For more than a year we have held reasonable defensive positions in our multi-asset portfolios. We've grown more defensive both among asset classes – being underweight stocks and overweight cash – and within asset classes.
Defensive may be a somewhat confusing term. We are defensive because, as valuation-driven investors, we believe the prospective returns of some riskier asset classes at present won't compensate investors sufficiently. In other words, we doubt the return is worth the risk today relative to history, because for us being more defensive entails avoiding the risk of the permanent loss of capital and maintaining flexibility to take advantage of future opportunities.
Importantly, the recent volatility in markets is not why we're defensive. We began moving to defensive positions more than a year ago, when we believed prices – especially those of U.S. stocks – began to depart from fundamentals. Just as trees can't grow to the sky, we believe prices will eventually come back in line with fundamentals. In fact, our defensive moves to date have prepared us well for this recent volatility and more – assuming there's more to come.
We recognise that, as in 2017, overpriced stocks may continue to rally. But we're happy to sit out those opportunities for near-term returns because we see the drawdown risk as being too great. If the true risk to investors is the permanent loss of capital, then overpaying for assets is a good way to take on a lot of unrewarded risk – exactly the opposite of what investors should be trying to do in our opinion.
Also, we're willing to be patient when much of our opportunity set is overpriced because markets are cyclical. That means overpriced markets are more likely to lose value, and vice versa. Of course, we'd rather be at the other end of the cycle – buying assets we think are underpriced and waiting for the market to recognise their real value – but discipline is needed at both ends of the cycle.
Low Interest Rates Complicate the Valuation
This investment cycle, stretching back to just after the global financial crisis, has been unusual for a number of reasons, with persistently and exceptionally low interest rates standing out as a leading cause. Loose monetary policy did not make investors less risk-averse, but it did push many investors further out on the risk spectrum.
Low rates continue to bedevil investors today. So, the question is whether you are investing for today's market or tomorrow's. Markets tend to be good at pricing current conditions, but less effective at pricing conditions yet to come. Thus, low interest rates argue for higher multiples on stocks, but only while rates are low. Given that rate rises seem probable, the future looks less sanguine for stocks.
We're Investing for the Full Set of Outcomes
It's important to note that we're not predicting poor results for U.S. stocks this year or next year. Instead, we believe that markets are priced such that the most probable outcome over the next seven to 10 years is that U.S. stock returns will trail their long-term average. Also, we believe higher prices imply a greater likelihood of drawdown or loss.
That's not to say that U.S. stocks can't deliver a 20% return in 2018; we just think that, of all the possible paths markets might take, that one is less likely. Looking across the possible outcomes, we allocate our portfolios based on our impressions of the most likely outcomes implied by valuations.
In this way, we're not happy to be underweight key equity markets and to be holding so much cash and short-term bonds. Cash has generally been a less appealing long-term investment across many countries over the last 117 years, as its value has been eroded by inflation, especially when cash rates are low or inflation is high.
However, in today's environment we hold more cash than normal for two primary reasons.
- First, it's arguably the best store of value over the short term across both rising inflation or falling growth scenarios
- But second, and perhaps more importantly, cash can be quickly converted into financial assets. We want to be prepared to buy underpriced assets, whenever they appear
Similarly, we've moved to more defensive asset allocation weightings in most portfolios and have moved away from many riskier sub-asset classes, especially in our fixed-income allocation. We've moved far underweight – if not completely out of – high-yield bonds and are overweight high-quality government bonds for the same reasons.
In some portfolios, we've also increased the weighting of quality stocks, or those we believe have more stable cash flows, because we think they would offer somewhat better downside protection compared to the broad market relative to the price of assets in general. This partly offsets the risks from the more cyclical equity exposures.
In portfolios, especially if they are outcome-based strategies, we can take large enough positions in these assets to significantly affect returns. This is a sort of barbell approach, with most assets in defensive positions and a select few riskier asset classes aimed at growth.
Patience Remains an Investment Virtue
We haven't stopped watching markets. Watching pitches go by takes considerable discipline—it's not easy. However, we believe this is where our strength lies. It is important to understand where your advantage comes from, and we believe ours are analytical, organisational, and behavioural.
Analytical advantage is the holy grail for fundamental investors, but awfully hard to maintain. We tend to see the best opportunities when most investors are selling, because they must sell or because they cannot deal with the psychological pain of losses. It leaves us perversely looking forward to rough environments, but, as usual, Warren Buffett has said it best:
"The most common cause of low prices is pessimism – sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer."
We believe that sticking to our investment philosophy and to our best investment ideas will help those we serve in the long run by taking advantage of underpriced opportunities while guarding against possible losses.
