Managing portfolio risk in an uncertain world

SAUL MILLER Senior Portfolio Manager, Truffle Asset Management

When we think of portfolio risk, we are primarily considering two risks: volatility, and the permanent loss of capital.

Permanent capital loss arises when the initial assessment of value is incorrect due to one’s assumptions not playing out as expected.

Volatility is not the same as capital loss. Although we would not want our long-term returns to be volatile, we are not overly concerned with short-term volatility. In fact, as an active manger we welcome it, as it provides opportunities to purchase investments below intrinsic value.

Volatility is a function of the underlying investments and importantly, the correlations between them. The less correlated the individual investments, the lower the volatility of the portfolio.

At Truffle, we employ the following four strategies to manage and reduce risk:

1. Diversification

The well-known way to reduce capital loss and portfolio volatility is most easily done through diversification, by investing in a range of assets that ideally have low correlations.

2. High equity exposure

Since 1900, equity has outperformed bonds and cash, and more importantly inflation, by a comfortable margin in most countries. From 1900 to 2018, in real terms, global equity delivered 5%, bonds delivered 1.9% and cash produced 0.8% (Dimson, Marsh and Staunton 2018). The problem with equity is its high level of volatility even over relatively long periods of time: the global stock market produced a cumulative negative real return for the 22 years between 1910 and 1931, and countries like France, Germany and Japan had negative streaks in excess of 50 years!

3. Rigorous valuation process

The valuation process is best separated into two sections: the overall market value, and relative valuation of individual shares within the market. Targeting high equity exposure when overall markets are cheap should help raise the odds of improved returns, but it’s not as straightforward as one would hope.

Finding a reliable valuation metric for the overall market with reasonable predictive power is problematic. The Shiller PE, which is based on a midcycle earnings estimate, does seem to have some predictability of returns over long periods of time. However, this metric would have kept you out of the market for a significant part of the last 20 years.

Valuation on an individual share basis is critical to our process at Truffle. We break up the future returns of shares into three key components: dividend yield, earnings growth and a change in the rating.

The sustainable dividend yield is the easiest component to determine as it’s based on the current performance of the company adjusted for any temporary excess or depressed profitability. The most difficult component to determine is future earnings and dividend growth. Ideally, we look for companies with high barriers to entry and good returns on capital. This ensures inflation-beating earnings growth over time.

We avoid companies on overly high PEs unless we have conviction regarding significant earnings growth going forward. High PE shares often have overly optimistic growth expectations baked into their valuations. When these expectations are not delivered, significant capital losses result.

It is not easy to determine the extent of sustainable high growth in fast-growing companies or the level of sustainable poor earnings growth in cheap companies. Although we acknowledge our limited ability to forecast, we at least try to avoid the traps many investors fall into when investing in deep value due to their deceptively low PEs or avoiding growth shares that are trading on overly high PEs.

4. Portfolio hedging

We use derivatives to provide insurance at a portfolio and stock level. The cost of this insurance must be reasonable. We currently have protection on 15% of our balanced portfolio covering the overall market and some individual shares like Naspers.

We own Naspers due to its investment in Tencent, a fast-growing diversified technology company, which is the key driver of its value. Tencent is likely to grow its share price in the high teens, a bit below its expected earnings growth of over 20% p.a. However, it currently trades on a forward PE of 32X. Should its growth slow down in the next few years, its high PE ratio could fall significantly and as a result we have purchased protection on a significant portion of our holdings.

The world of investing fits more in the world of social science than physical science. While mathematical models and statistics provide some level of rigour to the investment process, these should not be taken at face value.

An appreciation of risk requires a qualitative assessment of an investment that cannot be distilled down to a single metric. It requires many years of collective investment experience and a rigorous yet openminded investment process.