The next six weeks might make or break markets

Have markets gotten ahead of themselves? Have we seen the bottom, or is there room for the market to plunge again? Investors have been caught up in the excitement of the market rally, but is this excitement premature? 

Emanuel Datt, Principal of Datt Capital explains why he is prepared for the market to retract in the next six weeks. 

"I think we may have seen the bottom of this crisis in terms of downside for the equity markets, although there is a possibility that we have another retraction over the next six weeks."

Emanuel discusses his 'barbell' approach to investing and shares three stock tips that the market has ignored. 

As a relatively new fund manager, how do you prepare yourself for an impending bear market, and did this one shock you? 

As a fund manager the heart of our process and philosophy is rooted in risk mitigation. Consequently, we outperformed the broader equity market in terms of capturing less downside during the recent market fall and achieving more than the market return on the bounce back to the upside.

This bear market was a direct result of unprecedented government intervention in terms of societal lockdowns and curfews; a situation never experienced in any historical era. Understanding the catalyst directly behind the market fall was an important element in assessing which sectors could be invested in profitably and which held more risk than the potential return on offer.

We were very calm throughout the market turmoil having previously experienced the utter despair of investing throughout the depths of the GFC. This helped a lot having experienced a situation where there was legitimate uncertainty around the solvency of our modern financial system vs the current situation. I consider myself fortunate that I have seen and experienced the best and worst of what life has to offer; which definitely helps with maintaining perspective and composure during difficult times.

Whilst challenges still lie ahead for society we are optimists at heart, whilst not being blindly optimistic.

Do you think we’ve seen the bottom of this crisis? And how are you adjusting your portfolio to the uncertainty of that outcome?

I think we may have seen the bottom of this crisis in terms of downside for equity markets, although there is a possibility that we have another retraction over the next six weeks. It will still take a number of months until we have a clear path and an assessment of the damage caused by the societal shutdown and all its knock on effects. In particular, we are interested in the behaviour of the government, post the easing of societal restrictions especially in terms of fiscal policy and the social support system.

We are not taking any particular precautions as we believe the future is always uncertain irrespective of the environment at hand. Our only plan is stick to our strategy which has performed exceptionally well throughout this crisis. We are in the market to make money for our investors in a prudent, pragmatic fashion; if we try to time the market we run the risk of not achieving our core objective.

As a multi-asset manager, have you made any adjustments to your asset allocation through this volatility?

We have not made many adjustments to our asset allocation through the volatility except to liquidate some small non-core equity holdings into cash. Prior to the government intervention into the debt markets, we were beginning to find interesting opportunities in the fixed income markets. Ultimately, the government intervened before prices had really fallen enough to be attractive to us and we ended up selectively increasing our equity exposure just after the market bottom.

Your investment strategy has been labelled a ‘barbell approach to investing’. Can you explain what that entails and the role that this approach has played?

A barbell investment strategy involves blending low and high risk assets inside a portfolio to achieve a greater overall risk adjusted return.

We group our investments into 3 risk categories:

1. Real assets and income securities (lower risk) - Agriculture, precious metals, fixed income, private debt and infrastructure that typically provide a lower correlation to other asset classes.
2. Value reversion, cyclical opportunities and special situations (medium risk) - turnarounds, mispriced asset rich companies, stocks with exposure to markets with projected future supply constraints, spin-offs, privatisations.
3. Growth and emerging companies (higher risk) – Companies with unique business models with strong potential to compound capital for longer periods of time. Ability to grow their way towards market leadership and global audiences. Emerging companies may be from any industry with the capability to grow off a low base.

Our portfolio exposure is always spread amongst the 3 risk categories depending on our current opportunity set, which has led to good outcomes over time.

How are real estate developers holding up in this environment? Have there been any improvements in recent weeks as equity markets have recovered?

Professional, experienced real estate developers seem to be experiencing little distress and are usually more conservatively geared than the less experienced participants. We focus solely on projects being developed by well recognised and regarded participants in the core metropolitan markets of Sydney and Melbourne. As we invest in property debt, the recent volatility has not affected our debt portfolio whatsoever. Our risk assessment process eradicates poorly financed and higher risk projects; making us well equipped to capture superior returns at low risk.

How much cash are you sitting on? What (if anything) would cause you to deploy it?

At present, we have a cash balance of around 15% which is a typical weight for us. We really value the optionality of cash and it has served us well to hold a higher than usual cash balance despite the drag on overall portfolio returns. We like to hold reasonable amounts of cash on as it allows us to invest opportunistically at the right time.

We have been deploying our cash balances selectively during the recent volatility. These periods of volatility are quite a boon for the skilled active manager, as we are able to recycle our capital faster as underpriced investments revert to fair value much faster. This is evidenced by the fact that despite holding a larger than normal cash balance, we were able to significantly outperform the broader market in April.

You’ve stated that you’ve made some additions to your portfolio over the last two months to combat the negativity of the market. What are some of these equity additions and how have they assisted your portfolio?

Near the market bottom, we increased our exposure by picking up undervalued positions in a number of stocks. We purchased Challenger (ASX:CGF) in the low $4’s which was valued around 30% of its 12-month high. It had been marked down heavily by the perception that it would breach its APRA capital adequacy requirements, despite paying a dividend and reiterating the adequacy of its capital position multiple times to investors. Being Australia’s largest annuity provider and with the industry experiencing good tailwinds, we felt that the selloff had been overdone.

Another company we purchased was Eclipx Group (ASX:ECX), a fleet leasing company, which we purchased, again valued around 30% of its 12-month high. We felt despite the forced government shutdowns, the company has a fairly vanilla business and client base; and would also continue to benefit from its focus on divesting non-core assets and government stimulus. We had also noted that the company has been subject to various M&A offers given its market position in the local market and considered another tilt would be forthcoming if its value did not revert within a short timeframe.

During the turmoil, we discovered a growth opportunity that we are really excited about and have written about here into a company called Selfwealth (ASX:SWF). One interesting dynamic we’ve seen with the market volatility is the entry into equity markets of a greater number of investors. With many people having much more time on their hands due to lockdowns, and other asset classes delivering very marginal returns, the equity market is really the only way to make a reason return on capital.

This has benefitted companies like SelfWealth enormously. For example, In the most recent March quarter vs the December quarter: SelfWealth grew trade volume over 100%, client cash held grew over 150% and active users grew by almost 50% (achieving almost 70% of their previous annual growth target in 3 months) skewed towards the month of March. We expect this momentum to continue now that the company has likely reached profitability and we feel will continue to achieve additional mainstream success in time.

In markets generally, we are maintaining a fluid, agile approach with an emphasis on investing in companies with positive exposure to the current social environment but also leveraged to growth as society normalises.

We're always looking for new investment ideas

Datt Capital diversifies investments across asset classes and duration to reduce risk while maintaining relatively concentrated exposure to attractive investment opportunities. Find out more via the 'CONTACT' button below.