The March quarter was not a pretty one for financial markets in general. The ASX200 (including dividends) fell by 2.7%. Most equity funds delivered negative returns. Worries centred around China (again!), US interest rate rises (we don’t know why, since the US will only raise rates from here if their economy is growing rapidly) and Oil (where were all the doomsayers when Oil was over $100 per barrel not that long ago).
In Australia, the markets were also bothered by the potential for a housing crash. It’s certainly our biggest economic risk and it just might happen one day, but probably not when half the country is thinking about it. Doesn’t mean you should buy any more houses at the moment though.
The common theme among all these factors was uncertainty. Markets don’t like uncertainty, so they fell. At Affluence, we love uncertainty. It makes things much cheaper than they ought to be unless the worst case scenario unfolds. In our experience, the worst case scenario almost never happens. So we buy in times of uncertainty.
We are getting more bullish on commodity prices, and therefore resources and some agricultural stocks. We believe gold mining stocks have the greatest potential. But we are likely to see some pull-back in the short term as everybody in the world has gone from hating them to loving them in the past 3 months. Oil and oil related stocks also show promise. It seems a bottom is probably in place for the oil price, but markets have not yet acknowledged it broadly.
We expect continued improvement in commodity prices over the next 2 years, but not in a straight line. We currently hold around 5% of the Fund portfolio in commodity and related stocks. We are likely to increase this to about 10% during the course of this year as the world gradually realises the worst is over.
Our major banks are now starting to look quite cheap, but we just can’t quite bring ourselves to buy them yet. This is for two reasons. Firstly, most of our clients already own them in one way or another. Secondly, there is a long and growing list of negative pressures building up against our banks. Just this week, our PM came out swinging at a financial summit and essentially told the banks they needed to clean up their act. Not a good omen for any positive regulatory outcomes in the near future.
Normally at times like these, when the market is quoting plenty of negatives, it piques our interest. We start to look for positives that no-one is talking about. But alas, try as we might, we can’t come up with too much positive potential for our banks. About the best we can say is the big 4 are remarkably resilient businesses with fantastic pricing power. But when the world (politicians, regulators both here and abroad and most of your customers) have no sympathy for your plight, it’s unlikely to get better anytime soon.
It was a particularly difficult quarter in which to make money. Nonetheless, we did manage to do so, just. If we can still keep our heads above water in the tough quarters, it bodes well for the good ones.
Stocks both here and abroad are difficult to forecast in the short term. No big surprise there. What we can say is that the Australian stock market right now appears to be reasonable value, perhaps even a little cheap. But it’s hard to see what could make it rise substantially in the short term, given continuing pressures on our financial sector.
Our approach in this environment is to limit our long-only equity exposure and to supplement this by owning options in a number of Listed Investment Companies run by very good managers. These options provide potential upside in any unexpectedly large rallies. The benefit of such an approach is the options are very cheap to buy, and so even if they expire worthless, we have paid little for the privilege.
On the other hand, if stocks fall further, we have the comfort of knowing we have only about one third of the portfolio exposed to the stock market. Most of that is managed in a way that is likely to deliver much better than average results in a down market.
We are free to allocate as much of the portfolio as we want to offshore investments. Despite that, we are currently around 90%/10% invested in favour of Australia. Overseas stock markets, particularly the US, seem rather more expensive right now than Australia. Better valuations and franking credits keep us closer to home. As does currency uncertainty.
We said in January that the currency might well appreciate this year, and so far that has been the correct call. With the impact of the mining boom largely now factored in, we’re not sure what will drive the AUD too much below 70 cents to the USD.
We continue to avoid bond funds and fixed interest investments. We did buy two listed hybrids when the market was feeling particularly sad in February. You can read more about those here (website sign-up required). Other than that, try as we might, we can’t find anything in this space we think is capable of delivering our long term annual return target of inflation plus 5%, with minimal risk.
We do remain fans of lowly geared, quality non-residential property. It is delivering decent yields and diversification benefits for our portfolio. In this regard, our friends at Cromwell are still our core holding, but we are looking to supplement this with one or two other smaller holdings. We are not expecting a great deal more capital growth from this point though – it seems the easy money has already been made in this space. We would caution anyone against buying heavily into unlisted property at this time. In particular, we are avoiding any funds where stamp duty and other up-front costs mean you are buying at a large premium to the underlying net asset value.
There remains significant risk in world financial markets. In their efforts to stimulate growth, Central banks continue to push beyond the boundaries of anything that has been done before. In our view, we are now approaching a point where these policies will have no discernible positive effect. Even worse, it leaves Central banks perilously exposed and relatively impotent should a new recession or a proper crisis develop.
When interest rates are already negative, how much lower can you go before people just start putting their money under the mattress? That is undoubtedly a dangerous position to be in and a major risk for us all. Luckily for us in Australia, we have possibly the world’s most sensible Central Bank governor in Glenn Stevens, who has largely resisted the temptation to do anything stupid. Our economy is, and will be, much better for it.
We believe the best defence in this environment is to continue to do exactly as we have done in the Affluence Fund for the past 12 months:
- Don’t buy anything unless you believe (with a high level of confidence) it will deliver reasonable returns, over a reasonable period;
- Diversify by holding investments across all asset classes. Aim to own things that will behave differently regardless of market conditions;
- Invest with managers you like and trust, and who have proven themselves over long periods of time;
- Hold a decent portion of your portfolio in assets that can hold their value, or even deliver positive returns, when stock markets fall. In our portfolio that means market-neutral and long/short funds, some commodities and some quality non-residential property;
- Be very, very, very wary of taking on significant debt, and of any investment that uses substantial leverage to enhance returns; and finally
- Hold some cash (maybe 10-20% of your portfolio value) for opportunities. This means you have 5-10% cash available to buy quality investments if markets fall a bit. And another 5-10% to buy even more if they fall a lot. Your best opportunity to outperform long term averages is by being a buyer when everyone else is a seller.
Despite the difficult investing climate, we have identified another 5-7 great funds and managers. We will look to invest with each of them over the next few months as opportunity allows. Each is demonstrably different to anything else in our investment portfolio and thus assists us in our ongoing search for diversification.
We expect the Australian stock market will continue to fluctuate between slightly undervalued and slightly overvalued in the near-term. In that case, we will continue to do what we have done since the beginning. We make small additions to the portfolio on the days, weeks or months when the market is feeling down. And we remain patient at other times.
If you’d like to join us, think about making a small investment into the Affluence Fund. Our minimum investment amount is just $20,000.
We wish you good luck out there!
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