By Andrew Dittberner, Chief Investment Officer at Old Mutual Private Client Securities
There is an assumption that complex systems such as financial markets require complex investment strategies. As a result, based on the view that the more complex the approach, the more effective it is likely to be, complicated investment strategies are often favoured over more simplistic ones.
A photograph of Warren Buffett sitting at the same desk he has worked from for over 60 years has become quite well-known and is used to portray the power of keeping things simple. Buffett, widely regarded as the world’s most successful investor, does not use a Bloomberg terminal nor does he employ an army of analysts to make his investment decisions.
Instead, he keeps things simple by identifying great businesses and not overpaying for them. While we agree with Buffett and follow the same principle, we recognise that in over-simplification, there is a risk of overlooking key nuances, particularly in today’s complex world of investing.
Identifying the next big theme
Let’s go back some 40 years to 1980. The top 10 largest companies at the time were largely oil-related business given the oil boom of the 70s. By 1990 Japanese companies were the dominant force while the onset of the internet during the same decade saw many technologies, media and telecommunication companies in the top 10 largest companies.
Through the commodity boom of the 2000s on the back of China’s rise to dominance, many Chinese and commodity-related companies were counted amongst the top 10 largest companies in the world. And finally, today after 15 years of strong growth from many tech-related businesses, the top 10 is once again dominated by tech companies.
From this, it is easy to conclude that simply predicting the next major theme and maintaining broad exposure to it is a sure way to achieve great investment results. Of course, this is very difficult to do, as we know that humans are poor forecasters. A simpler approach would be to not invest in companies that are part of yesterday’s theme, as the majority of them fell from the top 10 largest company list over the following decade. This would suggest that they likely underperformed after a period of significant outperformance. But following this type of approach is likely too simple.
Firstly, it is evident that several companies were able to maintain their top positions, despite not benefitting from the theme of the day. These include businesses such as Exxon Mobil, General Electric, Microsoft and Apple. Secondly, investment themes do not emerge on the count of a decade, as evidenced by a number of tech-related businesses having performed exceptionally well over multiple decades.
This tendency to broadly categorise companies or even countries on the assumption that they are similar (or will likely follow a similar fate), is extremely widespread. Investors and economists often coin catchy acronyms to describe seemingly similar groups of companies or countries — Blue Chip, Nifty Fifty, FAANGs, BRICS and the Fragile Five spring to mind.
Once pigeonholed in this way, it is easy to fall into the trap of believing that those companies or countries will follow a similar trajectory. For example, blue-chip companies are supposedly well established, well recognised and financially sound businesses that are safe investments. Yet, looking back, it is easy to identify many of them that were fraudulent or subsequently went bankrupt (think Enron and Lehman Brothers!)
Emerging markets, commodities, tech companies and value/growth stocks are just some of the pigeonholes that we believe investors need to be particularly cautious about as the underlying countries or companies all have very specific nuances that set them apart.
The Ever Emerging Markets
Depending on the prevailing mood, emerging markets (EMs) are either the dogs or the darlings of the investment world. You may recall in the 2000s, EMs could do no wrong and generated returns that were far superior to what was achieved in developed world markets.
Following the 2008 Global Financial Crisis, EMs fell out of favour with the investment community. Entering a decade of low growth and low inflation, investors flocked to companies that they believed could deliver growth in the prevailing environment. Those companies were found in tech-related sectors, generally within developed markets, and more specifically in the US. The graph below shows the performance of EMs and developed markets over the preceding two decades.
The decision to invest in emerging markets is one that investors still grapple with today. Valuation divergences and growth outlooks are key considerations, with emerging markets often more attractively priced (i.e., cheaper) despite their superior economic growth outlooks. However, valuation and growth expectations are not the only factors to consider as there are many other aspects that differ — both across and within countries.
Considering the broad basket of investment factors, including the varying regulatory environments, geopolitics and demographics and politics, it is clear that every EM is vastly different to the next. Some have a higher probability of actually emerging, while others appear unlikely to ever emerge, remaining stuck in the low-or-middle-income trap.
As such, each market is likely to be priced differently, given their outlooks and respective risks. One should therefore expect each market to perform very differently too.
The Complexity in Commodities
Commodities have a reputation of being notoriously difficult to invest in. Time the cycle correctly, and commodities can deliver significant investment results; get it wrong, and they can wreak havoc on both short and long-term investment returns. This is due to the inherent cyclical nature of commodity prices.
Investing in a resource-heavy market like South Africa means that investment managers often have to answer questions regarding their views on commodities. The problem, however, is that pigeonholing all commodities into to a single bucket is an oversimplification. Each commodity faces different short-term market dynamics, with equally different long-term outlooks.
Commodity market dynamics affect different commodities to varying degrees. Over the course of 2021, commodity prices (viewed as a basket) increased significantly, predominantly driven by higher energy prices. Yet, upon closer inspection, there was a very wide dispersion in price movements across the various commodities.
Therefore, rather than trying to determine current views on commodities, the emphasis should be on which commodities are currently favoured? With this shift in perspective, the cyclical nature of commodities as a basket becomes less important, and the long-term outlook plays a far more significant role in the investment decision.
Let’s Get Technical About Technology
From FAANGs to FAAMGs and MANGA to MAMAA — these are but a few of the acronyms increasingly used over the past few years to categorise certain tech companies. And while acronyms can be fun, they are dangerous in the sense that once certain companies are grouped together, investors assume they are all of a similar ilk. In reality, these companies can be anything but similar.
For the better part of a decade, large tech companies (such as Apple, Microsoft, Alphabet, etc) have proven to be the ultimate investment and have been credited with doing much of the heavy lifting in global markets — and rightfully so. On the back of their stellar performance, and particularly through the COVID-19 lockdowns, this select group of companies was elevated to “antifragile” status, a designation previously reserved for US treasuries.[1]
Once again, a dangerous assertion to make and the first few weeks of 2022 certainly provided a wake-up call. Performance of the top 15 large tech companies shows that these companies do not all perform similarly and are by no means antifragile. There are two factors currently driving this divergent performance; namely valuation and business model.
A great business can quickly become a poor investment if one overpays for it, and not all tech companies are valued equally. From a business model perspective, many of these companies have to continuously reinvent themselves in order to attract new users. The market has become fixated on the number of active users, forgetting that there is a finite universe from a user perspective. This is ultimately what happened to Meta Platforms (formerly known as Facebook) following the release of their 2021 financial results.
Conversely, other companies have the necessary competitive moats in place, and they can focus on doing what they are good at. Typically, such businesses have diversified revenue streams, and are not at the mercy of the market from an active user number perspective. Examples of such companies include Apple, Amazon, Microsoft and Alphabet.
Understanding these two factors, as opposed to painting all tech companies with the same brush, is key to navigating the technology quagmire that is often presented to investors in an overly simplistic manner.
Big tech is yesterday’s theme. Today every company, in one sense or another, can be considered a tech company, as every company employs some form of technology in its operations. Therefore, just having exposure to the broader theme may not be an optimal strategy.
When Pigeonholing Makes Sense
Acknowledging that there is nuance in every pigeonhole is important, because at times, a simplistic approach to a theme or group of companies is suitable. Attempting to identify a winner within industries with complex structures and many competitors is incredibly difficult, often requiring a healthy dose of luck. Examples include the biotechnology and semiconductor industries.
The nascent biotechnology industry has a significant role to play in the future of healthcare and there will be many companies that will produce ground-breaking technologies. Moderna is a recent example. However, there will also be many companies in the industry who will fail. Identifying the long-term winner comes with a large amount of risk. Therefore, from a risk management perspective, investing in the broad sector as opposed to a single company is a simplistic, yet sensible approach.
The semiconductor industry is also relatively young in comparison to many other industries, yet it is highly complex. The semiconductor supply chain is multifaceted, with many competing businesses at various parts of the chain. For example, there are the equipment manufacturers, fabricators, foundries and integrated device manufacturers.
Compounding this is the many different types of chips being produced for a multitude of purposes. Again, it is a very difficult task to resolutely identify a single business within the industry that will be a long-term winner. As such, within our Global Equity Model Portfolio, we have taken the simple approach of investing in broad exchange traded funds to get exposure to both the biotechnology and semiconductor industries.
Getting the balance right
In an increasingly complex world, we believe that investing requires a simple approach. However, simplicity does not imply naiveté or a lack of expertise. Rather, it entails deep understanding, deliberation, critical thinking and the ability to see the bigger picture, while at the same time knowing when and how to narrow your focus.
At Old Mutual Wealth Private Client Securities, while we follow a simple investment philosophy (based on the principles of quality, valuation, diversification and time), our rigorous process ensures that we remain focussed on the right factors and understand the nuances at play within both the macro environment and the companies within our portfolios. In our view, this increases the probability of achieving solid long-term investment results.
Steve Jobs summed it up well when he said: “Simple can be harder than complex, you have to work hard to get your thinking clean to make it simple. But it’s worth it in the end because once you get there, you can move mountains.”
[1] Coined by Nassim Taleb, ‘antifragile‘ is used to describe things that benefit from disorder, and technology businesses have undoubtedly benefitted from the chaos that ensued following economic shutdowns.
