As a Managed Portfolio provider, we've fielded many questions on investing, many of which have been pointed and thoughtful.
Upon reflection, it only seems right to call 2019 the year of contrast. On the one hand, it has been a great year for investors. Double-digit returns will usually put a smile on most investors faces. But on the other, we've endured one of the more unpredictable periods in history, with political instability and trade wars dominating question time. With that as our precursor, we are pleased to introduce our top three questions of 2019. This ranking is subjective, of course, but they still have relevance leading into 2020, so we hope you enjoy them.
Why are you investing in the U.K.? Are you changing your conviction as the political and economic weakness evolves?
We believe the case for investing in the U.K. remains strong, especially in a relative sense. To explain why, we can answer it three ways; practically, fundamentally, and empirically.
- Practically, we know investors shy away from uncertainty, which has impacted sentiment and will continue to do so—for a while. The fact you're concerned about the U.K. shows that demand is impacted in the short term. However, we'd suggest you broaden your perspective when thinking about supply and demand. Ultimately, long-term demand is a function of the cashflows the underlying companies can produce, which in the case of the U.K., looks on a solid footing (see fundamentals below).
- Fundamentally, we are fond of saying that the U.K. economy is not the same as the U.K. equity market. In fact, over 70% of FTSE 100 companies (the 100 largest listed companies in the U.K.) derive their revenue offshore. Moreover, approximately 28% of these revenues are derived from emerging markets. Therefore, it is a mistake to think that buying U.K. stocks will give you exposure to the U.K. economy.
- Empirically, we'd simply cite that the link between economic growth and investment returns is weak at best. The point isn't that a worsening economy doesn't matter but that we've done the work and think that even in a very bad scenario we'd still make a decent return for investors, according to our estimates. So, yes – the U.K. economy could worsen, but that isn't a basis for us to change our conviction.
What is your 2020 outlook?
It has been a great year for investors. Double-digit returns will usually put a smile on most investors faces. But on the other, we've endured one of the more unpredictable periods in history, with political instability and trade wars dominating question time.
We'd prefer to reframe the 2020 outlook as the 2020-2030 outlook.
In this light, the only way we can explain our outlook at this time is to set the background. Following the global financial crisis in 2008, interest rates sank across the developed world and stocks launched a 10-year bull-market run. Markets have cheered rising earnings and lower interest rates, but seemingly few people have paid attention to how long this accommodating landscape could last.
Put frankly, markets are out of balance. And we expect rebalancing to come in the next decade. Performance gaps today between value-style stocks and their growth counterparts and between U.S. and non-U.S. stocks have widened to historical extremes. Looking across history, economies and markets tend to be cyclical—trees don't grow to the sky, as the German proverb puts it. So, we expect the next 10 years of returns to look very different to those of the last 10 years. Our view isn't based on proverbs so much as market fundamentals.
The good news for our investors is that these rare extreme performance gaps have historically been followed by high relative returns for valuation-driven investing approaches. Whilst these periods of strong cyclical returns leave investors susceptible to performance chasing, they can bring the best long-term opportunities for contrarians. In this sense, we believe benchmarks are susceptible to larger downside risk than normal, although we do see opportunities by favouring unloved markets and diversifying in a manner that protects against the risks ahead.
How will 2020 play out? That's anybody's guess. But we see opportunities for investors willing to be patient and stick to a valuation-driven approach.
Why are "risk-adjusted returns" more important than just "returns"? Surely people just care about the bottom line.
Put frankly, markets are out of balance. And we expect rebalancing to come in the next decade. Performance gaps today between value-style stocks and their growth counterparts and between U.S. and non-U.S. stocks have widened to historical extremes.
When we talk about risk-adjusted returns, we are focusing on delivering the maximum amount of return, for a given level of risk, as opposed to just generating returns without regard for the risk taken in achieving them.
As humans, returns are easy, while risk isn't. Risk analysis feels opaque, theoretical, and even counterproductive during the good times. So when returns are rolling in, it's easy to ignore risk, then a crash happens and it feels as important and alive as ever.
The lesson is simple: ignore risk at your peril. But we'd add to that – you need to focus on the right types of risks. We can usually bundle this into two core forms; 1) downside risks to your portfolio, or a permanent loss you can't make back, and 2) behavioural risks, including poor timing decisions that trigger a permanent loss (especially those that would otherwise be temporary). Things like leverage, valuations, or becoming technologically obsolete are true risks. On the other side, volatility feels like risk, but we'd argue it is less of a concern. For example, a market bobbing up and down is less risky than a market that carries unsustainable debt levels.
So, yes, risk-adjusted returns are important, as long as they are defined in the right way. We'd even say risk management can make you money, as minimising drawdowns in market falls can be as important (if not more so) than keeping up with the market as it rises.
Don't be fooled into thinking goal attainment is all about catching positive returns. Those that think this way are procyclical, which is a risky way to invest.