Having followed financial markets for over 30 years, it’s clear to me that adopting a disciplined approach to investing, and adhering to sensible ground rules, greatly improves the odds of making successful investments. There are a multitude of factors that need to be considered, but the following strategies and investment techniques have certainly enhanced my own stockpicking success.
Assessing investment risk
It is important to be aware of the risk embedded in a company’s valuation. The aim is to maximise the return available by taking as little risk as possible. Personally, I carry out 16 different risk assessments to get a picture of the overall level of investment risk.
It’s not an exact science, but as part of my due diligence process I carry out rigorous research, delving into key areas including:
- Understanding how profits are made and the potential for growth
- Robustness of cash generation and balance sheet strength
- Quality of management team and track record
- Shareholder structure
- Succession risk
- Pricing power
- Level and sustainability of profit margins
- End markets being sold into and scope for growth
- Impact of currency fluctuations on profitability
- Potential for earnings-enhancing complementary acquisitions
- Profit warning risk
- Geopolitical and legislative risks
- Economic risk
- Liquidity risk
- Volatility risk
I also assess how a company fared in the last downturn to ascertain the robustness of its profitability, and to understand how quickly profits returned in the ensuing upcycle. In addition, I assess whether a company is trading on a premium rating to peers and the market, and quantify the likelihood of the earnings multiple contracting.
Ultimately, you can only have conviction in making an investment if you have carried out thorough due diligence and have a complete understanding of the industry trends, business models and risk factors.
So, having carried out the risk assessments and determined the main bull and bear points, I then calculate a fair value for the equity. I take account of financial forecasts and sum-of-the-parts valuations to do so. The aim is to focus on companies where the upside potential is at least two to three times the downside risk.
If a company ticks the right boxes, and the risk-reward ratio is favourable, then it’s sensible to weight your shareholding accordingly, skewing the portfolio weighting towards companies where you have the greatest conviction. My fellow Investors’ Chronicle columnist and former fund manager, John Rosier, does exactly that, and successfully so.
Although holdings with the highest portfolio weightings may not deliver the greatest financial returns, the probability of a positive outcome should be enhanced, thus reducing the chance of making a capital loss. Ultimately, it’s a balancing act between having a spread of investments that offer potential for decent capital growth, and a smaller number of holdings that could produce once-in-a-lifetime returns – assuming of course you are comfortable with the risk in the first place.
The impact of macroeconomic and monetary policy
I always consider the bigger macroeconomic picture and ascertain how central bank and government fiscal policy are impacting financial markets. Quantitative easing (QE) is by far the most dominant factor at play in today’s markets.
Having been slow off the mark in realising that QE money-printing programmes were a gamechanger for equity markets at the bear market bottom in March 2009, I had a plan in place to profit from the next round of QE when the world’s largest central banks next ramped up their digital money-printing presses. To do so I studied the QE monetary transmission mechanism for my book Stock Picking for Profit to pinpoint likely stock market winners and losers.
This knowledge proved invaluable when stock markets tanked in March 2020 and central banks in the G10 countries and China pumped vast amounts of liquidity into the monetary system through their QE programmes. It’s worth remembering that the primary aim of QE is to drive long-term bond yields lower, force investors up the risk curve in search of higher returns relative to bonds, boost asset prices, and create a positive wealth effect.
However, it is more than a liquidity-driven process, because cheaper money has been recycled directly back into the real economy. Indeed, by soaking up the additional sovereign debt issuance resulting from government fiscal stimulus packages and pandemic-induced budget deficits, monetary authorities’ prompt actions went a long way to ensuring the Covid-19 induced global recession was short-lived.
As was the case during previous QE programmes, equities have been a major beneficiary. That is particularly the case in the period since March 2020, because alternative sources of yield have been thin on the ground in a zero-interest rate policy environment. The scale of the money-printing programmes was the primary reason why I nailed my flag to the equity bull market mast 18 months ago (‘Bull market rules’, IC 12 June 2020). Both the FTSE Aim and Small-Cap indices subsequently rallied a further 49 per cent to their autumn 2021 highs, outpacing UK mid and large-caps in doing so. The outperformance reflected a higher weighting to fast-growing sectors (technology, ecommerce and healthcare) that are beneficiaries of benign monetary and fiscal tailwinds.
Of course, central banks started reining in their QE programmes at the end of 2021 as economies rebounded. Financial conditions have also started to tighten as bond investors demand higher yields in order to mitigate inflation risk. From my lens, the easy gains have been made, and a market environment facing the headwinds of inflationary pressures, lower growth rates and tightening monetary policy will favour thematic stockpicking strategies rather than riding off the coat-tails of rising markets. I also feel at this point of the economic cycle that increasing exposure to low price-to-book-value plays offering decent dividend yields is a sensible strategy.
Understanding commodity price drivers
The potential for a strong global economic recovery in 2021 was one reason for being long of commodity stocks in 2021 (‘Reasons to be bullish’, IC 18 December 2020). It was not the only one. I was also heeding the bigger picture across the commodity spectrum.
In the oil sector, I felt that the combination of well depletions, underinvestment in new oil and gas fields, and an uptick in demand driven by a global economy on the rebound, could all construe to create a perfect storm for black gold in 2021. The oil price subsequently rallied 68 per cent by the autumn of 2021 and the natural gas price soared 144 per cent. Although markets have become volatile following the recent emergence of the Omicron coronavirus variant, relatively strong global demand means it’s sensible to expect the oil price to remain at elevated levels unless national lockdowns return for prolonged periods.
It’s worth noting that a robust oil price supports an accelerated transition to environmentally friendly energy alternatives. The shift away from fossil fuels is clearly gathering momentum and this has major implications for other commodities.
Copper is a major beneficiary from greater demand for electricity given that a higher portion of future power generation is forecast to come from renewable energy. Wind farms and solar panels require up to five times more copper than is needed for fossil fuel power generation, and electric vehicles use four times as much copper as internal combustion engine vehicles.
Analysts at research consultancy CRU estimate that wind turbines, electric vehicles and other ‘green’ technology will require 6m tonnes of refined copper by the 2030s, accounting for 20 per cent of forecast global consumption. Commodity experts at investment bank Bernstein forecast that copper demand from renewables and electric vehicles could grow more than seven times by the 2050s, if the world is going to meet its net-zero greenhouse gas emissions target. That’s a good reason to have exposure to copper producers. Three companies on my small-cap watchlist –…
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