A couple of months into 2021, being an investor can be likened to experiencing a storm at sea as the winds of the pandemic contend with the tide of support from government and central banks. The contest between these two forces creates huge waves in market prices as optimism or pessimism gain the upper hand. It has been said many times over the last year that we ‘are all in the same boat’ but author Damien Barr described the situation more accurately when he wrote: “We are in the same storm, but not in the same boat.”
As investors, we get to choose our boat as we seek to navigate the current storm on the journey to our ultimate financial goals. While a lightweight racing yacht may be ideal for moving quickly across calm waters, the current environment requires a more robust vessel that can withstand the huge waves and changing conditions. The key consideration for investors is therefore whether their portfolios are sufficiently robust to withstand the next wave, regardless of where it comes from.
This requires not only a balance of attractive return opportunities and more defensive assets but also an understanding of the impact on the portfolio of unexpected behaviour by asset classes – for example traditional defensive assets losing those characteristics or highly priced assets becoming even more expensive. The robust construction of portfolios should be our first objective as we enter the new year and has consumed much of the focus of the Morningstar investment team over the last six months or so.
Be mindful of extreme outcomes
While we remain in the current storm, we must be mindful of extreme outcomes and should seek diversification where it can be found at a reasonable cost. To do this, it is essential to have as many investment options available as possible. This, in turn, requires a granular research capability and an unconstrained approach.
As the broad equity indices become more concentrated in a small number of stocks, most notably US technology, communication services and consumer discretionary companies, there are many more opportunities that can be accessed elsewhere in capital markets.
While UK equities, energy and European financial companies were favourites for most of last year, following the sharp decline in prices during the first phase of the pandemic, we also continue to favour Mexican equities that are attractively priced but less directly linked to a post-pandemic recovery. Equally, some assets we became enthusiastic about in the early part of last year are no longer priced attractively. Most notable among these are inflation-linked and high yield bonds.
Adjust your positioning
As we travel up one wave or down another, it is important to bear in mind that such waves are always supported by strong stories that are likely to exploit our human weakness for extrapolating the current situation. This can lead us to believe we will continue to rise or fall on the current wave far into the future at just the time that it ends, and we are then presented with a new wave to tackle.
Nor can we fight every wave by adopting strong contrarian positions at the first hint of a change in the water level, as we will be at risk of swamping the boat. Instead, we must adjust our positioning as the waves grow bigger and the likelihood of reversal grows.
To do this, it is essential to have a reliable compass by which to navigate. A good compass will always point in the same direction regardless of the changes in the environment or our position on a wave. At Morningstar Investment Management, we use valuation as our compass and spend most of our time seeking to understand the long-term return we can expect from the assets in which we invest and whether that return is bolstered or diminished by the current price.
In this way our team seeks to ignore the howling of the wind or the crash of the waves as we steer the portfolio through the storm. While this is not the only way to invest and, at times, other ways of navigating the ocean of investment can deliver faster returns, in stormy conditions it is not always the fastest boat that makes it to the destination.
Dan Kemp is chief investment officer, EMEA at Morningstar Investment Management Europe
