1. Valuation is always critical
There's an old investment adage that price is what you pay for something, value is what you get and understanding the difference is critical.
While many good investors have made substantial gains by picking short-term market moves, the greatest investors in history are those who've outperformed the general market over long periods of time. The one trait they all have in common is they buy assets for less than what they're intrinsically worth. There is an old investment adage that price is what you pay for something, value is what you get and understanding the difference is critical.
The value of an asset is inextricably linked to the earnings generation and, ultimately, the cash distribution capabilities of the asset. A share in a company represents a claim on the earnings of that company, so the fundamental value of the shares is the discounted value of future earnings. Of course, different investors have different views on the myriad of variables that impact the future earnings of a company and this provides the basis for a well-functioning market.
While differences of opinion will always exist, by investing in assets that are understandable and deliver an earnings stream that can be objectively valued, we can reduce the risk of unpleasant surprises. Assets such as bonds, property and shares in profitable companies are the best examples of assets that can be objectively valued. At the other extreme are the likes of gold, currencies and other trading instruments that don't generate earnings streams and are, therefore, all but impossible to objectively value (although it doesn't stop many from trying). Their price is determined by forces of supply and demand, in markets where the dominant participants are often speculators. At UniSuper, we avoid taking outright positions in these types of instruments, although they're sometimes used for hedging purposes (e.g. forward currency contracts).
While valuation principles are most easily understood when applied to individual securities, we can also use the notion of relative value when judging the merits of different asset classes, sectors, markets etc. In determining the asset allocation for our diversified strategies, such as the Balanced option, we look at various metrics to determine the relative attractiveness of investments such as bonds compared to equities, developed markets against emerging markets, Australia against offshore etc. Relative valuation is the primary determinant of the various underweight or overweight positions in our portfolios.
2. Market inefficiencies exist, but some are easier to exploit than others
An inefficient market can be said to exist when the forces of supply and demand are such that the price is not a true reflection of the value of an asset. Inefficiencies, therefore, create profitable investment opportunities.
Markets are very often inefficient because they represent the collective actions of human beings who are prone to all manner of irrational behaviour, particularly when motivated by greed or gripped with fear. While greed and fear are often sources of the greatest inefficiencies, they’re often the hardest to take advantage of because, being human, it’s likely we’ll be feeling greedy or fearful at the same time as everyone else. Even the most confident and successful investors would’ve been fearful during the depths of the GFC. Waiting to pick the bottom of the market and ‘betting the bank’ can be the path to riches, but it can also be a path to the poor house and not what UniSuper is about.
Inefficiencies can be cyclical or structural in nature. Cyclical inefficiencies typically manifest themselves when herd mentality drives prices of all assets well in excess of, or below, fundamental value or historical averages. Identifying where one is in a cycle is a pre-requisite for successful investing (see belief 5).
The existence of structural market inefficiencies often provides the best investment opportunities. A structural inefficiency exists when the normal forces of supply and demand are being impacted by agents acting in a non-economic manner, resulting in distorted prices. The perennial non-economic agents are governments that, in conducting public policy, create opportunities such as tax arbitrages, credit and equity distortions.
The creation of structural market inefficiencies aren't, however, the exclusive domain of governments. The very nature of the asset management industry whereby funds are raised first then spent on certain asset classes, often regardless of valuation, creates inefficiency in itself. The fact many asset managers protect their business risk by aligning their portfolio with index weights, rather than where they perceive absolute value, is also a source of market inefficiency. For example, a manager of a global portfolio will typically consider an exposure of about 8% in Asia to be a neutral allocation because it accords with the weighting on a market capitalisation basis within the MSCI index. However, the Asian economies comprise about 30% of the global economy which logic would dictate is a much better starting point for the determination of a neutral position. Ironically, index managers who base their business model on the basis of market inefficiency are themselves a source of inefficiency.
At UniSuper we’re constantly looking for investment opportunities created by structural market inefficiencies.
3. Translating the macro view to an investment thesis is key
It's not hard to spot macro trends. The world is running out of oil, population growth will put great pressure on food supplies, Asia is likely to become the dominant regional force in the global economy, clean technology must be adopted to reduce carbon emissions etc. However obvious these trends are, it does make them obvious investment propositions. If everyone agrees on something, it's highly likely the market price will reflect the consensus - and therein lies a potential trap. For example, the threat of global warming has attracted many billions of dollars into clean technology companies (wind farms, biofuels etc.) but the returns in many cases have been abysmal. The results are a direct consequence of following the hype but forgetting belief number 1.
We can extend this principle to other macro variables. For example, an upward trend in short-term interest rates will often have people suggesting that one should "obviously" sell bonds (because bond prices have an inverse relationship with yields). But, if the general expectation is for increases in interest rates, there is every chance the expectation will already be factored in the current yield curve (or bond prices). Therefore, simply selling bonds because short-term interest rates are expected to rise isn't a sure way to make money. Interest rates would have to rise by more than that expected by the market to make money.
One of the most quoted macro statistics is the (worryingly high) debt/GDP ratio in the US. The high levels of debt are expected to be a drag on the US economy for years to come and, based on standard economic theory, such expectations sound reasonable. However, it doesn't necessarily follow that the high levels of public debt will render all American companies a bad investment, particularly those exposed to global growth. The high debt/GDP levels in the US are highly unlikely to dissuade Chinese and Indian people from owning an iPad. Indeed, large American technology companies with sound balance sheets and rapidly growing sales in Asia represent one of UniSuper's largest exposures.
4. Diversification has benefits, but it's not the answer to eliminating risk
Diversification is often portrayed as one of the best ways to mitigate risk, based on the age old wisdom of "not putting all ones' eggs in one basket". While age old wisdoms exist for a reason, the success of diversification as a risk management tool in the context of an investment portfolio is a matter of degree and definition. In "normally" functioning markets, it’s true a portfolio of stocks with varying degrees of correlation will exhibit less volatility than a single stock. However, risk mitigation is not really needed in “normal” times, it is needed in distressed times and the experience of the GFC (when everything was sold) showed diversification failed exactly when everyone needed it to work the most.
There is also the question of defining risk. If risk is simply defined as volatility, then diversification could be reasonably expected to reduce risk. However, to the average person, risk is simply the likelihood of losing money. If there is a fear of market failure and capital must be preserved, then diversification isn’t the answer; cash or governments bonds are the answer. Hence, for most investors the single biggest decision is whether to hold bonds or equities, rather than deciding the composition of their equities portfolio.
The vast bulk of UniSuper's portfolios are in strategies that are diversified on several fronts. The Balanced option, for example, is diversified in terms of having a mix of growth and defensive assets. Within the growth assets there is diversification across equities, property, infrastructure and also across onshore and offshore investments. Given the level of diversification at the asset class level, we’re able to take concentrated exposures at a sector, regional or individual security level.
Given the dearth of technology companies in Australia, attractive valuations and favourable industry dynamics, UniSuper’s global exposure is heavily concentrated in technology stocks.
Our property portfolio is heavily concentrated in high-quality regional shopping centres. These assets have a long history through many cycles of delivering consistent returns that keep up with inflation. They appear to be the classic ‘bet on Australia’. Our large, single-asset exposures include Victoria Desalination (31.5% shareholder), Adelaide Airport (49% shareholder), Karrinyup Shopping Centre (100% shareholder) and others.
5. The death of cycles is always exaggerated
Cycles, whether they’re business or market, change in amplitude or length, but they never die. The biggest mistake made during times of euphoria, or times of depression, is assuming their death is due to paradigm shifts. Over the past century, the contraction phase of an economic cycle has lasted less than 12 months on average and the expansion phase has lasted about five years. So, not only have there been many cycles, the overall picture is one of long-term growth. This shouldn’t come as a surprise because economic growth is fundamentally driven by population, productivity and participation (the ‘3 Ps’) in the workforce.
From time to time, growth is also fuelled by leverage and nominal (as distinct from real) growth which also includes inflation. This type of growth is illusory and eventually self-defeating as we have witnessed in many developed economies post the GFC. Medium to long term, however, the fundamentals of the ‘3 Ps’ will assert themselves. Looking at Emerging Asia all three are unambiguously positive and it’s against this backdrop that UniSuper is likely to maintain a bias towards Asia within the global equity allocation. Of course, any such investment will be subject to valuation – which brings us back to belief number 1.