I am (I may have mentioned it before) Welsh. And Tracey, my wife, is an international tax accountant. I think it is fair to say we are ‘glass half empty’ people. I look for investment risk under every bed while she looks at corporate tax compliance risk. I know, the winter nights fly by.
As a result, whenever we travel, we have a full medical kit (Imodium), air tags, jungle formula insect repellent (smells like Brut), after sun (mostly useless ludicrously overpriced moisturiser) and at least one (preferably two) changes of clothes in our hand luggage in case the rest goes missing – despite neither of us ever having lost luggage in the past.
Now, all things are relative: I am always complaining that Tracey is overly cautious. I am the optimist in the house.
As I was recently approaching 60, I decided I needed to be out of the country on the big day. I decided Peru was the obvious country to escape to. As usual, the cases were groaning as we set off for Heathrow. Guess what? My luggage went missing both ways and Tracey’s on the way home. The air tags were invaluable and the change of clothes in hand luggage a godsend, together with hotel laundry services. Despite seeing many mozzies neither of us got bitten, so we didn’t need to smell like Henry Cooper or Kevin Keegan (1970s cultural reference) and the hats Tracey made me wear ensured there was no need of white gunge being doused on my thinning scalp. The system was working well.
Protected against the mozzies, forgot about the cliffs
That is, until Machu Picchu. We were halfway up the mud road to the world-famous Incan ruin in an aging Mercedes bus when Tracey noticed there weren’t any crash barriers. I assured her the bus drivers were highly skilled and she was worrying too much. Quarter of an hour after we reached the summit, one of the buses crashed on the way down. Its brakes had failed, and it had nose-dived one level down of the switchback road. Fortunately, only a few broken hips and legs were sustained.
That’s the thing about risk: you often seemingly waste your time and money trying to mitigate risks that never materialise, like mozzies carrying Yellow Fever, yet when they do finally happen (three cases lost in one trip) you thank your lucky stars for packing the proverbial spare underpants. And, there are always risks that you simply didn’t count on.
Of course, not all risks are bad. Due to the bus crash closing the road, we had Machu Picchu almost to ourselves, so our photos were people-free. I jest, of course, but my point is that surprises lead to positives and negatives (and often a mixture of both). The world is complicated and things don’t always pan out the way you think they will at the outset. Surprises – ‘risk’ in investment parlance – drive losses but they also drive profits. And that’s why we can’t simply wrap ourselves in cotton wool and avoid all risk. We’d make no profit and we’d lead extremely dull lives.
Risk and reward come as a pair
As a multi-asset team, you would expect us to try and anticipate risks to minimise losses or drawdowns and of course we spend a lot of time on this. At the beginning of this year, we looked at many macroeconomic headwinds: the Middle East, the continued fallout from the Ukraine war, UK and US elections, increasing tensions in Taiwan, the list goes on.
We get asked about these issues all the time. We rarely get asked about the risk of positive surprises that we might miss out on because of our decisions. We do talk about these a bit in our latest podcast, but we do tend to focus much more on the negatives as we look to reassure investors. But positive surprises really are as important as the negatives, in my view. Our funds have return targets and so, while it might seem obvious, we need to capture excess returns when they are available if we are to achieve them.
The problem is positive risk surprises are as random as the negative ones. You cannot ‘market time’ them as the catalysts often come from totally unpredictable sources. So how do you set about this?
There’s no fool-proof method and huge amounts of patience are required, which is often in short supply in this game. I find that positive surprises are most likely to affect investments that are completely unloved or even hated, whether that be a company, an industry, an entire asset class or an investment theme. What they probably have in common is that they are cheap. But investments can remain cheap for years or even decades. Think UK equities versus their US counterparts, for example.
We try to look at asset classes and investment themes that are out of favour over a long period of time and try to anticipate a possible catalyst that could shift sentiment. One example towards the end of the 2010s was oil. You may remember the ‘stranded assets’ narrative which coincided with a rush on clean energy alternatives. This reached its apogee as the oil price went negative one bonkers day in April 2020. From our point of view, we felt this was a mistake. Not only was oil going to be economically important for much longer than the prevailing narrative at the time, but we also believed oil exposure was extremely useful as a way to mitigate the risk of unrest in the Middle East, which sadly is a constant.
The risk of a bull in China
At the beginning of this year, our attention moved to China. The long-awaited recovery from COVID-19 had seemed to end before it began. The fallout from rampant overbuilding of property continued to weigh on sentiment. Add in increasing restrictions in trade with the US and rumours of greater tariffs to come, it was extremely difficult to be positive. And, indeed, we were not.
However, we did recognise that with sentiment so negative there was the chance of a positive surprise as the government came under pressure to restimulate household demand. The problem was, we had no idea if and when this might happen.
We weren’t brave enough to increase our portfolios’ allocations to our Chinese investments. However, we did agree that we would back our Western companies reliant on the Chinese consumer, despite a lengthy period of poor performance. That meant adding to them when their prices fell to keep them at a constant proportion of our portfolios.
Our conviction was tested all year, as they continued to underperform and we continued to add, right up until last week when the government finally signalled more support. Will it be enough? It’s too early to say, but we feel the ‘one-way street’ negative narrative is at least broken for now.
The other point to make on positive surprises is that when they happen they often trigger a string of events that makes the recovery dramatic when it comes. Not only do you have short investors rushing to close their positions (buying the shares as they have unlimited liability if they keep their short), you also have many investors suffering from FOMO (fear of missing out). Those that have to capitulate and accept they may have got the thesis wrong: missed returns can be just as painful as realising a loss. The resulting almost panic-buying can quickly turn into outsized returns that you need to be disciplined enough to realise.
I have started to analyse the risks ahead of my next overseas trip to the US West Coast, excess tipping, traffic cops with guns and insincere wishes of a nice day being the downside and pretty obvious. Maybe the positive surprise could be a salad made up of more than leaves.
Tune in to The Sharpe End - a multi-asset investing podcast from Rathbones. You can listen here or whenever you get your podcasts. New episodes monthly.
