Avoiding the portfolio ‘torpedoes’

I have had the “fortunate” experience of having observed both the GFC in 2007-08 and the Tech Wreck in 2001 from the vantage points of helping to manage conservative value-style funds.  During these periods the portfolios were populated with companies paying dividends from stable recurring earnings such as TransCanada Pipelines and Amcor. We had no exposure to companies that were reliant on the previous frothy market conditions continuing such as Pets.com or Allco Finance. What I learned from these experiences is that a portfolio constructed in a conservative manner with a strong dividend yield will bounce back from the doom and gloom.

When a major market dislocation occurs, the best thing for investors to do is step back and think what it will do to the earnings and dividends from the companies in their portfolio. If the answer is 'not much' and the dividend stream will be largely unaffected, then the falling market has given you the opportunity to add to positions at a discounted price. For example, it was hard to see how the falls in the US market earlier this week were going to impact rental income from SCA Property’s portfolio of neighbourhood shopping centres or Amcor’s sales of PET soft drink bottles and flexible food packaging.

What I am trying to do is develop a picture of what the changing market conditions means for the earnings of each company. This may result in changes to your valuations for the various companies, but you have come back with fresh eyes and hopefully a clear head and not simply reacting to the direction of the market and the opinions of others.

The first move is to try and understand what is changing, this week it is mostly a normalisation of interest rates. I will then go for a walk to get away from the noise with a copy of the portfolio and methodically go through each holding. I also like to keep an aquarium in both my home and Martin Place offices that provide a calming influence during market downturns.

When you’re staring into the face of a crash, the worst thing that you can do is look at the sea of red on your computer screen for hours at a time reading the breathless market commentary in the financial press or coming out of the trading desks at the investment banks. The former is designed to sell newspapers and the latter is done to try and influence you to incur brokerage.

Focus on downside protection

In the current environment we see that investors should be looking through their portfolios for the stocks that could “torpedo” portfolio performance. In early 2018 rather than scouring the market for the next Blackmores or A2M Milk, we are spending time thinking about what could go wrong with the various companies in our existing portfolios.  As a quality style manager, I am now looking closely at the quality of company earnings and the percentage of earnings that are derived from recurring earnings that will hold up over time, rather than profits coming from revaluations, asset sales or performance fees.

In terms of sector positioning I would be cautious on the mining sector, especially at the sexier end of lithium and graphite. The frenzied activity, promise and hype in this sector looks like a movie I’ve seen before.  While the consensus view is that commodities will stay strong in 2018, a large part of the price moves we saw in 2017 was the result of Chinese stimulus plans enacted in 2016 which has begun to fade. Declining Chinese dependence on fixed-asset investment to drive growth will put downward pressure the prices of commodities such as coking coal, iron ore and copper.

A stock set to benefit in a downturn

While listed property trusts as a sector are viewed with suspicion by many investors, we continue to like SCA Property. This trust is exposed to domestic food, liquor and services consumption via long-term leases to Woolworths. During major market meltdowns such as the GFC, consumers cut back spending on discretionary items such as clothes and going out to restaurants in favour of cooking and drinking (larger than normal) glasses of shiraz at home; all of which are supportive for SCA Property’s earnings.

Woolworths’ landlord continues to benefit from the supermarket giant’s battle to regain market share from Coles, as a portion of the rent is tied to turnover. The trust is conservatively run by an experienced and honest management team and importantly has low gearing and minimal near-term debt maturing. After management upgraded guidance for 2018 on Tuesday the trust is trading on a yield of 6.3%.