The investment world is your oyster

In the investment world the truth is seldom pure and rarely simple. The strength of global equity markets between 2003 and 2008 was interpreted by many to be ‘tangible evidence’ that company and economic fundamentals around the world were robust. Bond yields were historically low, inflation relatively benign, corporate profit growth was being achieved year-on-year and stock market returns were strong. On the face of it, economic utopia, pure and simple.

However, the events of the last 18 months have proved otherwise. The aftermath of unprecedented credit-fuelled consumer spending and irresponsible fiscal policies that enabled developed economies, particularly the UK and US, to grow only by living beyond their means will weigh on us all for years. Stock markets tumbled around the world as spooked investors reassessed their exposure to risk.

Those investors who constructed portfolios based on benchmark weightings rather than fundamental analysis have been particularly exposed. They would, of course, have made money riding the bull market (2003-08), but as Warren Buffett said, “It is only when the tide goes out that you know who was swimming naked.”

Benchmark strategies are momentum strategies by another name and create a herd mentality. The fear of underperforming can encourage taking benchmark positions to reduce risk. However, by their very nature, indices are backward looking and tell you very little about the financial stability or prospects for any country or company.

By way of example, China and India currently constitute a very small proportion of the MSCI World index, yet both economies are seen as key drivers of global growth for decades to come. A snapshot of the MSCI World index at the end of 2006 reveals that there was a 26 per cent weighting in financial stocks, many of which were US and UK banks.

This is purely a reflection of the growth in the share prices of many of these banks as investors focused on soaring profits rather than the increasing opaqueness of off balance sheet funding and falling lending criteria. Remember in 1990 when Japan accounted for 45 per cent of the world index? Heaven help anyone who invested so much in that country at that time.

These are just a couple of examples of why we believe investors should ignore indices in portfolio construction and concentrate on using firsthand research to find good quality companies with long-term prospects. After all, an investor’s money is being invested in the fortunes of the individual companies rather than countries’ fortunes per se.

It is only by knowing an investment intimately that one can have the confidence to take a decisive bet against a benchmark — and it is only by deviating from a benchmark that one can hope to outperform it. This is known as active stock picking.

Sustained recovery or bear market rally?

A full autopsy of how the developed world came to be in its current critical economic state is not required here — it has been debated widely. It is worth noting, though, that those Australian investors who sought offshore exposure will be, by and large, disappointed with their returns versus the local market over the last five years. This has been further exacerbated by the closet benchmark hugging managers who ensured their clients were highly exposed to both the US and, particularly, financials.

Now, though, is not the time for Australian investors to beat a retreat from the global market. While caution is warranted, long-term opportunities for the patient remain.

Australia is a small part of the overall global market and offshore exposure provides both an opportunity to invest in higher growth economies and leading high quality companies operating in sectors that have little exposure in the local market. Not only does this bring diversification to clients’ portfolios, in many cases valuations are more attractive than we have seen in a long time.

We remain cautious about the short- to medium-term economic outlook, believing that global deleveraging will continue despite the efforts of governments and monetary authorities as rising savings rates and unemployment constrain consumption and growth. The best that can be hoped for is that policy measures can make the slope of decline a shallower one.

From a company perspective, we believe that newsflow will deteriorate throughout 2009 as falling demand feeds through to lower revenues. Profit warnings, capital raisings and bankruptcies will rise, and the recent rally in stock markets should not be seen as the beginning of a sustained recovery.

While the bad news is getting less bad, the touting of genuine ‘green shoots’ may be a little premature. The recent rally perhaps lends itself more to investors being fed up with being fed up and choosing to focus on the less negative newsflow rather than being based on a substantial and sustained recovery in economic and company fundamentals.

Although recent lows may well be re-tested, around the world, high quality companies with strong competitive advantages and sound business models that were previously expensive are now trading at attractive valuations. In particular, we have seen opportunities in Asia and other emerging markets.

While the downturn in developed markets is structural, and it will take many years to pay down debts, in general the downturn in emerging markets is cyclical, with the balance sheets of individuals, companies and governments in a much healthier position. We have therefore selectively added to our exposures in these markets where we are able to identify high quality companies.

Equally, at the end of 2008 we also repositioned our portfolio at the margins to take advantage of the unprecedented valuations we saw in some very high quality companies that we have followed closely but hitherto had been unable to justify adding to a portfolio given their high valuations.

It is important that investors continue to plant seeds for future performance in two to three years’ time. By remaining entirely defensive you risk the holdings in the portfolio hitting the buffers at the same time. By taking a slightly contrarian approach, it is possible to gain access to some selective opportunities in the energy, financial and industrial sectors that are currently unloved, and thereby valued accordingly.

The high-quality companies in these sectors with the experience and balance sheets to survive should prosper when economic growth undoubtedly returns — the trick is to be patient.

In the current environment, however, it is more important than ever to use a range of appropriate valuation and quality measures. For instance, price-earnings ratios are becoming less relevant, given that earnings forecasts are only just beginning to be downgraded and the profit outlook is increasingly uncertain. Measures such as price-to-book, whereby a stock’s market value is compared to its book value, are becoming all the more pertinent.

Meanwhile, in terms of identifying company quality, there is no substitute for face-to-face contact with company management and meticulous comparative research aimed at uncovering those companies with the management track record, competitive advantage and financial strength to outperform in the long term, wherever they may be located.

Despite the gloomy outlook for the world economy, the current environment offers rich pickings for equity investors with a global mandate and a long-term perspective. After years of struggling to find value within global equity markets, the past few months of panic and volatility have presented us with a plethora of opportunities to invest in companies with sustainable business models, healthy balance sheets

and experienced, trustworthy management at attractive valuations.

For Australian investors with a strong stomach and a longer-term investment horizon, we believe such opportunities cannot be ignored.

Stuart James is a senior investment specialist at Aberdeen Asset Management.