistic says it all. Two-thirds of the total real monetary gain of investing in Wall Street over the last century has been on the dividends received on the shares held by investors. The emphasis on capital gain which accounts for the other one-third is therefore misplaced. You have to give as much consideration to the prospects of regular and rising dividend income from your portfolio as you do to capital gain. In fact you might even argue more.

5. The period of investment is important, but timing is even more important.

The Dow Jones Industrial Average was 100 in 1916 and again 100 in 1942. It rose to 1 000 in 1966 and oscillated around that level till 1982. Then it rose to 10 000 in 1999 where it once again stood 10 years later. The point is that the market goes in surges and the big challenge now is to time your investment at the moment when the Dow is about to set off for 100 000. Has that moment already arrived with the Dow at nearly 13 000? Again, the debate around this question will be much richer if it includes the US economic scenarios, flags and probabilities.

6. Portfolios should at all times be diversified.

With all the qualifications made so far, portfolios should nevertheless be diversified by asset category (equities, bonds, property); within each asset category; and geographically. The reason is that, despite the approach already outlined which embraces uncertainty, you can still be wrong. Part of your portfolio must capture unexpected upside and part must be your insurance against unexpected downside. You will never make as much money as those who bet on a single outcome and who are then subsequently proved right; but you will never lose as much money when they are proved wrong. In the end, your portfolio should reflect your attitude to risk. That is the starting point. You have to know yourself.

7. All asset categories now carry risk.

If anything bears out this rule, it is the recent downgrading by the rating agencies of the national debt of some countries (including the US) which a couple of years ago was considered triple A i.e. the safest paper around. The threat of default has turned some of that paper into junk bonds. Cash not only carries a currency risk but also the chance – however minor – of the bank where it is deposited going insolvent. Moreover, rock bottom interest rates mean that the return on cash even in a savings account no longer offsets inflation. As for commodities and gold, they will always be highly cyclical. Property, other than in prime residential areas in major cities, has lost value and become difficult to sell to raise cash in an emergency. Derivatives, as Warren Buffet puts it, are financial weapons of mass destruction. Equities we all know about.

Thus, constructing a portfolio with a particular risk profile has become a trickier affair.

8. Adopt the foxy normal.

The market is abuzz with the phrase “the new normal” to indicate how much the game has changed. In response, I would offer “the foxy normal” where the basic instinct and behaviour of the investor is aligned to that of the fox: ever watchful for the flags which indicate the environment is about to change; ever creative in adopting the strategy to cope.


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