Standard defensive responses to current market volatility may cause investors to miss attractive opportunities among certain cyclical stocks while paying too much for their defensive counterparts.
And, looking further ahead, excessive defensive positioning may leave investors poorly placed to make up losses let alone reap gains once the market does turn.
So said Mustafa Sagun, Chief Investment Officer of Principal Global Investors (Principal) Equities, on a recent visit to Australia where he met with institutional investors and analysts.
“Investors are understandably falling back on conventional risk management tactics to counter volatility in the market. While approaches such as minimum variance and risk parity certainly have their merits, they tend to be purely quantitative algorithmic strategies and as such are inherently perpetually defensive,” Mr Sagun said.
Mr Sagun went on to explain that such highly defensive approaches fail to capitalise on situations that can and do occur even in volatile markets, when in certain “risky” areas valuations have become so depressed that the amount of further downside risk is actually quite low and the opportunity to add active returns is high.
“The nub of the issue is that most investors probably can’t achieve their goals solely from so-called “safe assets” and some degree of equity exposure is warranted. You simply can’t achieve the better return potential of equities without taking risk. And the flipside of locking out risk in super defensive portfolios will eventually also be locking out returns. Combine that with the herd effect of many investors rushing into defensive positions and the consequent demand-driven price rises and you get investors paying over-the-odds and likely to be disappointed in the long run.”
To address these concerns, Principal advocates an opportunistic unconstrained global equity approach, using a systematic methodology to identify growth opportunities at attractive relative prices while still achieving lower volatility compared to the market averages. And, said Mr Sagun, the generally negative mood of the market can work in favour of those seeking out such opportunities.
“The fact that the market is so concerned and thus paying too much for defensives means there is an even greater differential between the expensive defensives and the cheap cyclicals. That provides a significant safety net because buying growth stocks cheaply protects capital – and positions you to participate more fully in the upside when the bull market returns.”
By way of a recent example, Mr Sagun cited Hong Kong real estate stocks which were being pessimistically priced, with price multiples that implied an expected 40% drop in Hong Kong property values. However, the Principal team’s detailed research into the specifics of the Hong Kong market led to a more optimistic view, pricing in a much smaller reduction. In Principal’s view these stocks represented a prime opportunity.
“What we did there was to exploit the extreme volatility anomalies that are occurring in this market, and taking advantage of the extreme corrections that inevitably follow,” said Mr Sagun.
He also stressed that only stocks that meet Principal’s required fundamental quality criteria are considered as part of this unconstrained opportunistic strategy.
“Features such as quality earnings streams and good earnings growth remain pivotal, no matter what the environment. What it comes down to is that whereas opportunities driven by extreme valuation dispersion such as the Hong Kong example might only rarely emerge during a year in an ‘ordinary’ market. However, with investor sentiment remaining quite fragile, and with more government intervention in markets, cycles have become far shorter. That means more of these opportunities are cropping up more often. What we are doing is developing a consistent framework that analyses the rapidly changing risk premiums so we can identify these opportunities as they arise rather than locking ourselves out altogether with a purely defensive play.”
