INVESTING: THE SWEET SPOTS
– AND CARDINAL SINS

After a career spanning more than three decades in the world of investments, I’ve recently taken some time to reflect on my experiences in what I regard as a fascinating industry. It has certainly never been boring – over the years, we’ve been confronted many times by what commentators would refer to as ‘one in a hundred’ events.

At the start of my career, I was managing institutional money – retirement funds and unit trust portfolios – but my focus shifted somewhat in 2007 when I was tasked with growing the asset management capability of Sanlam Private Wealth (then called Sanlam Private Investments), leading the investment process with a clear focus on growing the wealth of individual private investors.

TIMELESS PRINCIPLES

When I joined the business, I was very clear about the principles I regarded as being non-negotiable. Some of these appear to be rather simple. However, when the prices of financial assets are trending in a direction that would suggest that these principles are no longer relevant, it’s exceptionally tough to convince shareholders and our clients that they’re not only still relevant but indeed timeless. These principles are:

• Price matters. Low prices provide a margin of safety, and paying a high price or holding assets that are trading on high prices increases the risk of losing capital permanently.
• Don’t rely on forecasts. No one can forecast accurately on a consistent basis. Most forecasts are extrapolations, and if the environment doesn’t change, the forecasters might be given a pat on the back. However, because they mostly use the same method, this can hardly be a profitable exercise, as the news would already be in the market. We should rather try to understand the correct perspective – at Sanlam Private Wealth, we manage our clients’ portfolios taking into account the balance of probabilities.
• Understand investment cycles. History is often repeated, but not sequentially. Well-known American investor and writer Howard Marks explains it well: ‘The events of history don’t repeat, but familiar themes do recur, especially behavioural themes.’
• Trust numbers, not opinions. So-called investment gurus might be very popular and entertaining in the media, but in our view, it is numbers that back up arguments, not opinions.

INVESTMENT INSIGHTS AND LESSONS LEARNT

After 15 years at Sanlam Private Wealth, I still believe these principles should form the foundation of a sound investment process aimed at growing wealth over the longer term. Of course, there were many other nuggets of wisdom and insights gained – even lessons learnt – over the period, including:

There is fundamentally no difference between the construction of a private client portfolio and an institutional portfolio. When I joined our business, I got the sense that there was some concern that I wouldn’t understand private clients, since I only had experience in managing institutional investment portfolios. My view was simple, however – there are good investment decisions, and there are bad decisions, and there is no room for the latter in either private client or institutional portfolios.

There are two notions here that are important to grasp. First, our portfolio managers need to have a deep understanding of our investment mandate, and their decisions should be aligned with this mandate. Mandates for private clients are often very diverse, and customised. Portfolio managers should apply sound principles in building portfolios that meet the unique requirements of individual clients – but this does not mean non-compliance in terms of our agreed investment principles.

Second, our private clients have special service requirements. I learnt early on that private clients are not fond of ‘surprises’ – they need to remain informed about our strategy and even individual investment decisions. As asset managers, we are merely the custodians of our clients’ funds. This implies that at a business level, we need to inform our clients of our strategic direction, and our portfolio managers need to engage with individual clients on the day-to-day management of their funds. Managing institutional money required a rather different approach to communication.

Managing investment portfolios with long-term growth in mind allows them to outperform. On joining our business, I was immediately confronted by what is in my book a cardinal sin: ‘shortism’ or a trading mentality. There are many participants in financial markets, including high-frequency traders, hedge fund managers, passive managers, management teams of companies and long-only investment managers. Many of these are interested only in the investment outcome over the short term – the outcome varies from the next price tick for the high-frequency trader to short-term ‘catalysts’ for hedge fund managers and the three-year option cycle for company management.

Given the unpredictability of short-term price movements, we can manage portfolios only for long-term outcomes based on investment cycles in which traditional forces drive financial markets through their various stages. Understanding long-term cycles reduces guesswork when managers construct investment portfolios. I’m therefore more convinced than ever that the correct way to position portfolios and pick assets is with a ‘through-the-investment-cycle’ time perspective.

On this basis, it’s my view that the skill of investment managers can only be measured over longer-term periods. Short-term performance has zero predictive power in terms of the prowess of an investment manager, as chance or randomness has a major impact on short-term performance.

Rationality pays off in the longer term. In theory, investment management is based on sound, ‘scientific’ principles. Most analysts worth their salt should be able to calculate the value of a financial asset based on normal financial principles. However, we’ve often witnessed wild swings in the price of assets, which would put this theory in doubt – the oscillation in investment sentiment from greed or euphoria to fear or depression can drive security markets to unsustainably overpriced or cheap levels, depending on the mood of the market.

These material swings in investment sentiment are clearly driven by emotion, and not rational thinking. This behaviour hasn’t changed for centuries, and both the bubbles and the despair in financial markets are well documented. It’s also unlikely to change – in fact, the psychological ups and downs are integral to the market.

Experience has taught us that the ‘sweet spot’ for investors often lies somewhere in the middle of the pendulum swing. Extreme changes can create highly lucrative opportunities for rational investors. We saw this in the 2001 dot.com bubble, the commodity boom in 2007/8, the global financial crisis (GFC) in 2008/9 and, in my view, the bubble that formed in many information technology stocks in 2021.

A final comment on the irrationality of markets. It’s not easy to predict when the average investor will return to rationality, and the ‘rational’ investor may therefore look a bit stupid for quite a while as euphoria or despair dictates the direction of prices. Rational investors are often accused of ‘not understanding’ the current trends. But as Warren Buffett observed, it’s only when the tide goes out that one will find out who was swimming naked. I’ve often remarked to my colleagues that common sense and a strong stomach are far better attributes to cultivate for investment success than simply being in possession of a sharp intellect.

Uncertainty is not uncommon in investment markets. At the start of each calendar year, our clients expect their investment manager to provide a view on how financial markets are likely to evolve over the next 12 months. Our in-house discussions then often revolve around increased uncertainty regarding the future outlook of financial markets.

As I’ve argued above, if one is in the camp of not buying into the predictive ability of forecasting, it goes without saying that uncertainty will always be part of the investment landscape. Despite this, there should still be enough opportunities for rational investors to generate a return that would compensate for the risk.

However, in my view, it has since the GFC become increasingly difficult to understand the financial landscape. The main reason is that authorities are interfering more and more in financial markets, distorting the prices of financial assets.

Let me provide an example. During the GFC, monetary authorities interfered – correctly so – to support the financial system by providing liquidity, dropping interest rates to very low levels and ‘pumping’ money into the system through a process called quantitative easing. This dose of ‘antibiotics’ ensured the survival of the ‘patient’.

A similar process – even more extreme compared to 2008/9 – was followed after the outbreak of Covid-19 in early 2020. However, it meant that interest rates were artificially low, and this drove inefficient allocation of capital. Credit was too cheap for too long, and businesses borrowed cheap money to fund their activities. This might not have made sense under normal financial conditions.

Again, at the time, investors bought into the positive narrative. In reality, however, weak business models flourished undeservedly, and inflation became an issue for the first time since the 1970s. This distortion finally dawned on the markets in 2022 when interest rates started to rise and investors realised that the euphoria of 2021 was badly misplaced, and both equities and bonds sold off.

Similarly, the intervention of the authorities in China – currently the world’s second biggest economy – in financial markets is well documented. However, financial markets have responded quite violently to some of these very unpredictable interventions.

Analysts must remain sceptical when engaging with the management teams of potential investments. Even as a young analyst, I learnt quickly that management teams tell analysts only what they want them to know. Although it’s understandable that managers aren’t permitted to share information that might be price sensitive or may compromise their competitive position, the ‘analyst’ in me tends to take highly selective information sharing by companies with a pinch of salt.

Companies – especially young and growing businesses – need capital to grow. They raise capital by issuing new shares. It’s obviously to their benefit if they can raise this money via a higher share price, and they may therefore be inclined to sell an outlook that is rosier than reality would suggest.

Managers are often rewarded with share options that vest over an agreed period. If a new management team takes over, it’s not too surprising that they may portray a rather gloomy picture of the current situation. Putting the share price under pressure creates a low base when these options are issued. One can expect the opposite when the vesting date of these options is approached – positive news may then inflate the share price and make for lucrative payouts when the options vest.

Investment management is not a day job. It requires commitment and a passion for financial markets. Managing money requires managers to immerse themselves into the world of investments. One can only do this if investment is a true passion, not just a job. I was privileged to be surrounded by many passionate and astute investment professionals at Sanlam Private Wealth. I’ve always argued that Sanlam Private Wealth has an investment ‘DNA’ – a culture that is deeply embedded, and that will stand the company in good stead in the future under the leadership of my successor, David Lerche.

A LAST WORD

I’ve often asked myself how much value our investment team has added to our clients’ wealth over the years. There might be a perception that when financial markets appreciate, client portfolios do well, and when markets are on the back foot, portfolios lose value. A close colleague recently remarked, however, that the role of a private client asset manager is to protect clients against themselves. I realise this sounds harsh and even rather arrogant – but allow me to explain.

Over my years at Sanlam Private Wealth, I have repeatedly seen that clients generally tend to want to jump in and participate in a trend at an advanced stage, but then buy in when prices are already elevated. Similarly, clients often want to exit assets when the news flow is negative, despite obvious low valuations associated with these out-of-favour assets. FOMO, or fear of missing out, unfortunately has a very strong pull in the investment world.

Our 15-year investment performance suggests that we’ve succeeded in protecting our clients at the various inflection points, since both our equity and our multi-asset portfolios have comfortably outperformed their respective benchmarks over the period. Our job as investment managers is to ensure that we remain disciplined in our approach and true to our principles, to ensure we fulfil our promise to beat mandated returns for our clients who trust us to grow and preserve their wealth over the long term.