This is normal
Market cycles aren’t pretty. The age-old saying “it’s time in the market, not timing the market” feels old and tired when a portfolio has dropped 20% or more.
Although there is some truth to the saying, it’s also a cop-out. There’s no point in hanging on indefinitely to themes that don’t have attractive long-term prospects. Conversely, it does make sense to hold tight when sensible strategies suffer a bit of volatility.
It’s about time in the right markets, rather than the markets in general.
There’s no question that a market correction was necessary. Things ran so hard over the past 12 months that a sell-down was inevitable. The important thing is to understand why it happened and whether it changes any of the long-term thinking that goes into our portfolio construction.
Importantly, when we invest in funds, we do it on an unleveraged basis. In simple terms, that means we are never forced to sell just because the market takes a dive. This is a critical point to understand – the option exists to ride the storm and wait for things to come back.
Risk vs. reward
In any portfolio, risk is typically measured as volatility. This is technically the deviation from the mean but can be explained in a far simpler way.
If you imagine a share price graph with a long-term trend, the volatility would be reflected by the extent to which it moves above and below the trendline (the sharp diagonal lines that are a feature of most share price charts). Riskier assets have sharper and larger moves, causing moments of elation and panic along the way.
However, to be attractive investments, riskier assets need to offer a more impressive trendline than less volatile investments like gold or government bonds. Even shares in mature South African companies would typically be less volatile than exciting international growth stocks like Facebook.
If too much of your money is locked up in volatile investments at a time when you need to live off your investment income, then your advisor isn’t doing a good job. At Heritage Wealth Partners, we are focused on getting the balance right between long-term investments and short-term income requirements.
So, these sell-offs are normal?
There isn’t much about the market that can be described as “normal” over the past year, but market corrections (or sell-offs) are normal. A substantial sell-off can be as high as 30%, with smaller drops of 10% quite common during investment cycles.
There is always a catalyst for a sell-off. This time, the catalyst is inflation.
When there are fears of inflation, the expectation is that treasury yields will go up (the rate at which the US government borrows money). This drives a general increase in interest rates, which upsets the valuation apple cart, even if the inflation risk is arguably short-term in nature. In the current environment, inflation is being driven by cost-push inflation (e.g. commodity price increases) and supply chain shortages around the world, as value chains try to catch up to recovering demand.
This valuation impact is more severe for companies with long-dated cash flows. Growth stocks that are forging a path in new industries and focusing on revenue rather than profit are hit the hardest. Most of their value lies in what will be achieved ten years from now. When discounting that value to today, the rate used is higher when inflation is higher. This causes a drop in the present value of those cash flows.
Simplistically, a jump in rates causes a drop in equity valuations. Conversely, a drop in rates causes a rise in valuations, which may be in the case if the inflationary environment tapers off.
The impact on offshore investments has been made worse by an unseasonably strong Rand. Make no mistake – this has very little to do with the situation in our beautiful country. The Rand strength against the Dollar is largely to do with Dollar weakness because of unprecedented money printing in the US, dished out as stimulus payments to drive the economy. A return to load shedding is a timely reminder of our extensive structural issues.
This is the same driver of growth in the crypto market, with punters moving out of Dollars and into cryptocurrencies. That is a high-risk strategy and perhaps appropriate for at most a very small percentage of a portfolio.
When one looks at what is really going on in the market, there is much to be excited about in our high-growth funds.
Look beyond the share prices
The share price has a grip on our emotions. When we view portfolio performance, the share prices determine whether things are green or red. Of course, they are extremely important and are the ultimate measures of wealth creation.
However, prices ebb and flow. This is the volatility we discussed earlier. The more important analysis is to consider the underlying companies and how they are performing.
Companies listed in the US report earnings every three months. Many have just reported results for the period ended March 2021. With limited exceptions, leading technology companies shot the lights out. Many of these businesses are growing revenue by over 50%, as themes like cloud adoption and gaming gain traction. The trajectory for these companies is exciting and will be hugely profitable.
The Unicorn Fund has nearly 60% exposure to the technology sector. This is a powerful growth strategy for wealth creation but means the ride will be bumpy at times.
Apple and Amazon both had bumpy rides to where they are today. The reality is no different for the Apples and Amazons for tomorrow.
In a wealth creation strategy, it’s better to be on a bumpy ride to the top of a mountain than a smooth ride that slowly sinks into the ground. We remain confident of our strategy and what it should achieve for our clients over the next decade.