Diversification is at the heart of investment best practice, but until recently trustees may rightly have asked why they needed to worry about it. Market leadership was dominated by a handful of global technology companies, which accounted for much of the growth in stock market portfolios over the past few years. Why not focus our attentions on those areas alone?
There are a number of arguments against this: valuation, for example, is important. There are lots of great companies with innovative products and capable management teams. However, this doesn’t mean all of them are great investment opportunities. If - as was the case with some of the technology giants - they are trading at over 200x that year’s earnings, exceptionally high growth is factored in the price of the shares. If the company fails to meet those targets, the share price is vulnerable.
The impact of rising rates
Valuations can also be influenced by external factors. The valuation of any company is, to some extent, determined by interest rates. If interest rates are higher, a company’s future cash flows are less valuable. If investors can get 3% on their cash holdings, for example, a return of 6% per year isn’t as valuable as it would be if investors can only get 1% on their cash balance.
This has hurt the technology sector this year. As interest rates have risen in the US, technology companies’ future growth has become less valuable. This has been an important factor in falling share prices.
At the same time, problems often emerge unseen. For the global technology giants, GDPR has become a huge issue, but few would have believed data privacy could cause such damage 18 months ago. Companies are addressing the problem, but it is costing them considerable sums to do so. Social media giants have had to bring in additional data ‘police’ to prevent some of the problems on their sites.
Markets tend to get very excited about new ideas and may neglect valuations. Electric Vehicles hold huge promise, but does that mean we should we overlook the high debt and over-optimistic expectations inherent in the share prices for some companies?
While it is important to have access to these structural growth stories in a portfolio, it must always be in the context of a diversified portfolio and with an awareness of valuations. The performance of the global technology sector since October last year has highlighted the importance of this discipline. With relatively little change in the outlook for these technology companies, share prices have fallen by as much as 25%.
Across our portfolios, we strive for balance. We scrutinise all our holdings under three different scenarios: a core view, an inflationary view and a deflationary view. In a lower growth environment, high quality companies with visible earnings are likely to perform well: growth is at a premium. In a more expansionary phase, economically sensitive areas such as industrials or commodities may thrive.
Today, it is possible to make the case for either scenario. In response to recent weakness, the US Federal Reserve has put interest rate rises on hold and China has chosen to stimulate its economy. In this scenario, global growth could keep moving forward for some time, albeit at a slower pace. However, an alternative view might be that China and the USA only agree a very narrow trade deal or don’t agree at all and /or markets suffer a shock from a particular event such as a hard Brexit leading to a recession across Europe. Here, a far gloomier picture emerges for global growth.
Our belief is that reality will lie somewhere in the middle, but we cannot dismiss either scenario and need to be prepared to adapt portfolios as circumstances change. This argues for holding a balance of higher growth assets, such as technology companies and more defensive areas that show less volatility.
When a particular type of company has performed well, it is tempting to extrapolate that into the future and turn a blind eye to the risks. This can mean that you are not fully prepared if the environment changes or if unexpected events change a company’s or region’s prospects. Proper diversification and a respect for valuation are crucial in managing risk over the longer term.
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
This article was previously published on www.smithandwilliamson.com prior to the launch of Evelyn Partners.