Portfolio Management: the art of handling uncertainty
There was an article in the Sunday Times1 by Matthew Syed entitled ‘The words I’d love to hear from a G7 leader: “Honestly, I don’t know”.’ The message of the article was that while politicians may sometimes win votes by over-simplifying the situations they face, often such over-simplification doesn’t deliver good results. The world is too complex for simple one-liners.
Then last week when I was on holiday in Stockholm I came across a book written by Bjorn Natthiko Lindeblad, a Swedish economist turned monk, entitled “I May Be Wrong”. When asked what was the most valuable skill that he gained from his 17 years as a monk, he said it was “not to believe [his] every thought”. His point was that most features of the world are impermanent, subject to rapid change, including our own thoughts and emotions.
I haven’t spent 17 years as a monk, instead I’ve spent 17 years at Invesco, but something really chimed with me about how these two ideas relate to investing.
To borrow from Syed, markets are hugely complex, and it doesn’t pay investors to over-simplify. Plenty of smart, credible, persuasive people have strong opinions on the direction of inflation, on interest rates, on geopolitical dynamics, demographics, property prices or the impact of new technologies. But the reality is that most of these opinions will be wrong. To position a portfolio in such a way as to make it very sensitive to one or two specific factor risks like the direction of interest rates or the impact of geopolitical tensions would, in our view, be unwise.
To borrow from Lindeblad, people are subject to differing emotions from one day to the next, and as a result markets are over-sensitive to the story of the day (or to the dominant emotion of the day). But we need to be mindful that in a few months’ time the environment may have changed markedly, no matter how entrenched the current trends appear to be. Whether that is a change in geopolitics, a change in inflation expectations, or a change in technology – we need to make our portfolios flexible enough to handle it.
How do we actually do this in practice?
Our awareness of uncertainty can be seen in our management of factor risks. We think our skills are in bottom-up stock selection and in taking contrarian positions versus the market; we sometimes take a view on macro issues, but we are very mindful that these views can be wrong. We are much more comfortable with a diverse collection of stock-specific risks than with two or three big macro calls. So when our risk teams analyse our selections, they tend to find that stock selection risks far outweigh factor risks. If and when our risk teams tell us that factor risks are creeping up, then we tend to take action to bring them down again.
For example, country risk is one form of factor risk, and we have a rule of thumb for large countries in the benchmark such that we will try to stay within a range of 0.5x-1.5x the benchmark weight in those countries. For countries with smaller weightings in the benchmark, we consider +/- 5% to be more applicable. This can sometimes feel constrictive. For example, at the moment we are finding quite a lot of Korean stocks attractive, and in some portfolios we are sitting at the top of the desired range at 1.5x the benchmark weight. This means we are effectively adopting a ‘one in, one out’ policy for Korean ideas. In contrast, we have no holdings in The Middle East (Saudi, Dubai, Abu Dhabi and Qatar constitute roughly 7% of our benchmark), which makes us more alert for ideas in that region. On one view, this could be seen as weak, or as limiting our upside; we don’t see it like that because we don’t want factor risks to dominate portfolio performance.
Our attitude to uncertainty also comes into play when explaining our investment style, in a couple of important ways.
To the extent that ‘growth’ and ‘value’ are just factors, then we will be trying not to let either one dominate the portfolio excessively as per the discussion above. But when viewed in this context of our discussion of uncertainty, there is a sense in which growth is more uncertain than value. Growth companies are often valued on earnings in two or three years’ time instead of earnings which have already happened and are therefore known. There is a leap of faith taken each time anyone refers to a stock trading on “20x 2024 earnings” because a multitude of forecast errors can be hidden within the rest of 2023 and throughout the whole of 2024. In contrast, when a company is trading on a discount to historic book value (i.e. the value of its net assets at the end of last year), then no leap of faith is required other than believing that the auditors have done a good job in checking the financial statements! Hence it should be no surprise that one of the consistent characteristics of portfolios we manage is that they trade on a lower price to book than the reference benchmark index. We don’t want factor risks to dominate, but we do have a valuation bias.
Another consistent characteristic of our portfolios is that they have lower balance sheet risk than the benchmark. Frequently we find that a majority of the stocks in a portfolio have net cash on their balance sheets. This is quite simple to explain in the context of uncertainty – if you don’t know what the future will hold then you may be safer with a strong balance sheet. You might put a cap on the upside potential by shying away from financial leverage, but you also help mitigate downside risk.
In summary, a large part of the way we manage money can be explained by the fact that we are acutely aware that we might be wrong in many of the views that we take. That might not sound like an obvious sales pitch, but we think it is a crucial part of managing our clients’ money in a responsible and honest way.
Boring times spent on cruise control?
Given the size of our investable universe, we normally feel that there are always opportunities to be had. We spend most of our time looking for opportunities where price has deviated meaningfully below fair value, usually in unpopular areas – this is our cruise control. Many investors find looking at unloved stocks boring, but this is how investing should feel. If there is excitement about a stock, it usually means that the stock is already well liked and so therefore less likely to be undervalued. Today we feel that there are plenty of areas within the market where expectations remain low. This backdrop enables us to construct a portfolio which trades at a discount to the market, but which doesn’t give up too much prospective growth, and which is well diversified across countries and sectors. We believe in the importance of sticking to our process, our focus on fundamentals and belief that valuation is paramount.
