We’ve been receiving a lot of questions about trade wars from you. Our in-house investment professionals have answered them for you.
Let us first say that protection is only one side of the coin. Of course, we want to protect against the downside, but we equally want to avoid speculating on unknowable matters or getting scared out of an investment. These are behavioural traps that feed the ‘buy high, sell low’ problems that regularly haunt investor returns. Portfolio construction needs to be broader than focusing on a single potential downside pressure.
A better way to think about building portfolios, we believe, is to ensure adequate diversification that aims to buffer against any external shocks, not just possible trade war repercussions. That is, our attention should be on getting the most out of drivers of long-term returns such as total payouts (dividends and buybacks), expected cashflow growth, and any overvaluation/undervaluation changes.
Last, one of the best sources of protection is to look at developments opportunistically. As investor fear typically drives bad decision-making, it can lead to oversold assets that now present compelling value and have less downside risk (ie less potential for loss). We’re always looking for buying opportunities, but especially during crises.
We look at trade wars through the lens of how it shapes market sentiment and therefore price action. As valuation-driven investors, we seek to buy assets when they are out-of-favour and underpriced. We do this via a four-pillar framework, where we look at:
Trade wars may have a subtle impact on the fundamental risk pillar, yet it is the price action of other investors that can cause a shift in the other three pillars.
For example, let’s say the U.S. and China relax the trade tariffs and come to some sort of truce (keep in mind we avoid predicting such an outcome), other investors may become overconfident and push stock prices higher. If this were to occur, our 10-year return expectations would be reduced and the contrarian indicators would turn negative—which all else being equal, could lead us to reconsider our conviction in an asset.
Downturns are always concerning. However you have every reason to be confident in our valuation-driven approach during such periods. To provide context, we often first point investors to think carefully about what is knowable (versus unknowable) and important (versus unimportant). We are dealing with a lot of important unknowables when investing, hence why we focus on the power of true diversification.
Further, there is one important knowable that has a habit of showing itself during downturns. That is, the importance of valuations. As valuation-driven investors, we view market prices in the context of their underlying
fundamentals. For example, stocks are shares in businesses that aim to produce cash flows for the benefit of shareholders over time. Fundamentals represent the asset class’s ability to produce these cash flows into the future. In this context, we can better appreciate when an investment may
be cheap or expensive.
The evidence supporting our valuation-driven approach is compelling to us, where we can show the downside protection offered by preferring cheap markets over the long term. Evident in Chart 1 below, we can see that all assets tend to suffer drawdowns (even the cheapest quintile). However, the cheapest assets tend to hold up much better than the most expensive. This should hold us in good stead.
Chart 1: The evidence supporting a valuation-driven approach is powerful. We can’t always avoid losses altogether, but a preference for cheaper markets can reduce severity of drawdowns.
Source: Morningstar Investment Management calculation. Using Shiller data from 1891 to 2014. For illustrative purposes only.
People ask us this question often. Of course, the answer is, “No one knows where markets are headed”. We all know this question doesn’t have a true
answer, but that knowledge doesn’t seem to stop us from asking it.
We think asking this question can be dangerous—not so much in the asking but in the weight put on the reply. We prefer to focus on the long term and try to tune out the noise to help us do so. For example, we don’t have cable news running all day in our offices, nor do we hold a morning meeting, like many asset managers do, to review data that came in overnight.
However, we know that market prices can depart from fundamentals in the short term. So, we study asset class fundamentals and market prices as a way to improve the probability of better performance. This is valuation—comparing the quality of an asset, defined as the level and durability of its cash flows, with its price. When we see assets grow overpriced, we expect them to underperform in the future, and when we see assets become well underpriced, we expect them to eventually outperform. In the meantime, we try to wait patiently for our thesis to play out, always monitoring fundamentals.
We know that since the 2008 financial crisis, Chinese banks have grown their assets significantly by lending to local governments and households. This has particularly shaped emerging-markets financials, where the largest country exposure is unsurprisingly China, accounting for 29% of the index, with the next 42% spread reasonably evenly between India, Brazil, Taiwan, South Africa, and South Korea. Therefore, while emerging-markets financials are certainly not isolated to the China story, they are heavily influenced by it.
As long-term investors, we’re not in the business of predicting if or when a Chinese debt crisis may flare. However, we do know that as the government looks to tighten liquidity, banks face the prospect of holding more capital while potentially incurring higher bad-debt provisions. When considered holistically and over the long term, one should expect a negative impact on profits over time, requiring a degree of caution to be built into valuation metrics. Looked at this way, we don’t see much attraction in the emerging-markets financials sector given current pricing and the potential downside risk. We do still like parts of emerging markets, where valuations make the risk-adjusted returns appear worthwhile.
Importantly, we want to disclaim that we never know the exact time to buy. Nobody does. Based on our decades of research, the best we can do is adopt probabilistic thinking, where we increase our positioning depending on how extreme the asset is priced.
In a portfolio context, this means we’re very selective. We monitor our position sizes closely and increase exposure only when we have meaningful confidence that we can enhance the expected risk-adjusted outcomes. That aside, for the average investor, drip feeding is likely to be a very sensible strategy.
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