History shows that the market is more discerning in tough times as opposed to when things are going swimmingly, when many less-than-stellar companies are carried along by the sentiment and momentum of favourable operating conditions.
Whereas in the current environment to earn an adequate return, we think you are going to need quality companies. Yet being value investors at heart, we also believe in buying companies at attractive prices – based on conservative assumptions, the classic margin of safety.
Buying excellent companies at high prices may not be the quickest way to poor performance but it certainly puts a brake on performance.
Whereas if we can identify companies that, for whatever reason, enjoyed the benefits of so-called economic moats AND if we were able to purchase them at good value prices, we believe that we can deliver strong returns over the long term.
Economic moats are central to many investors’ definition of a quality company. Economic moats can result from a range of factors: a technological advantage, though these can and are periodically made vulnerable by other technology developments; an overwhelmingly strong brand; clear and sustained market dominance; government sanctioned monopoly; high barriers to entry, to name a few.
With this backdrop, what are our guiding investment principles for today’s world?
#1: Defend on the Downside
Looking at our portfolio as a whole, our research has shown the following key characteristics: we have captured 100% of upside market movements and experienced only 60% of downside change when compared against the benchmark over the period. In effect, nearly all our excess performance (over the benchmark) has come from defending on the downside. A lot of alpha can be generated by reducing drawdown and in the market we are currently facing, we think that feature is about to become a lot more important.
#2: Avoid Value Traps
As a value investor we are often asked about the risks of succumbing to ‘value trap’ investing - when an apparently great company is attractively priced. This is often a result of a market view on impending or possible structural change. When setbacks happen, this can be a great opportunity to buy a great company cheaply.
Yet discerning between what is a temporary problem and a permanent structural decline is not always easy. To avoid ‘value traps’, we look for businesses that could recover from setbacks by virtue of their economic models, stable historical earnings and margins, market-leading positions, and strong return on assets. It is also worth considering that we are nearing the end of a long growth cycle; if a company is not generating returns now, it is unlikely to turn the situation around in tougher conditions to come.
#3: Get Active
Strategies that track the market through index or ETF products have risen in popularity in recent years. While quantitative easing has created a favourable environment for passive investing over the last five years, we believe an inflection point may be near. In the current environment, we strongly believe diversification across a broad range of stocks through an index fund will underperform a more selective, value-focused portfolio.
#4: Value Matters
Value investing has been out of favour in recent years, with the market led by increasing prices and multiples for growth stocks, but over the long-term, valuation does matter. Invest in the right companies, but only at the right prices. We think the market is paying too high a premium for growth and any earnings misses could see a dramatic re-rating.
#5: Set Realistic Return Targets
Globally, interest rates are now coming off historic lows. We expect lower returns on financial assets, increased volatility, a wider spread between winners and losers and lower margin for error as monetary policies gradually normalise. This is without taking account of the uncertainties generated by tariffs, trade wars and other geo-political issues. In short, the future is very unlikely to look like the past. We think investors need to moderate their return expectations and anticipate there will be periods of high volatility.
Where to now?
Investors must adapt their portfolios to achieve their return target. Specifically, we believe investors need to:
- Focus on the right companies, higher quality names with more predictable earnings.
- Focus on valuation. Invest in the right companies, but only at the right prices.
- Diversify sensibly, not naively. A widely diversified portfolio perversely may be more risky than a concentrated portfolio.
- Remember that currency could play a major role. Investors should consider currency in their process.
Want to hear more?
You can read further insights and analysis from the team at Lazard here