Reducing Portfolio Volatility through Quality Assets
Before I begin this week’s article, I thought I would inform you of my thoughts on The Spark’s direction over the next few weeks. Once I have fully constructed the portfolio, I will dedicate one or two weeks to explain my reasoning behind each holding and its weighting, as well as the sector breakdown, overall volatility, and so on. This should help you to understand the thinking behind my security selection, as well as how to construct a diversified portfolio.
I will also analyse any major updates on stocks in the portfolio as they emerge and inform you of my thoughts behind them in my weekly articles, or potentially in separate posts. These stories can sometimes be market moving and can influence my conviction behind a particular investment. This week I came across an article that seemed very bearish for Micron Technology’s (MU). Reading this article may cause some investors to panic-sell MU. If this story was big news, the stock price would have dropped, but it rose 1% on the day it was published. This is because a similar story was also published by an analyst at a major investment bank a month prior which caused MU stock price to drop like a stone. So why did I buy the stock? Because even before the analyst published his report, MU management had already warned that revenue would fall in 2022, due to supply chain issues for its customers. MU’s customers couldn’t get other component parts to manufacture their products, so reduced orders with MU. This highlights two things; one, that markets are not efficient (as textbooks suggest), and two, management is both astute and conservative with their estimates. Looking at the chart below illustrates this, with MU’s management having beaten earnings estimates every quarter for the last seven years.
Micron has beat earnings estimates every quarter since 2016 (see green E at bottom of chart), source: TradingView
I am more than happy to pay 4x EV/EBITDA multiple for a company with excellent margins and strong revenue growth, which I have no doubt they will beat, as is evident from the above chart. I hope this brings clarity to any readers worried about the short-term performance of Micron.
In other news, I said I would add more to Airtel Africa (AAF) should the price fall, but after its recent outstanding half-year results, the stock rose 10% and momentum is now our friend. I will be allocating an additional 1.5% of capital to bring the position to 5% in total. Airtel’s results can be found here and here.
Now on to this week’s article.
Lowering Volatility through Quality assets
In recent weeks I have been adding growth companies through Micron Technology’s and Airtel Africa, value through oil and Dave & Buster, and precious metals two weeks ago for uncorrelated returns. This week I plan to add quality stocks. These are businesses with strong free cash flow yields, reliable revenues, and lower volatility (beta). Such companies are good diversifiers (much like precious metals) and help to reduce overall portfolio volatility. I will allocate a small percentage of capital to such companies and increase exposure should markets take a turn for the worse.
The name’s Bond. Unattractive Bond.
Traditionally, it has been accepted that a balanced portfolio would hold 60% of capital in equities and 40% in bonds, or a higher percent in equities for younger investors. Bonds were typically seen as a safe-haven asset, which you could buy to collect income (in the form of semi-annual coupons – the bond’s yield) and preserve capital. Still today, investors rush to the safety of developed nations’ government bonds in times of extreme uncertainty (recessions), such as March 2020. Investors sell risky equities and buy safe bonds. As previously mentioned, this is because countries such as the US, Germany, and the UK are very economically stable, and therefore are highly unlikely to default on their debt.
Nevertheless, aside from crises, recent years have been rough for bond investors. As I have shown in many articles now, interest rates are in a long-term decline. This has correlated with a long-term fall in bond yields and therefore bond prices have continued to rise. Bonds are becoming more and more expensive, and as I explained in my precious metals article, this is in large part due to the exuberant spending of governments around the world and the willingness of central banks to purchase their own government bonds. This makes fixed income increasingly unattractive as an investment.
US 10-Year Treasury Yield, Source: Bloomberg
But don’t take my word for it. Just read what Warren Buffet had to say in his 2020 letter to shareholders:
“Bonds are not the place to be these days. Can you believe that the income recently available from a 10-year U.S. Treasury bond had fallen 94% from the 15.8% yield available in September 1981? In certain large and important countries, such as Germany and Japan, investors earn a negative return on trillions of dollars of sovereign debt. Fixed-income investors worldwide – whether pension funds, insurance companies, or retirees – face a bleak future “
When most equity markets fell last month, developed countries’ government bonds also struggled, with yields rising and therefore prices falling (see below). As I mentioned, traditionally in times of uncertainty, investors would rush to bonds. They are not doing that at present. As I explained two weeks ago, inflation is not good for bond investors because they are holding a negative-yielding asset when inflation is higher than bond yield. Yields are rising (prices are falling) as investors price in inflation and therefore interest rate rises. As prices fall, investors will be forced to search elsewhere for a safe haven, which is why I added gold to the portfolio two weeks ago.
Government bonds have struggled in the face of recent volatility, Source: FE
Choppy waters
The prospects of stubborn inflation and interest rate rises are currently being aggressively priced into markets. This is a huge risk for fixed-income investors and equity investors alike. We are deep into earnings season so I’m sure you’ve noticed some companies beating earnings, and the stock subsequently falling several percent. You would be right to question why this is happening. This is because the market is favoring cash flow conversion and margins over revenues at present due to fears over tapering of bond purchases along with interest rate rises.
This is evident in Suncor’s recent earnings: “Since the beginning of 2021, Suncor has reduced net debt by $3.1 billion and repurchased $1.7 billion of its common shares since… February 2021… The company is on track to exceed its previously communicated debt reduction and share repurchase targets for the year”. The stock was up 13% on the day.
There are two main issues with the market today. Number one, many companies are highly valued. This means that strong earnings beat and booming growth are expected. If earnings come out in line with expectations, the stock is at risk of a fall, as is evident with Amazon’s recent earnings. The second problem is that over the last 10 years we have seen minimal inflation in any major economy. No company has experienced inflation anywhere near 5%-6%. How long it will last and the effects it will have on businesses are huge question marks today. It is very difficult to know which companies will execute their plans and continue to perform, and which will fall off. Quoting my first article, “it is preferable to back solid companies, with strong free cash flow generation, at an attractive valuation relative to peers”. In an environment of tightening liquidity and higher inflation, pricing power and free cash flow are what investors (and The Spark) want.
Looking elsewhere for quality
For the reasons outlined above, I am turning away from fixed income when looking for quality assets to hold. To be clear, with yields rising I do not see defensive companies providing much scope for upside in the short term, hence why I am allocating a small percentage of capital. Defensives are used in times of turmoil, and with yields rising investors are likely to move away from such assets. However, things can change very quickly in markets, so I believe a small position to reduce volatility is prudent.
Looking globally, Japan currently offers excellent value. After its monumental bubble of the late 1980s, the stock market crashed and is only now coming back to its all-time highs. Most individual Japanese stocks are unavailable on UK-based platforms, so investment trusts and Exchange Traded Funds are the only way to get exposure. There are several excellent trusts focusing on small-cap (small company) stocks, such as Baillie Gifford Shin Nippon (BGS) and AVI Japan Opportunity Trust (AJOT). However, they are unfortunately outside of my market capitalisation boundary, being less than £1bn, therefore the only exposure I can gain is through the passive iShares MSCI Japan (SJPA) ETF. This tracks the performance of the Japanese stock market and allows me to gain exposure to the market at a low cost, as passive ETFs often carry low fees. Japan is the third-largest economy, and The Spark portfolio has no exposure in the region at present, so this ETF is also good for diversification purposes. Also, due to long-term deflation in Japan, a large number of the companies hold huge levels of cash, making them lower risk.
Going further down the defensive route, I will be adding a small exposure to a utilities company, Pennon Group. Other options for further research in the UK are SSE and Centrica, or the Invesco Utilities ETF (XLUP) for exposure to the utilities sector more generally, which I would have purchased if it was above a market cap of £1bn. Utilities are usually a sector you would add to a portfolio preparing for a recession, and be clear I do not see evidence of a pending downturn, but as I said, due to tapering I do see increased volatility in the market, and Pennon Group will help reduce this volatility within The Sparks portfolio. I will be adding 3% of capital in Pennon Group (PNN) at a price of £11.66 and a 5.2% position in iShares MSCI Japan Index (SJPA) at a price of £37.92. Both prices are of the closing price on Friday.
I hope you enjoyed this week’s edition of The Spark. Please leave any questions or comments here.
Until next time,
Peter
Disclaimer
This communication is for informational and educational purposes only and should not be taken nor used as investment advice, as a personal recommendation, or solicitation to buy or sell any financial instrument. This material has been prepared without considering any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or structured product are not, and should not be taken as, a reliable indicator of future performance. I assume no liability as to the accuracy or completeness of the content of this publication.