How active portfolio management can preserve wealth in wild markets

Active portfolio management will be a key means of tackling sector head-winds, writes Jonas Palmqvist.

The Australian stock market is up 24 per cent over the past year including dividends, so it’s easy to forget just how big the relative moves between different sectors have been during this time. 

There are always parts of the market under strong pressure, be it cyclical or structural. The stock market is, after all, a place to facilitate movement of capital from declining to rising industries, fuelling the continuous so-called ‘creative destruction’ in the economy. In the end it helps drive economic growth. 

The struggling stocks in the mining and mining services sectors are the obvious current examples of the process, a pressure that has yet to bottom, in our view. 

The domestic steel, retail and media sectors are examples from recent years (see Graph 1). What sector will be next? 

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The key point is that in a well-managed active equity fund you can limit your exposure to these destructive forces, preserving some capital and re-investing it in other, potentially thriving sectors.

The alternative to an active fund – an index fund – is cheaper; however you are always guaranteed full exposure to the under-performing parts of the Australian and global economies. 

The upside bias 

Most discussions around long-only Australian equity funds are typically about their ability to find winners. This is only to be expected, as it plays into the inherent bias of the market to look for upside in stocks, before downside risks are considered. 

Firstly, most people are hard wired to look for upside to start with and secondly, the majority of market participants are clearly incentivised to push the positive side of things – be it bankers, broker analysts, portfolio managers or company managements. 

Most participants make more money over the cycle cheer-leading stocks, rather than critically questioning them. This creates a relative opportunity for investors who do their own work on companies’ fundamentals. 

From head-wind to tail-wind 

The issue with this built-in upside bias is that it can cost investors money. There are always stocks, and whole sectors, under strong structural or cyclical pressure. 

These stocks can under-perform for a long period as the market only gradually comes to terms with their lack of future earnings power.

Put another way, the market is very efficient at setting a price for stocks on short term news, but much slower at setting a longer-term value. It can take years as the negative forces play out.  

The opportunity and challenge for portfolio managers lies in identifying these earnings pressures early enough, limit the exposure to the trend, and re-invest the money in sectors with a brighter outlook. 

So, even a long-only fund in a relatively narrow market such as Australia can be involved in a bit of capital preservation. 

A core, diversified equity fund will of course always have some exposure to these negative forces as they play out, whereas a more concentrated fund has the opportunity to avoid the pressure all together - but the risks are obviously higher, if the fundamental analysis proves to be incorrect.  

There are many historical examples of sectors under pressure in the share market. Some of the more recent ones are steel and domestic retail during 2007-2012, when these stocks fell a long way. 

By completely avoiding investing in these sectors, investors made almost 3 per cent relative performance during those years, preserving some of the capital and having a chance for bigger exposure to sectors with a better momentum such as banks, consumer staples or health care.  

The vanishing mining super cycle 

The ongoing pressure on mining and mining services is obviously the main current example of sectors under pressure. Since the peak in 2011, these stocks have gone from a combined 32 per cent to 18 per cent weight in the index. 

There’s been value destruction in absolute terms as well, with their total market cap decreasing by more than A$150 billion during this period. The stock market is telling us that the mining super cycle is ebbing away, but once again it’s only being priced in gradually (see Graph 2). 

 So are we coming to an end of this negative trend now? Our work on future earnings indicates probably not.  

The global commodity price boom peaked in 2011. The price-led part of the cycle is over and earnings are now reliant on production growth and cost control - both of which pose far bigger challenges. 

For mining services companies, they’re facing more than a -25 per cent drop in Australian investment by resource clients, already, in 2014. 

Projects with a total future value of over A$100 billion have been cancelled or postponed, and the number keeps rising.

The realities of this are now setting in for the mining services industry (see Graph 3) – we recently saw over a dozen profit warnings in just a few weeks. 

 So there’s strong pressure on a very important part of the Australian economy, but this doesn’t automatically mean we should avoid equities. 

Again, the recent 12 months is a good example: mining and mining services sectors have fallen heavily but the market index is up a very solid 21 per cent thanks mainly to financials, telecoms, health care and food & beverage.

So, in the face of the ending of the super cycle, equities have proved to be a good investment - but some stock selection has certainly helped boost returns.  

The elephant in the room? 

Australian bank stocks have had a tremendous development over the past year, returning nearly 50 per cent including dividends. 

This has partly been backed by solid earnings and rising dividends, reflecting the strength of the franchises and the improvement of international funding markets. 

Indeed, recent financial reports by the banks resulted in small upgrades of earnings and dividends, which have been a rare event in the Australian market recently. 

That’s not to say there aren’t risks to watch very carefully. Funding markets could worsen again, indirectly putting new pressure on deposit margins.

The Australian domestic economy is currently showing clear signs of weakness, as indicated by rate cuts by the RBA, and we could see a rapid rise in unemployment. 

At the same time, the banks’ bad debt costs have come back down close to the low pre-GFC levels. Banks earnings look solid at the moment, but are not indestructible. 

Of course, given the current $A355 billion market cap and 30 per cent index weight of the bank stocks, the implications of a real earnings head wind for them could be substantial for the overall savings of Australians. 

However, an active portfolio manager can help investors preserve wealth if this was to unfold, whereas an index fund will guarantee you have full exposure to the downside of such a headwind (see Graph 4). 

Jonas Palmqvist is AMP Capital’s senior portfolio manager/analyst.