Classical finance theory suggests a high allocation to equities when the investment horizon is distant, and when an investor has the wherewithal to withstand an element of - hopefully just temporary - loss. As the investment horizon shortens and a drawdown phase approaches, it is usual to seek a gradual shift to less volatile assets such as bonds to mitigate the risk of having to exit an equity position at a temporary low.
At this point it is also necessary to consider the use of the investment proceeds – whether the ‘liability’ (the future financial obligation) is ‘real’ in the sense that it increases with inflation like school fees and living costs, or nominal and fixed in value like a mortgage debt.
With traditional bonds making up the bulk of tradeable financial assets and not providing a great inflation hedge, those with real liabilities often seek alternative ‘real’ asset investments such as real estate and infrastructure or even more exotic options such as timber funds and agricultural land. To some extent this overlooks what a great inflation hedge equities can be, whilst also underappreciating potential drawbacks that alternative assets might embed, such as illiquidity and excessive valuation. Our view is that a ‘complementary’ approach of incorporating the equity of more resilient businesses may produce a superior risk-adjusted outcome.
Whilst to some extent it makes sense to consider equities as a single asset class, it belies the fact that the underlying companies conduct a wide array of vastly different activities. Operating a mine or a bank is a world away from making food stuffs or medical devices. Individual companies’ capital structures also vary considerably as some sit with a buffer of cash on deposit, whilst others have significant levels of debt effectively magnifying both the potential upside and downside of any operating changes. A relatively stable business with a lot of debt can turn into a volatile investment when management assumptions go awry. With most equities being more cyclical by nature - around 65% by market capitalisation – the remaining less cyclical businesses can get overlooked by association.
By design, the Sanlam Stable Global Fund seeks out those companies with less volatile business models that are less susceptible to economic volatility. Whilst an artificial knee and hip replacement maker will see a slight change in people seeking prosthetics depending on employment levels, this volatility is (very) slight compared with an iron ore producer whose future fortunes may be largely contingent on whether a Chinese fixed asset investment is going to see further stimulus or not. We are also conscious that low profitability or low cash conversion can also become a weakness even when income might be relatively stable. We thus only consider businesses that can cover their costs of capital with cash at both the peak and any trough of their relatively muted business cycle.
By ensuring the companies we invest in have relatively stable businesses and cashflows, one component of volatility, namely earnings variability can be isolated or dampened to produce a more stable return outcome over time. However, like everyone else, we have no control over the bid and offer price of publicly traded assets. The value the market places on our portfolio’s earnings or cashflows will wax and wane over time. We do however take advantage of relative value, selling those companies that have risen through our estimate of intrinsic value to recycle into new positions that should meet our investment objective of CPI + 6% over time.
Maintaining a disciplined approach to valuation allows us to implicitly avoid companies whose share prices may be embedding unrealistic or unlikely assumptions. Whilst by no means giving complete protection to the downside, focusing on undervalued or ‘cheap’ companies helps to diminish the impact of periods of retrenchment in the market’s overall valuation, and perhaps avoiding altogether parts of the market that are overheating and have become susceptible to bubbles.
Thus, when it comes to asset allocation and an imperative to reduce volatility by reducing exposure to equities, we encourage a nuanced approach. Most investors’ caution towards equities is based upon wariness of volatility and fear of significant loss. Such events typically occur when economies are about to or do turn and have a marked impact on the most cyclical of companies like banks, mining companies and industrials. It also occurs when parts of the market become over-heated on valuation as market participants focus on one or a limited number of factors which later succumb to extended assumptions and disappointments. By focusing on more resilient businesses with a disciplined approach to valuation we try to capture the equity market’s upside whilst reducing volatility and the scale of likely drawdowns over time. Rather than rushing for the equity exit door, a migration from riskier equities through less risky equities offers the potential to remain invested in higher return assets for longer.
The Fund has holdings which are denominated in currencies other than sterling and may be affected by movements in exchange rates. Consequently the value of an investment may rise or fall in line with the exchange rates.
The Fund holds a concentrated portfolio which could mean that it will be volatile when compared to its benchmark.