Protecting portfolios through market downturns
One important thing for investors to think about is how to ensure that the portfolios can be meaningfully protected through inevitable periods of downturn and ensure you remain well positioned to participate in the resultant recovery. In this wire, we discuss five key ways to achieve this.
1) Focus on Balance Sheet
The ability of a business to fund both its day-to-day operations and ongoing growth strategy is an obvious starting point when understanding how an investment could be susceptible to overall financial stress. Businesses with more precarious balance sheets are almost always the most exposed through periods of market downturns, given their ability to fund operations becomes demonstrably harder when heavily reliant on external providers of capital.
One need only review the painful lessons learned through the Global Financial Crisis of a number of excessively levered financial companies with business models predicated on the ability to raise capital cheaply, gear it, and then deploy into higher yielding investments. When capital markets shut (and/or became prohibitively expensive to access), the velocity with which these companies unwound – along with resultant value of their equity – was incredibly aggressive.
As a general rule, it is better to avoid highly geared businesses regardless of where we sit in the broader investment cycle, however that reluctance to be exposed to more demanding balance sheets grows more acute through periods of greater financial stress. While ensuring each investment has the ability to self-fund its growth serves primarily as a risk protection measure, we tend to also favour the embedded optionality that stronger balance sheets provide management teams in being able to deploy that capital into growth opportunities should they become available. Some of our best performing investments through the GFC period, for example, were companies that entered the period in a net cash position and were able to acquire financially distressed businesses with their available cash at highly attractive prices.
Having comfort with a company’s financial position means having a complete understanding of their cash flows (i.e. how much cash a business generates and how much it uses in its normal operating activities). Ultimately, for any business that is held in the portfolio, it is better to have a high degree of comfort they are able to meet their immediate and shorter-term obligations (regardless of underlying market conditions), avoiding the need to engage in a highly dilutive emergency-type raising at a point when additional capital is at its most expensive.
2) Focus on Quality of Business
While balance sheets give a better understanding of financial leverage, you also want to ensure you have a thorough understanding of a company’s operational leverage (or how sensitive their overall earnings are to an underlying driver or economic variable).
When investment managers refer to ‘high quality businesses’ they are typically referencing businesses with earnings more resilient to a weaker economic environment, or those with underlying earnings drivers that are broadly well protected (either through high operating margins, a deep competitive advantage or a dominant market position).
Given how important quality of business is through periods of market downturns, understanding the resilience of a company’s earnings through each stage of the broader economic cycle is a critical part of our investment process.
For every new investment into the portfolio, we subjectively review how we expect that company would perform in a global recessionary scenario, taking into account a number of variables including:
- Balance sheet (can they fund their operations without needing external capital);
- Underlying earnings drivers (and their sensitivity to broader economic activity); -
- Market sentiment toward the sector (financials, for example, are typically aggressively sold off during periods of market stress regardless of the quality of business); -
- Opaqueness of earnings (or how easily forecastable their earnings are); -
- Sustainability of dividend (does the business have a yield that can support the share price through market weakness); and, -
- Currency exposure (the AUD, as a commodity currency, tends to underperform through periods of depressed global growth while the US Dollar tends to appreciate via safe haven flows).
While not every company added into the portfolio will screen perfectly against all of the above metrics, this is not the intended outcome of the exercise. What the measurements allow is to ensure we have a portfolio of companies that are well balanced for the particular period of the cycle in which we currently face. Should those underlying variables change, we are also fortunate enough to have a reasonable understanding of how each company may perform through that scenario and can move to adjust weightings/exposures to those businesses as we best see fit.
Unsurprisingly, our exposure toward businesses with more economically resilient or noncorrelated earnings streams will tend to increase through periods of broader market uncertainty, whilst those with higher levels of operational leverage will be more sought after during periods when the cycle is working in their favour.
3) Don’t Overpay for those Businesses
Valuation always remains core to our underlying stock selection. While the Australian equity market can, at any one time, provide easy access for investors to own any number of truly wonderful, well-capitalised and high-quality businesses, the ultimate return we receive on the capital invested in those companies will always remain a function of the price paid.
While the underlying operations of a listed business may be viewed as low-risk in themselves (i.e. in respect to its ability to generate earnings through a period of economic distress e.g. a health care operator), paying an aggressively high earnings multiple to access that earnings stream is not a low-risk strategy. Similarly, one shouldn’t be afraid to recycle capital when an investment thesis successfully plays out and a resulting elevated valuation no longer provides enough margin for error should market expectations not be met (regardless of underlying quality).
This grows more important through periods of heightened volatility, as the market is decidedly less prepared to give more expensive businesses the ‘benefit of the doubt’ should their nearer-term earnings outlook adjust negatively.
This remains an active consideration currently, given the valuation of a number of businesses across the small and mid-cap space remain elevated. The most expensive industrial companies across the ASX Small Ordinaries at present (top quartile, as measured by one-year forward PE) now trade at an average 25.2x, or 46% above the ten-year average.
As a result, through periods where we have grown more concerned about the nearer term outlook for the underlying market, we tend to see this recycling of capital out of companies with more demanding valuations occur more frequently as we look to add businesses where we feel the valuation more suitably represents the available growth on offer (or the risk around the ability of the business to deliver that growth).
Given we look to invest in businesses that are delivering above-market levels of growth, we typically expect the median valuation multiple of the portfolios will sit slightly higher than the overall market. This premium should be adequately compensated, however, by a superior earnings per share number, reflective of the growth being generated by this business.
4) Remain Mindful of Liquidity
Like highly geared balance sheets, it is not often until times of acute financial stress that the underlying liquidity of an investment (or lack thereof) becomes immediately, and sometimes painfully, apparent. When investing in smaller capitalised businesses, the ability to reasonably enter and exit a position is of paramount importance and one should be mindful to incorporate plenty of buffer to allow for the tightened liquidity constraints that occur during market downturns.
This is of particular importance as investors venture down the market cap curve, as the smaller and micro-cap end of the market tends to wear the greatest cost of tighter liquidity conditions during market drawdowns. Publicly listed assets are ultimately priced by those willing to buy them at any one time and when the appetite for lower capitalised businesses disappears, this can have fairly significant impacts on overall portfolio valuation. When investor redemptions in the space are then added to this environment, shorter-term pricing outcomes can become highly volatile.
As a result, it is important to remain consistently mindful of maintaining a strong liquidity profile and always err towards larger and more liquid companies during times when more vigilance is warranted.
5) Alignment of interests
Finally, while not a structural protection measure as such, we always remind investors that the capital in which they have entrusted with us is invested in exactly the same manner in which we have invested ourselves. Alignment of interest with unitholders has always remained a core pillar of the Ophir business, given the Senior Portfolio Managers, Ophir staff and their families retain significant investments in both Funds. This ensures the team are incentivised to share not only in the upside of the Funds, but also remain equally focused on the protection of their (and our unitholders) capital as well.
Andrew has over 15 years’ experience in portfolio management of listed companies, stockbroking and economic analysis. Prior to co-founding Ophir, Andrew worked from 2007 to 2011 as a portfolio manager at Paradice Investment Management.