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Point of View

Do markets really care about the politics?

By Matthew Brittain, Investment Analyst

Financial commentators are always looking to justify market moves. And with politicians never short of wind they provide a convenient source of noise to justify any conceivable price action. This fitting-the-story-to-the-facts overstates the role politics play in financial markets. That’s not to say politics doesn’t have a huge impact at times, how else could one explain the dramatic market moves following Brexit, Donald Trump and the French election? It’s just that these occasions are infrequent and, in each of these cases the event started a binary moment for something that financial markets care a lot about.

In purely financial terms the Brexit vote is simply about access to the EU economy. The “Trump trade” is about deficit expansion (infrastructure spending and especially tax cuts). The French election only mattered because it could’ve catalysed the euro’s demise. The rest is largely just noise that makes for interesting headlines or is relevant to other stakeholders. Tweets, firings, debates and meetings may give clarity on the probabilities of certain outcomes but their impact on prices should be viewed with scepticism.

Even in cases where something seemingly dramatic happens, the ultimate effect is usually pretty benign. The ride the Mexican peso has been on since the US presidential election is a great, example of this. Given all the noise before the election about the border wall, etc., etc., there was a very aggressive move in the peso, weakening after the result became clear from Mex$ 18 to over Mex$ 22 to the dollar – a ~20% move. It may be hard to believe, but this move has completely reversed despite little changing regarding plans for walls and taxes.

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SOURCE: Bloomberg

We position our client’s portfolios conservatively ahead of such events - where the outcome has a binary outcome – a stance that added significant value last year where we did not anticipate the result of either the EU referendum or the US presidential election. This approach of not overestimating our own forecasting abilities is the foundation of our investment philosophy. We know how difficult it is to forecast events, and how correctly anticipating the market’s reaction further compounds the challenge.

Investing in uncertain times

We think it is easier (and better) to focus on companies whose earnings are less dependent on the global outlook. While this may not be the most exciting of strategies, well-managed companies with strong balance sheets and an attractive competitive advantage can offer investors a steady and sustainable way of achieving growth. This is because they have traditionally offered higher returns on capital and they have the ability to distribute excess cash to shareholders rather than constantly having to re-invest in their own business.

Quality stocks exist in all sectors (albeit some more than others), and across all geographies. It is very difficult to predict what the wider theme of the day is going to be and, within our own stock picking, we don’t spend much energy on this risky approach. Rather, we spend our time looking for businesses with: 

  1. Growing industries, like technology, healthcare, consumer goods, etc. We don’t want to swim upstream, no matter how well the business is run
  2. Stable business models that are very difficult to replicate
  3. Powerful brands, patents, and/or scale, as these are all barriers to entry, and give companies pricing power and stable margins. We know roughly, for example, what the earnings are likely to be for Johnson & Johnson next year, but it’s anyone’s guess what some new hot fashion stock will earn
  4. Strong management teams that have a track record of delivering returns to shareholders by allocating capital well and running a tight ship
  5. Financial statements that show the business is not overly indebted
  6. Products that are not commoditised. We want companies that are in control of pricing, rather than the market dictating this.

 
Once we have identified the businesses we want to own, we wait for bad news, or a poor quarterly earnings report. This usually spooks the market and gives us a chance to buy a great business at a price where the returns we expect make sense over the longer term.

How do quality stocks perform versus ‘normal’ stocks?

The chart below shows how quality stocks have outperformed the standard index over the last 30 years. Where the graph shows an upward trend, it means that quality stocks outperformed normal, and vice versa.

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SOURCE: Bloomberg​

Past performance is not a reliable indicator of future results
 
We know quality stocks are not always as fast growing, but because they don’t have upsets nearly as often their long term performance has been exceptional. Of course their share price can fall like any other stock, and their earnings will suffer if the economy is suffering, but the underlying businesses are more resilient and they usually bounce back very quickly once confidence returns.  In times of political uncertainty this approach can offer some peace of mind.

Investing involves risk and the value of investments and the income from them may fall as well as rise and are not guaranteed. Investors may not get back the original amount invested.