Investment Strategy Archives - the patient investor

February 27, 2023

Forecasting risk

The danger with forecasting is that our analysis may be accurate, based on the evidence at hand, but the outcome may be completely different because of some unforeseen event. Someone at a live food market in Wuhan develops a respiratory fever, crude oil falls to minus $37 per barrel, the Fed dumps $3 trillion into financial markets in just three months, China imposes economic sanctions on Australian coal, and Russia launches a full-scale invasion of Ukraine — all of these events are unforeseeable and likely interconnected.

So why do we persist in making forecasts and basing investment decisions on them?

Consider the alternative.

An inability to make forecasts would destroy the global economy. A farmer consults weather forecasts when planning what crops to plant, how much to plant, and what fertilizers are required. A retailer may similarly consult economic forecasts when making decisions to stock her shelves. Forecasts are necessary to plan for future events, whether they be crop harvests, retail sales or longer-term investments.

Conclusion

We need to recognize the uncertainty surrounding forecasts. The more complex the environment, the higher the degree of risk.

Attempting to accurately forecast future events is futile. And anchoring investments to a particular outcome is risky. It is safer to simply estimate whether the risk of a particular outcome is high or low.

For example, we may believe that the risk of a hard landing in the next 12 months is high and position our investments accordingly. But bear in mind that no particular outcome is certain and we need to retain sufficient flexibility to adjust our strategy if the probability of an alternative outcome should increase.

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” ~ Samuel Clemens

January 19, 2021January 20, 2021

Prediction | Joseph Calhoun III

“An investor’s task is not to predict the future but to properly analyze the present.”

~ Joseph Calhoun III

March 5, 2018March 5, 2018

Warren Buffett: Bonds and portfolio risk

It is a terrible mistake for investors with long-term horizons – among them, pension funds, college endowments and savings-minded individuals – to measure their investment ‘risk’ by their portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk.

~ Warren Buffett, letter to the shareholders of Berkshire Hathaway – February 24, 2018

October 4, 2017October 5, 2017

Structural Trends and Affected Industries

Discussion of major structural trends in the global economy and the impact they have on specific sectors or industries. A full list of identified trends is available at Structural Trends. I will focus each month on changes to existing trends, the latest statistics, and their impact on sectors or industries.

Cyber Security

Rapid growth of the Internet and online services has spawned a whole new array of threats to governments, corporations and private individuals. Data breaches and identity theft are growing.

The type of cyber attacks has evolved from early blunt instrument, denial-of-service attacks — where co-opted servers are used to overload the target with bogus traffic — or destructive viruses, to more sophisticated penetration of security networks using phishing, worms and trojans.

Opportunity

Growth of cyber attacks and data breaches has established a niche for specialized security software and consultancies to protect client networks from external threats. First Trust have a Cybersecurity ETF (CIBR) that illustrates sector performance. Their top 10 holdings are not a comprehensive list of companies in the industry but offer a good start.

Threats

All industries are vulnerable but Trend Micro identifies the most targeted industries as:

Health Care
Education
Government
Retail
Financial

Serious security breaches are capable of destroying shareholder value as with the September 2017 Equifax (EFX) announcement of a major data breach. The credit reporting specialist recorded a 37% fall in stock value.

But at this stage security breaches are considered unlikely to blight an entire industry.

Social Media

Social media giant Facebook (FB) dominates social networks with three of the top five networks ranked by number of users: Facebook, WhatsApp and Facebook Messenger. The other two are Youtube (Google) and China’s WeChat (Tencent).

Social media is dominated by mobile users. Approximately 90% of active users connect via mobile, according to We Are Social global stats for January 2017, and mobile social network users grew 30% over the previous 12 months.

Opportunity

Social media growth is expected to continue over the next three years but is then expected to slow as saturation increases. Mobile usage growth has already slowed to 5% (Asia-Pacific: 4%) and should act as a constraint on long-term social media growth.

Threats

Proliferation of fake news and misinformation threatens the industry. The motto of early Internet adopters was “Information is free” according to Mike Elgan at Computerworld, but it has now become “Information is fake”.

He explains:

The rise of false information online is caused by five factors:

1. The Internet allows anyone anywhere to publish anything everywhere.

2. Digital content is easy to counterfeit or modify.

3. Many people have powerful incentives to spread false information.

4. It’s easier for social network algorithms to favor emotionally reactive content than true content.

5. The public increasingly relies upon digital internet content for “knowledge.”

Facebook, Twitter and Google claim that they’re taking active measures against the rise of fake information. But previous efforts have failed.

Reaction from major advertisers and governments is likely to impose greater responsibility on online media to restrict publication of misleading information on their platforms, or face onerous penalties.

Online Retail

E-Commerce retail sales are growing rapidly and now exceed 9% of total retail sales or $110 billion on a quarterly basis.

US online retail giant Amazon has announced plans to open its first major Australian warehouse in suburban Melbourne, according to ABC News.

Australian Retailers Association, Russell Zimmerman, played down the threat (to Wesfarmers and Woolworths) saying traders had been planning for Amazon’s arrival.

But Amazon operates on a lower cost structure than traditional bricks-and-mortar retailers and their margins are bound to come under pressure.

Opportunity

Online retail is expected to grow significantly as a percentage of total retail sales over the next few decades.

Threats

Medium-term: Bricks-and-mortar retail margins are likely to shrink.
Medium-term: Shopping center vacancies are expected to rise.

Electric Motor Vehicles

Adoption of electric battery-powered vehicles is accelerating in Europe, with several countries targeting zero sales of internal combustion engines in the next decade.

Opportunities

Huge amounts of money are being poured into battery research and development but there are no clear winners as yet. The rewards will be massive.

Threats

Australia lags far behind in the adoption of electric vehicles but the long-term threat to automotive groups is diminishing revenue. Not only from new vehicle sales, with manufacturers like Tesla selling direct to the consumer, but also falling service revenue as electric vehicles have far lower service requirements.

Telecommunications

The telecommunications industry typically requires massive capital investment to deliver low marginal costs, whether that be for mobile phone calls or Internet connections. It is dominated by a few large players, whose size delivers cost advantages over competitors.

Australia

In Australia, the natural order has been disrupted by the government-funded National Broadband Network (NBN) which delivers fiber-to-the-home in some areas of the country and fiber-to-the-node to the rest where fixed line copper or co-axial cable (Foxtel) is used to bridge the last 500 meters to the home. The NBN supplies broadband Internet connections at the same basic cost to large and small telcos alike, allowing smaller players to undercut large competitors such as Telstra, who have traditionally dominated fixed line and broadband, eroding industry profit margins.

Broadband

Growth in numbers of broadband subscribers has slowed but download volumes are growing exponentially.

Already there are complaints of slow download speeds on NBN as telcos overload purchased bandwidth to compensate for narrow margins.

Telstra and Optus have announced plans to commence the roll-out of 5G mobile broadband in 2018. At 10 Gigabits per second, speeds are expected to be up to 100 times faster than the existing 4G network and 10 times quicker than the fastest NBN plans.

Mobile

Growth in the number of mobile handset subscribers (26.3 million) in Australia has slowed, to 3.4% for the six months to June 2017. But download volumes increased 44.5% for the year ended 30 June 2017.

Threat & Opportunity

The telecommunication industry faces a profit squeeze in the medium-term (say 3 to 5 years) as the NBN disrupts profit margins but the long-term future looks bright as data downloads in both broadband and mobile are expected to grow exponentially.

August 15, 2016

Beware of recency bias

Every the year the 2016 Russell Investments/ASX Long-term Investing Report provides an invaluable summary of before and after-tax returns on various asset classes for Australian investors, over 10 and 20 years.

Naive investors are likely to automatically pursue the asset classes that offer the highest yields. Recent performance is more likely to attract our attention than more stable longer-term performance. Josh Brown highlighted last year that mutual funds that attracted the most new investment tended to underperform funds that attracted the least new inflows. I suspect that the same applies to asset classes.

If we consider each of the asset classes highlighted, it is clear that performance over the next 10 years is likely to be substantially different from the last decade.

Australian Asset Classes 10-year Performance to 31 December 2015

Source: 2016 Russell Investments/ASX Long-term Investing Report

Australian Shares

Australian Shares endured a (hopefully) once-in-a-lifetime financial crisis in 2008. 10-Year performance is going to look a lot different in two years time (20-years is 8.7% p.a.). Prices of Defensive stocks, on the other hand, have since been inflated by record low interest rates.

Residential Property

Residential property prices boomed on the back of low interest rates and an influx of offshore investors. But growth is now slowing.

RBA: Australian Housing Growth

Listed Property

REITS were smashed in 2008 (20-years is 7.7% p.a.). But before contrarians leap into this sector they should consider the impact of low interest rates, with many trading at substantial premiums to net asset value.

Bonds & Cash

Low interest rates again are likely to impact future returns.

Global Shares

Global Shares also weathered the 2008 financial crisis (20-year performance (unhedged) is 6.4% p.a.). Subsequent low interest rates had the greatest impact on Defensives, while Growth & Cyclicals trade at more conservative PEs.

I won’t go through the rest of the classes, but there doesn’t seem to be many attractive alternatives. It may be a case of settling for the cleanest dirty shirt, and the least smelly pair of socks, in the laundry basket.

November 30, 2015

The Trouble With Chasing Hot Strategies | Josh Brown

This should be blindingly obvious, but amazing how often it is ignored. Great post from Josh Brown at Reformed Broker:

How do most investors (and many advisors) select funds or strategies to allocate to? They look at what’s been working, learn the story and get long…….
And then mean reversion shows up – outperforming managers subsequently underperform, hot themes become over-loved, winning strategies become too crowded to offer excess returns. “No problem,” says the advisor, I’ve got six new ideas to replace the six ideas that are no longer working!”

It’s sad to say, but this is exactly how it works. I’ve been watching this for almost 20 years…….

Research Affiliates has an interesting pair of charts demonstrating this phenomenon in a new note from Rob Arnott, Jason Hsu and Co. They illustrate that increasing fund flows are a decent predictor of subsequent underperformance and that performance-chasing is destructive to returns across all types of investment products:

Research Affiliates

August 23, 2014

The Decline and Fall of Fund Managers | WSJ

Jason Zweig predicts the demise of active fund managers:

So active management won’t disappear entirely. But index funds and comparable exchange-traded portfolios now account for 28% of total fund assets, up from 9% in 2000. And no wonder. Over the past one, three, five and 10 years, only one-fourth to one-third of all stock funds have beaten the index for their category, according to investment researcher Morningstar.

Meanwhile, index funds effectively match the returns of those market benchmarks at fees that often run only one-tenth of those of active funds.

Skeptics have pointed out that if individual investors — those Wrong-Way Corrigans of the financial world — are rushing into passive funds, then active funds might be due for a resurgence….But the net supply of outperformance always is zero; one fund manager can beat the market only at the expense of another who must lag behind it.

Not quite true. Active management is not a zero-sum game. Zweig is ignoring individual investors who, as a body, consistently under-perform the benchmark index.

Mega fund managers are more likely to promote index funds because their size makes it difficult to beat the benchmark index, while smaller, more nimble players are able to do so.

July 26, 2014

Diversification – the only ‘free lunch’ in investing

Diversification is often referred to as “the only free lunch in investing” because it affords investors the opportunity to reduce investment risk without reducing returns. Most investments involve a trade-off between risk and return, with higher returns requiring investors to expose themselves to greater risk. But effective diversification allows investors to reduce risk, by spreading their investments, while maintaining higher levels of return.

What is effective diversification?

Not all diversification is effective. Many investors buy a wide range of stocks in the belief that this will protect them from risk. The benefits of such diversification are likely to be insufficient if the stocks are all listed on the same exchange and selected using the same method. The entire portfolio will tend to rise and fall in unison — as in the well-known adage “a rising tide lifts all boats.” The key is to select stocks or investments that have low correlation.

What is correlation?

Correlation is the degree to which separate investments rise and fall together. Correlation measures the tendency of investments to advance or decline independently of each other. The correlation coefficient, identified by the symbol r, expresses the level of dependency between two variables (stocks in our case). Values for the correlation coefficient range from 1.0, for stocks that are perfectly correlated, to -1.0 for stocks that move inversely to each other.

Only two shares of the same stock, like BHP Billiton, are likely to have a correlation as high as 1.0. But stocks from the same sector are likely to share high values. And stocks from the same market are also likely to share a reasonable degree of correlation in larger time frames (i.e. the primary cycle).

You are also unlikely to find stocks that are the perfect inverse of each other — a coefficient of -1.0 — except possibly from an index ETF and its bear counterpart.

We are not necessarily looking for stocks with negative correlation, however, but stocks or investments with low correlation — closer to zero than to 1.0. As you can imagine, going long and short the same stock would protect you from any variation in prices, but would not deliver much in the way of return. If we had a spread of investments with low correlation (i.e low dependency) their price movements will tend to offset each other, providing a smoother portfolio return.

3 Ways to achieve diversification

We are likely to find investments with low correlation using three different techniques:

Diversification by asset class;
Diversification by geographic location; and
Diversification by strategy.

Asset class

There are a number of asset classes available to investors. Asset classes as diverse as stocks, real estate and fine art, however, are all subject the vagaries of the economic cycle and tend to rise and fall together.

Bonds tend to have low correlation to stocks. We need to make a distinction here between government bonds with low risk premiums, which fluctuate largely with the interest rate cycle and tend to be counter-cyclical (i.e negatively correlated) to stocks, and corporate bonds which are subject to far higher risk premiums that may expand and contract in line with the stock market cycle. Credit spreads tend to be low when the stock market is bullish and widen sharply during a contraction.

There are other asset classes such as insurance funds, where risks such as weather events tend to have low correlation to the economic cycle, but investors need a fair degree of expertise to assess the risks associated with these investments.

Geographic location

Australian investors tend to be highly concentrated in the Australian market, with only about 15% of assets invested offshore, both directly and indirectly through managed funds. Most major stock markets tend to rise and fall together, but diversification, especially to US markets, affords investors the opportunity to diversify into sectors not available on the local exchange.

By strategy

Diversification by strategy is often overlooked. If an investor, for example, diversifies their stock portfolio across several value-based fund managers they are likely to find that their investments rise and fall in unison. Even though the managers may hold a wide spread of stocks, they are all selected using a similar process and will tend to behave in a similar manner.

By spreading investments across several strategies, the investor is likely to achieve more effective diversification and more stable returns. Diversification between value-based strategies and our own momentum strategy is an obvious example. Recent research shows ASX 200 Prime Momentum has a low correlation of 0.3368 with the popular Perpetual Industrial Share Fund [PER0011AU] and moderate correlation of 0.4263 with Colonial First State Australian Share – Core [FSF0238AU].

Diversification is not the only “free lunch” available to investors — effective tax planning also enables investors to enhance returns without increasing risk — but it is important and should not be neglected. It is a complex area and we recommend that you consult your financial adviser before taking any action.

The best argument for mutual funds is that they offer safety and diversification.
But they don’t necessarily offer safety and diversification.

~ Ron Chernow