Quest global equities

Stone walls, towers, moats and heavy wooden portcullises. Medieval monarchs and lords certainly knew how to build strong defences. They successfully deployed several different types of fortification to protect their wealth.

The investment community could learn a thing or two from the nobles of the middle ages. While most investors appreciate that protecting capital during the bad times can lead to better returns over the long run, few understand what it takes to build a genuinely resilient portfolio of stocks.

In fact, many of the conservative equity strategies currently popular with investors have the same glaring vulnerability – they rely on just one line of defence.

Take for example “low volatility” equity – one of the fastest-growing strategies. Funds that are referenced to the MSCI Minimum Volatility Index often invest in companies that pay high dividends in sectors such as utilities, staples or real estate. 

These firms are considered stable investments also because they often behave like fixed income securities. Investing in low volatility strategies has worked well in recent years as bond yields have hit historic lows. But dividend-paying companies are unlikely to be as reliable in future. That’s because most of these firms have consistently increased debt to fund dividends and share buybacks, weakening their balance sheets (see Fig. 1). So when business conditions deteriorate, as they are doing rapidly right now, dividends are sure to be sacrificed, weighing on the returns of "low-volatility" stocks.

Fig. 1 - Dividends at risk as debts mount

Cumulative debt (in USD bln) since 1998 of low volatility companies and top quartile 4P companies, ex-financials

Investing in funds that target “value" stocks, or those which trade at an attractive discount to a firm’s intrinsic value, is another popular "style" approach. 

In fact, it is one of the oldest equity investment strategies, pioneered in 1930s by the renowned British-American investor Benjamin Graham, a mentor to Warren Buffett.

Conceived as a way to help investors avoid overpaying for stocks, the approach has proved particularly fruitful during periods of modest economic growth. 

However, cheap stocks aren't necessarily the bargains they appear to be. Relying exclusively on this investment style carries risks.

Take financials stocks, a staple for "value" investors.

Using the MSCI Value index, which tracks large and mid cap securities with value style characteristics across 23 developed markets countries, it is clear that value investors have had an overweight stance in the financial sector relative to the benchmark MSCI World index (see Fig. 2).

Shares in financial companies have suffered disproportionately as the coronavirus outbreak spread globally. And for two reasons. First, the sharp slowdown in economic growth will inevitably cause a spike in banks' non-performing loans. Second, deep cuts to official interest rates will further dent bank profit margins.

Financials are not the only problem area for "value" enthusiasts. So too are energy stocks, another favourite with such investors. 

Energy shares have endured a 30 per cent-plus decline due to a supply glut in oil markets. A recovery looks a remote prospect. Making matters worse, "value" investors have also missed out on technology stocks' long winning streak: the digital economy has thrived as lockdowns have taken effect worldwide.

Fig. 2 - Exposed: single style/factor investing reduces diversification

Active sector weights relative to MSCI World Index

As these examples show, equity funds that focus on a single factor or style expose investors to uncomfortably high levels of risk.

Not only can single factor strategies concentrate investments in overpriced stocks, they are also not flexible enough to adapt to sudden shifts in macroeconomic conditions, such as a collapse in growth or unprecedented monetary and fiscal stimulus.

As a result, they can suffer disproportionate losses when markets turn sour.

To minimise these risks, and build a more resilient portfolio, our investment strategy takes a flexible approach. It invests across styles and factors, tilting allocations according to prevailing economic and financial conditions. The process we follow gauges a firm’s investibility along four dimensions: profitability, prudence, protection and price – what we call our “4P” factor framework.

Fig. 3 - 4P at a glance

The Profitability factor is our gauge of a business's strengths and competitive advantage. Companies that rank highly on this measure have, among other things, steady earnings growth, low operational leverage and high cash generation. Our research shows that firms with a strong track record of profitability tend to have more reliable and predictable earnings than firms whose stock valuations are in part based on lofty expectations for profit growth.

Prudence is the factor that captures a company’s operational and financial risks. In our framework, prudent firms are those that exhibit a lower risk of default and expand organically rather than through acquisitions. We invest in businesses that can create and preserve shareholder value by pursuing manageable growth and maintaining a sound financial profile. We measure this by looking at the nature and stability of the company’s cash flows relative to its financial commitments, including interest, dividends or capital spending.

Our Protection metrics monitor how a firm behaves over the course of the economic cycle – the aim is to quantify systematic or company-specific risks. We are looking for companies that have sustainable business models and whose prospects are insensitive to shifts in economic cycles. At the same time, we also analyse a stock’s volatility and its correlation with other equities to understand how it might affect the risk-return profile of the overall portfolio.

Finally, we don’t want to overpay for our investments. Therefore, our Price screen incorporates several reliable valuation models that help us identify the most attractively-priced stocks. Without this screen, portfolio managers could overlook promising investments or choose stocks that risk a capital loss. As a result of this comprehensive approach, our portfolio has a defensive profile that encompasses large cap, quality, value and low volatility stocks.

Each of our four Ps represents a single line of defence that, when combined, produce an equity portfolio that better able to withstand market shocks.

Preserving capital with a multi-dimensional defensive approach is key to securing healthy returns over the long run.