Experiences that have been enjoyable in the past are always sought after into the future. This behaviour is often referred to as 'anchoring'. Andrew Fleming, Deputy Head of Australian Equities at Schroders, says risks are building in situations where historical conditions have lead to ‘wonderful’ experiences for investors.
Fleming highlights the recent bank levy as one example of risk that has unexpectedly accrued to equity holders:
“Often, risk emerges where you don't expect it, and probably when you're most complacent. The fact that the environment has been quite strong for the last couple of decades, shouldn't be mistaken for complacency about what's likely to emerge in the future.”
Why is it time to think differently?
There's always a good reason why people anchor. Experiences that have been enjoyable in the past, are always sought after into the future. Sometimes though you have to be alert to conditions changing around you. So, to the extent that we've had a very buoyant period of credit creation in Australia, and a very benign environment of bad debts, it's lead to a wonderful experience for bank equity holders. That's unlikely to be able to be repeated in the future to the same extent. In fact, it's impossible that it'll be repeated to the same extent through the next decade. It doesn't mean that they get catastrophic.
It does mean that diversifying away from what has been the silver bullet of return with low risk on the Australian equity market through the next 5 to 10 years, is probably an imminently sensible idea.
It doesn't mean in doing that, that you'll likely have to sacrifice any real return. It is likely in doing it that you're buying quite a degree of risk protection at a moderate price.
What risks are investors overlooking?
Risk at a fundamental level is simply a function of the gearing embedded in a company, but also its operating earnings in the future.
The bank levy we've seen recently is arguably an example where risk has accrued to equity holders where they weren't expecting it. On the one hand, pricing power was evidenced through the banks putting up mortgage rates continuously.
On the other hand, they arguably left the door open for a political response, where the extra profit that was obtained through increasing prices of mortgages, is now being taken back by the government, as a levy.
Often times, risk emerges where you don't expect it, and probably when you're most complacent. The fact that the environment has been quite strong for the last couple of decades, shouldn't be mistaken for complacency about what's likely to emerge in the future.
People often criticise BHP for being arrogant, because of its position, and its dominance in an industry, and for wasting the proceeds of the cash flow for most privileged assets. It's a great example where being big in itself can sometimes be a disadvantage and not an advantage and necessarily accrue to equity holders into the future any ongoing benefit.
In fact, there's a good argument to be made and Woolworths is a classic case study of this through the last five years.
By far the hardest thing for companies to do, whether their big or small, is to focus on being good, rather than being big.
Most return accrues to equity holders when companies best executed upon a goal of being good, rather than being big.
The Schroder Equity Opportunities Fund is an index unconstrained, all cap strategy managed by the highly rated Schroders Australian Equity team.