Panic, Pandemic and Effective Investment Strategy
Posted 05 March 20
With "preppers" buying up every last roll of toilet paper, this serves as a glaring illustration of short-term, irrational behaviour devoid of rational analysis (especially when Australia has significant scale production of toilet paper!). Irrationality tends to be exponential, which feeds into ill-judged, ill-timed decisions and actions, which are somewhat more serious than stocking up on toilet paper.
Effective investment strategy needs to be able to look beyond the immediate horizon of panic and irrationality. It does so by muting behavioural biases by proper analytical method. Sounds simple, but the human condition is fraught with biases and insecurities. The outcome invariably, is that wealth transfers from the impatient to the patient investors.
The current COVID-19 (novo coronavirus) situation is both serious, complex and evolving. From an investment strategy standpoint, what we can say with some confidence is that there are significant economic costs which will impact business, government and households. Of course there are human impacts and costs, and we do not seek to diminish these, but for a disciplined investor the question is what does this mean for my long-term wealth strategy?
Point 1: Risk Management and Asset Allocation Strategy
Recently we published our Economic & Investment Strategy for 2020. It sees our Core multi asset allocation strategy remain significantly underweight to market risk assets with 50% allocated to cash and interest-bearing securities, and a reduced exposure to Australian equities. This reflected our balance of risks assessment, particularly our concern for the health of the Chinese economy and Australia's significant reliance on China. COVID-19 is, to a large extent, a "black swan" event which has occurred against this backdrop of elevated equity valuations and credit concerns. Diversification in asset allocation is there to take account of this and be a shock -absorber for "black swan" events, and to mitigate the risk of elevated draw-down.
During the GFC, the ASX200 fell 53% and it took the market 10 years to recover back to this high. For the Core multi asset allocation strategy, it took only 17 months for these portfolios to return to their 2008 highs (and to then participate in the next broad uplift in markets). From 1 January 2020 to 3 March 2020, the Core strategy has delivered break-even performance, and for the 12 months has still produced 9.2% per annum. Prior to this market dislocation in January, this strategy took automatic asset allocation and rebalancing profits.
Having a clear and defined framework and strategy for risk and tolerances is the the primary means to manage and mitigate undue short term risk - it is what manages the unknown unknowns. The below graph illustrates the spectrum of risk strategies that Cameron Harrison manages. This is integrated with clients' specific risk management strategies to arrive at a desired position.
Cameron Harrison Asset Allocation
Point 2 : Value is Long Term Cashflow
Value is ultimately what one party is prepared to pay another at a point in time. As we know, this is influenced by a myriad of factors, and in a period of market dislocation many of these factors are short-term biased and in the present environment, almost exclusively dominated by coronavirus news-flow. Ultimately however, value is a function of the stream of cash flows discounted back to the present value. The key elements are therefore cash flow and interest rates, and we take each in turn.
- Cash flow: a reduction in cash flow over 1 to 2 quarters has a minor impact of valuation. Should the impacts of the virus and actions by authorities adversely curtail economic growth for longer then the looped impact could see a deeper recession. Mitigating this will be monetary policy and government spending.
- Interest Rates : this really means 10 year government bonds. In Australia this is at 0.8% pa and in the US at 1.06% pa. As already noted, monetary policy is supporting short term rates and liquidity. Should this be a 2 quarter impact then we would expect bond rates to normalise. This environment is supportive to valuation (and probably a 'turbo charger'). If however government responds to significantly expand government spending and this proves hard to politically withdraw post the immediate crisis response, then we could see inflation pressure build which would elevate bond rates to levels above pre virus concerns. This would be unsupportive to valuation. A Trump/Biden US election contest would be preferred in this regard, whereas a Sanders/Trump contest would unsettle bond markets.
As the data currently stands, we assess that both cash flow and interest rates settings (which drive valuation) look reasonable once you account for likely adverse earnings adjustments over the next 2 quarters. In China for example, we are seeing early and reasonable uptick in economic activity post the Lunar New Year closures which is a reasonable indicator of return to ramping up production again.
Point 3 : Robust Portfolio Income
As matters currently stand, we do not expect any material adjustments to dividends from companies in our Australian and Global Equity strategies. Likewise we anticipate no distribution impact from our listed property and interest bearing. Where income is the core funding source for investor drawdown to fund lifestyle, it is particularly reassuring to know that portfolio income is robust and able to meet these needs. Our Core strategy seeks to achieve two-thirds of total return from income with the balance from capital growth. Sustainable, growing cashflow generation underscores returns at the end of the day.
Peace of Mind Investing
Cameron Harrison have been advising business owners and their families on asset allocation and intergenerational wealth management for over 50 years. We have demonstrated over a long period our ability to manage investments through both the good times and bad by keeping the client at the centre of our business.
For more information on our approach to investment strategy or any other inquiries, please contact us on +613 9655 5000.
Claudio Schwarz on Unsplash