Damien Petit, Head of Private Banking Investments, discusses Banque de Luxembourg's key investment principles in an article published in the latest Wealth Management supplement of Paperjam, the Luxembourg business magazine.
Economic uncertainties, chiefly linked to the consequences of the Trump administration’s ongoing trade war and the risk of the UK leaving the European Union without a deal, have been at the centre of investor concerns in recent months. The cyclical slowdown in the global economy is confirmed by confidence indicators and activity data. This comes at a time when the potential for growth is considerably weakened due to less favourable demographic trends, slowing productivity growth and a record level of debt weighing on economic momentum.
Given this gloomy outlook and the equity markets’ exceptional performance over recent months, many investors are starting to wonder whether now might be the time for a wholesale departure from the markets to safeguard against a potential upcoming correction.
Dangers of ‘market timing’
‘Market timing’ is a strategy aimed at trying to predict the markets’ short-term price movements. But does it work?
In our view, straying significantly from a strategic allocation exposes the investor to potentially detrimental consequences. The opportunity cost of exiting the markets (or deciding not to invest) can turn out to be substantial. The risk is illustrated in the following example.
Between January 2003 and September 2019, an investor on the European equity market obtained an annualised return of 6.5%. However, if this investor missed out on the 10 (30) best stock market days – these days representing less than 1% of all days in the period in question – their annualised return would have been much less, dropping from 6.5% to 2.4% (-1.8%)!
European equity market annualised return – January 2003 to September 2019
‘Far more money has been lost in anticipating market corrections than during corrections themselves’ – Peter Lynch.
This example shows the importance of the discipline of remaining invested in line with your investment strategy.
Volatility inherent to equity markets
Having a long-term exposure to the financial markets inevitably exposes investors to market volatility. Volatility is inherent to the equity markets.
Between 1980 and 2018, the average corrections during the year on the European equity markets was around 15%. But these regular dips within the year did not prevent the European market from closing the calendar year in positive territory in three years out of four and posting annualised growth over the whole period in question of around 7%!
European equity market calendar-year returns and market corrections during the year – January 1980 to December 2018
Defining risk profile appropriately
Although volatility is normal, not all investors can accept it in the same way. It is therefore crucial to accurately define each investor’s aversion to risk (and losses) and ensure they opt for an investment strategy that meets their risk profile. A more defensive asset allocation, with limited exposure to the riskiest assets and hence less volatility, will automatically reduce the investor's expected return, particularly in an environment of negative interest rates in the eurozone.
How can we increase the probability of a discretionary portfolio achieving the target return while limiting volatility?
By following some key investment principles:
Our portfolios are geographically diversified. Our strategic allocation in equities is based on the economic weight of the different regions – their gross domestic product – and not on stock market capitalisations. Excessive concentration in a single geographic region can prove damaging. Investors may remember the US market's considerable underperformance between 2000 and 2010.
We also diversify our portfolios by introducing small and mid-cap companies in the equity segment. This section of the market is often ignored by investors. In our managed portfolios, companies with a market capitalisation below 15 billion euros account for around 40% of our exposure to equities. These companies have a number of strengths: analysts tend to cover them less and they may become useful prey for bigger groups that are looking to expand. In the last three years, no fewer than seven companies (out of fifty) in our American portfolio have been takeover targets. International exposure to this market segment improves the portfolio’s risk/return ratio.
We invest in high-quality assets. In equities, the companies in our portfolio have to satisfy a number of criteria. First and foremost, these companies must have a transparent business model as well as one or more sustainable competitive advantages (technology, patents, vast distribution network, etc.) which protect their high profitability. They must also have a strong ability to generate cash flow.
In bonds, we avoid investing in ‘high-yield’ corporate debt/junk bonds, in other words debt issued by companies with a fragile balance sheet.
A strategy that involves investing in high-quality assets – at a reasonable price – helps avoid a definitive loss of capital (as in the case of Thomas Cook, for example).
A long-term view
We emphasise the importance of an investment horizon. Time is the investor's ally. A portfolio’s volatility automatically reduces with a longer investment horizon. For example, the annualised return of the S&P 500 over a period of 30 years is much less volatile than over periods of 1 or 10 years. It is also interesting to note that an investor taking up a position in US equities on the eve of the Great Depression in 1929 would still have seen an annualised return of 8% over 30 years.
S&P 500 annualised return over 30 years since 1928
‘The stock market is a device for transferring money from the impatient to the patient’ – Warren Buffet
Holding investments for the long term does not mean outlawing tactical movements of overweighting or underweighting different asset classes to a limited degree. Both absolute and relative valuation levels are used to calibrate the portfolio in this way.
For example, the contraction of valuation levels on the equity markets in the last three months of 2018, coupled with the absence of an imminent risk of recession, encouraged us to significantly strengthen our exposure to equities in our discretionary portfolios.
Importance of the price paid
Here too, it is crucial to take a long-term view. There is only a slender link between equity market valuation and short-term performance. This means that a market that is expensively (attractively) valued can deliver excellent (meagre) performance in the following months. On the other hand, the relationship between the two variables of valuation and performance becomes much closer as the time horizon increases. Over a 10-year period, the link narrows considerably: high valuations result in an actual return that is generally weak, and vice versa.
Investors need to pay very careful attention to the price they pay for an asset, as the price paid is a determining factor for long-term return.
Link between valuation and performance over 10 years on the global equity market – January 1994 to 2019
A time-tested approach
This approach to portfolio construction, based on various simple and systematically applied principles, protects us from the types of emotional and cognitive biases which all too often cloud the judgement of investors: herd mentality, over-confidence, illusion of control, etc. It has stood the test of time with discretionary portfolios delivering a very favourable risk/return ratio.