The recent past has not been easy for investors in the Investec Cautious Managed Fund. Every investment approach or style experiences periods of underperformance, but that doesn’t make it easy for clients to retain their poise. We are acutely aware of the importance of ensuring investors understand what we are doing and why.

 

From a portfolio manager’s perspective, the best approach in tough times is to focus on what we are trying to achieve and to make sure that our process still makes sense. I believe it does. In fact, in a world where the persistence of low inflation has become an article of faith – and, as a consequence, many portfolios look increasingly uniform – our different and diversified strategy may make more sense than ever for clients looking to build a diversified portfolio of funds.

The Cautious Managed portfolio looks quite unlike its peers:

The Fund’s underperformance has been driven primarily by three of these features, specifically: the strength of the US stock market; our focus on value stocks, at a time when growth stocks have soared; and the fact that we hold precious metals for defensive purposes rather than bonds, when the latter have done well in this long phase of subdued inflation and low yields.

 

Below, we discuss the rationale for these positions in the context of the current environment. The short version is that we think there is mounting risk in the dominant market view. Investors have herded into equities with perceived defensive characteristics (i.e., growth stocks) fearing a downturn, while trusting in bonds to offset an equity slide.

Consequently, they are paying high prices for their equity exposure, and thus limiting the possible upside; while failing to guard against the potentially inflationary policies that today’s populist politicians are likely to implement if the global economy deteriorates. Inflation would be simultaneously bad for growth stocks and bonds – a particularly unwelcome scenario for those holding both in the hope that doing so will stabilise a portfolio.

We think inflation is a non-negligible threat. Having responded to recent crises by repeatedly lowering interest rates, central banks can’t cut rates much further. The response to future slowdowns or recessions will likely be aimed more directly at the general populace, through increased government expenditure. That will put up upward pressure on prices.

Our short position in US equities, which has been one of the main sources of underperformance for the Cautious Managed Fund, reflects our view that the US stock market is overvalued and ripe for a reversal. On a broad range of valuation metrics – share prices relative to earnings, share prices relative to book value, total market capitalisation relative to US GDP, and more — US equities are trading at levels rarely seen in history.

Driven by a small group of companies, the main US equity indices have hit record highs this year, outpacing the stock markets of other major developed nations. This has occurred against the backdrop of a slowing global economy and multiple indications — including labour market data, consumer confidence surveys and an inverted yield curve — that the business cycle has peaked. Markets always retain the capacity to surprise. But it is becoming increasingly difficult to see how the elevated prices of US stocks, which have run far ahead of those of the rest of the world not just over the past 12 months but over the last decade, can be sustained. Maintaining this short position hasn’t been a comfortable ride. But we continue to think it is the right way to address a significant market imbalance that we believe will, in time, correct.

 

Our allocation to value equities – typically those of businesses that are more closely tied to the economic cycle – has been the biggest drag on performance. Value stocks are deeply unloved and as cheap relative to growth equities as they have been for years (see chart). As discussed, a key reason for this is that investors are worried about the economic outlook and prefer defensive (growth) stocks to cyclical (value) stocks.

Many investors think growth will maintain its lead for the foreseeable future. The past, as it says in the small print, is no guide to the future. But history suggests that for growth to dominate in perpetuity would be unusual, to put it mildly. Value has always bounced back after significant weakness, and that bounce-back has always been robust. If inflation takes hold, the shift back into cyclicals could be swift and we doubt it will be easy reorient a portfolio after it has begun. So we’ll continue to provide our investors with exposure to the value factor, which has typically seen strong returns over the long term.

 

Of course, a broad reversal in equity markets won’t benefit value or growth, and there are plenty of causes for concern. The economic cycle appears to be past its peak, major equity indices are at or near record levels, and we’re concerned what central banks may do next. We don’t try to time the market and believe that long-term success relies on staying invested. But given the balance of upside vs. downside risk at present, in allocating to equities it makes sense to us to be choosing stocks that are extremely cheap rather than ones that are extremely expensive.

As a reminder, we buy stocks that are out-of-favour and that we believe will come back into favour as issues are dealt with by management or operating conditions improve. Typically that takes 3-5 years, and at any one time our equity holdings are usually spread across this recovery cycle.

A significant amount of our recent underperformance has come from a relatively new crop of stocks – ones that we bought in 2018, using the proceeds of a 2015 vintage that ultimately did well despite a sticky start. Some of these 2018 vintage stocks have since moved more out-of-favour, including: Adient (car seats), Delphi (car components), Cielo (Brazilian payments processor), Capita (IT outsourcer), and Barclays. However, we believe it is still early days for these holdings and that patience will be rewarded.

We fully acknowledge that the volatility of value equities may be disconcerting for investors. But we also believe that, with many value stocks in the bargain basement, this is a time that we can make the most difference to the long-term performance of their portfolios. We are buying exposure to industries that we think will be around for many years (including autos, building-related sectors and banks), but which investors are selling down aggressively because of recessionary fears.

That brings us to the defensive part of our portfolio. As we noted earlier, we don’t try to time the market, but we recognise there are major risks. The instinctive reaction of this generation of investors in the face of danger is to buy bonds. But given the inflationary threats we outlined earlier – stemming not least from trade tariffs, anti-globalisation, anti-immigration policies and the shift of power from capital to labour – we are steering clear of this asset class, which would compound risk-asset losses (rather than ameliorating them, as intended) if bond yields rise. This is why our portfolio has significant exposure to precious metals – to smooth returns in the event of an equity downturn.

In short, we are sticking to our knitting because we believe that doing so will serve the long-term interests of our investors. We know these are tough times for them. But we also believe that our different and diversified Cautious Managed approach is appropriately aligned for the risks and long-term opportunities in the market, and could have an important role to play in a well-diversified portfolio. We are grateful to those who have chosen to come with us on the journey.

 

 

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