Investors should stick to their guns

Adhering to some basic guiding principles will help investors avoid some of the hidden pitfalls presented by the current Australian equities market, writes Michelle Lopez.

Despite relatively strong performance and resilience in global terms, the Australian equities market is still jittery.

Speculation about whether it has reached full valuation is interspersed with nervous reactions to events overseas. In this environment, investments based on a clear-headed and valid rationale offer the best prospects.

And while the recent release of company reports is revealing the extent to which a company’s actual performance justifies its valuation, a number of other guiding principles can also be used to assess a company’s true worth.

These include stepping away from the benchmark, keeping an open mind, addressing risk appropriately and focusing on quality. And for best results, investments should be made with conviction to avoid diluting success with mistaken attempts at ‘diversification’.

When the market is doing well, as is the case at the moment, standing apart from the benchmark can seem difficult or ‘risky’.

However, this instantly becomes easier once it’s understood that the benchmark is not a zero risk position, nor is it an effective starting point for portfolio construction. It’s certainly not an indication of future prospects or of quality, only past history.

The truth is that the fortunes of index investors fall, as well as rise, with the benchmark — an inconvenient truth too often forgotten by benchmark devotees driven by the momentum of short-term expectations.

Further, momentum investing — jumping on the benchmark bandwagon in the good times, as investors may be tempted to do right now — can be a major instigator of such falls.

That’s just one good reason to avoid running with the benchmark crowd and, more specifically, to be wary of managers that must own stocks within a 1.5 to 3 per cent plus or minus variation of the benchmark, even though these companies may fail their investment screens.

So, if not with the crowd, where should we be running?

The answer is usually in the opposite direction. Towards companies that demonstrate good long-term growth prospects, irrespective of sector or benchmark weighting.

Looking ahead to companies that demonstrate intrinsic quality such as a sustainable business model, a strong balance sheet to fund growth and trustworthy and competent managers offers a far more compelling chance of long-term success than looking backward at a historic index composition.

A benchmark unaware approach and the open mind that goes with it offer the freedom to assess companies on their merits, with a long-term view unfazed by often inflated, shorter-term market-driven concerns which may drive benchmark investors away from quality stocks with high potential to deliver growth and returns.

Equally — and just as importantly — the reverse also applies.

The mere fact that the benchmark favours a certain stock or sector is far from a guarantee of strong performance or growth and in offers no valid reason for investment. Holding a little bit of a stock your process identifies as a poor prospect for risk management purposes is a travesty.

Take Australia’s banking/finance and resources sectors, for example. Between them they make up the bulk of the index but, despite such significant weighting, each comprises companies with vast variations in business models and underlying fundamentals.

Individual companies within the sector can and frequently do fail to meet sustainability, profitability and other rational investment criteria and can, in spite of their large benchmark weight, offer an unacceptably high level of downside risk.

Taking a more absolute view of risk than may be conventional — one which focuses more on the downside concepts of margin of safety and loss of capital, rather than the blue sky components of an equity investment — is therefore another guiding principle that will serve investors well over a full investment cycle.

On the small caps front, the majority of small cap energy companies are in the exploration phase, with high cash outflows and significant capital expenditure required to develop fields and move to profitability.

In the materials space, investors are generally faced with single commodity risk, high cost operations and short life assets.

If one defines risk as the potential for actual loss of capital, rather than deviation from the benchmark, then clearly these are high-risk propositions, and for many, if viewed in these terms, unacceptable.

What this boils down to for investors is a simple message: have the courage of your convictions. If you like a stock, hold it. If you do not, then don’t. A portfolio should be a concentrated reflection of your best ideas, so once you identify a good company, invest a meaningful amount.

To paraphrase John Maynard Keynes, numerous small investments across a large range of companies about which you know very little in the name of ‘diversification’ is unlikely to deliver a strong result. Instead, focus on having significant stakes in companies you know very well.

Michelle Lopez is portfolio manager at Aberdeen Asset Management.