Many of us are struggling to make sense of the world at the moment. It seems to lurch from crisis to crisis. Governments are changing policies and economic responses on a daily basis, and yet stock markets are holding on to their gains and calm has largely returned to the credit markets. It's a very confusing time to be an investor.
We have to grapple with these issues on a daily basis, so we’re able to provide some perspective for investors about how you balance investment objectives in what has been a very volatile and an increasingly complex world.
What we've had in recent years is an exuberantly optimistic period, which has been characterised by FOMO and the chase for yield. In March this year, Fear Of Missing Out was replaced by just Fear.
That downturn was exaggerated by a range of market participants undergoing their own stresses in their business. For instance, some hedge funds have blown themselves up, and subsequently closed down. Some sovereign funds have sold enormous amounts of equities to fund an oil war. Industry super funds have been caught out in terms of their unlisted equity holdings, and have had to reprice them in quite a difficult period. Margin loans have been called in, and there really has been a lot of panic, particularly during March.
On a global scale, governments have tried to induce economic hibernation while simultaneously attempting to build a bridge across the lockdown. And when I say a bridge, I mean via stimulus and by getting coordinated support both from and to big institutions in Australia; typically the big four banks, the big supermarkets, giving a lot of support to the airlines and those industries that have been under enormous stress. And yet, strangely enough, simultaneously through all of this or coming out of this, we appear to be back to TINA (which is There Is No Alternative) to equities and FOMO (Fear Of Missing Out).
The implications of this are enormous. We think forecast risk is totally off the charts. We think balance sheets and business models are essential for survival. Not for making money, but for survival. We think that the strong will get stronger. And so, we think there'll be a lot of companies falling by the wayside or getting absorbed or being permanently damaged. Leadership is emerging as the quintessential element in determining who succeeds and who doesn't, provided you've got a decent balance sheet and business model. And we think the opportunities for wealth creation are remarkably large, but simultaneously, you've got to be really worried - because of the high volatility - that you could do some serious damage to your wealth.
So, how do we put this all together and how are we managing our way through this?
Typically, any investment manager needs to worry about three things in terms of investing. First of all, the quantum and then the certainty of future cash flows. And then, thirdly, the cost of money, in order to value assets and to invest that money.
Our 8-pillars for investing in uncertain times:
1. Mandate: First and foremost, you've got to be very clear about what you're trying to achieve. What is your mandate? The reason that I invest and the reason I have a fund, and I'm one of the biggest investors in the fund myself, is to either create or maintain financial independence. That is the sole reason why I invest. That mandate, therefore, has to be about preserving capital first and foremost.
a. Capital preservation: If you think your financial independence is going to be predominantly in Aussie dollars, then the best thing for capital preservation is to maintain the real value of money in Aussie dollars.
b. Reasonable risk: I think that a reasonable real return is best demonstrated by whatever the risk-free rate is plus at least 6% for your risk premium of being in growth assets. Otherwise, why bother taking the risks?
2. Risk perception: For us, investment risk is about a) capital preservation risk, and b) getting enough reward for the risk we take on. And there's a whole lot of sub-components to that. One of the biggest problems in the market at the moment is that people are confusing tracking error or business risk with their investment risk. Investment risk is absolutely not tracking error. Tracking error, or how you do against the market, is your business risk. Many fund managers are chasing being fully invested, or chasing high-beta stocks in order to try and keep up with this rampant market at a time when for-cost risk is the highest that it's ever been.
3. Preservation toolkit: If you're going to focus on a mandate that attempts, for example, to manage investment risk and attempts to preserve capital and make a reasonable return, you have to have the building blocks or tools that allow you to do this. I would put to you that many mandates are configured not to do this, but rather to manage their tracking error or their business risk. So in our view, you need a capital preservation toolkit; you need to be benchmarked and aware, have a defensive bias; and have the ability to stay in cash when you're not sure. You can't be constrained to be fully invested. And don’t forget currency risk: you need to be very cognisant of the fact that if you're investing in a universe that has a diverse range of different currency earners, you need to be clear about what your currency risk is. You also need to be able to use derivatives, if and when, needed. That has been a very valuable capital preservation toolkit for us.
4. Know the power of cash: A lot of people think that being able to go to cash means you're trying to time the market; I’m completely opposed to that view. We know we are lousy market timers. For us, cash holdings are an outcome of whether there are available opportunities, or not. And in simple fact, cash is a low-risk, income-producing asset (albeit very, very little at the moment), but it's an income-producing option to take advantage of future opportunities. For instance, in January, we ended up with 18% of our money in cash. It was a big number in a rampant market. It took a lot of courage, but, essentially, even though we were quite optimistic, like everybody else about the outlook, we weren't finding opportunities. And therefore, we ended up with a lot of cash. Almost, paradoxically, two months later, in the midst of March, we were probably more pessimistic than most. But the opportunities were so vast that we deployed a lot of cash, over $120 million, and we ended up with our lowest cash holding ever. I can tell you that having the ability to do that takes a lot of discipline and makes you lose a lot of hair, but if you have the tools to do that, it certainly helps.
5. Be patient or brave: There is a time to be disciplined, and a time to be brave. Leave a room when everybody else is trying to rush into it, and then conversely, try to get back into the room when everybody's rushing out of it. So that's what we've really seen in January, March, and come to even now. We feel like we're traders because of this volatility, but pricing is a very real driver. I cannot tell you how hard it is. This is nontrivial, but during March, we did some of our best buying because we felt like vomiting every time we bought something, because I knew then I was going to sit down and buy more of that stock, 5% lower. In the last two weeks, the same thing's been happening almost in reverse, in that we've been selling things. We've made a lot of money on the valuation. It's no longer appropriate to hold, and we've been getting up and walking around our desks, trying hard not to feel absolutely sick because we know we're sitting down and selling more at a 5% higher price. I guess that is probably the hardest part of managing money in a disciplined way when you're focused on capital preservation.
6. Build a team: Probably the single biggest thing to do is to just keep yourself psychologically sound, and you can't do it by yourself. So you need a team where people know when they have to take the baton because you're exhausted and you don't have the wherewithal or the psychological soundness to do it. And you need someone to have your back during this period.
7. Stick to your process: We've seen quite a few people buckle under the pressure in other businesses where they have stall drifted. People often tease us that we don't know how to do anything else. Well, that's probably appropriate. Our process has three steps: idea generation, assessing investment opportunities, and crafting a portfolio. Following the cash is the theme for us.
8. Guard your fundamental beliefs: Everyone's got their own process. We like to follow the cash and we have a reputation that cash is what we follow. You can speak to any management team we ever interviewed, they'll say, "Those are the guys that like the cash." We used to have a saying when I was a stockbroker at UBS. I used to go around the world and meet all these really smart fund managers around the world in every geography. And we always said that if you ever came back at the end of that trip and still believed or your investment thesis still held up it was probably a good investment thesis because everybody would try and rip it apart, and everyone was a lot smarter than you. We think this investment thesis and this process has stood the test of time because everyone's had a go at it and we think it still absolutely stands up.
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