What’s next 2020? A timeless answer in uncertain times - June 2020
2020 has included the fastest 30% equity market sell off ever, a record widening of investment grade credit spreads, the largest monetary and fiscal response since WWII, US unemployment whipsawing from the lowest level in 50 years to the highest in 80 years in the space of just three months, negative oil prices, a global health pandemic, and the greatest economic contraction since the great depression. It is not surprising investors are left asking, “What’s next?”
The honest answer is that we have no idea. And market participants who profess (pretend?) to know, with any degree of certainty, where markets are headed in the short term are fooling themselves. As JK Galbraith said: “There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know”.
The future has always been uncertain and unknowable. Today, however, the range of possible economic outcomes is far wider than usual. A better question, perhaps, is how should investors be positioned? The answer, in our view, is timeless and likely to be the same regardless of the macroeconomic backdrop: the best protection from uncertainty is to construct a diversified portfolio of undervalued ideas.
In a multi asset fund, this means owning a range of asset classes which behave differently in different environments. Within each asset class, diversification should be amplified by owning securities that are fundamentally uncorrelated. Adequate diversification, it should be noted, is quite quickly achieved: with only 20 securities nearly all market risk is diversified. It certainly does not mean owning “a bit of everything”, which is frequently cited as good risk management by novice investors.
So where do the twin principles of fundamental diversification and undervaluation lead us?
Within equities, we like:
Salesforce: the global leader in CRM (customer relationship management) software which enables sales force, customer service and marketing digitisation and automation. The company has expanded into adjacent areas, including business intelligence and data analytics, and has ultimately become a key partner for companies looking to drive digital transformation, a trend that is in its early innings. Salesforce has grown revenue at 25% pa over the last five years, and we expect revenue to grow at mid to high teens going forward. This rapid pace of growth is accompanied by a clear roadmap to 30% plus EBIT margins, exceptional cash conversion and an unlevered balance sheet. Management is innovative and the company has strong ESG credentials.
Unilever: with 2.5 billion customers using their products daily, and heritage brands stretching back to the 1800s, this is a durable, dependable business. The range of outcomes for Unilever has changed minimally, whereas the average business is faced with deep uncertainty. It didn’t make sense to us that this franchise should underperform through the Ccovid-19 sell-off.
Ping An Insurance is a Chinese business driven by life insurance, with interests in P&C, healthcare and broader financial services, enhanced by unique technological capabilities. Life insurance penetration is low in China and the business has a long duration growth opportunity. Since its IPO in 2004, Ping An has grown earnings and NAV by >20% pa. On approximately 9x earnings, we believe the shares are attractively priced.
You may have noticed that these stocks span the “growth”, and “value” factors, and include both US and non-US businesses. The widely discussed outperformance of the US over everywhere else, and the apparent disconnect between growth and value stocks may have merit in aggregate (though we would never bet the portfolio on any one factor, and have no conviction when or if these apparent anomalies will revert) but have little bearing on the fundamentals of individual stocks. Our team continues to find opportunity across the spectrum.
The classic diversifying asset in your typical 60/40 balanced fund is government bonds. Historically with good reason, because bonds delivered a dependable real return and usually appreciated in times of equity market stress. In fact, over the last two decades bonds have become the ultimate low-volatility, low-risk, high real-return generating asset and have actually beaten equities by 0.5% pa.
However, as bond yields approach the zero bound, the asymmetry of returns skews increasingly one way. Yields cannot forever be compressed, so the upside potential is limited (bond prices go up when yields go down) and there are a number of ways to lose: miniscule starting yields guarantee poor prospective returns should rates stay where they are; negative real returns from monetary debasement; and negative absolute returns should interest rates rise. Select corporate credits offer better value, while gold and inflation protected securities should cushion the blow from unanticipated inflation.
This is an updated version of the article that first appeared in Financial Mail’s Investors Monthly, May 2020 edition.