Value Perspective Quarterly Letter – 4Q 2018

Value policy



The Value Perspective team

2018 has been a miserable year for investors in equity markets. The FTSE All-Share fell nearly 10%, its worst year for a decade. Fears around the outcome of Brexit have stalked the market since the summer – compounded by prolonged uncertainty around trade wars, a slowdown in China and fed rate hikes. Many have been quick to scream from the rooftops “markets have never been so uncertain!” It is as though the industry’s invincible record[1] of accurately predicting the future is under threat.

The reality is the future is neither more nor less (un)predictable now than it ever is. Once we accept that no one can consistently foresee what will happen next, and that this is not a new phenomenon, uncertainty is no longer feared. It also allows us to analyse risk in a more rational and objective manner. It allows us to distinguish between risk and uncertainty, which, contrary to popular belief, are not the same. When share prices fall, and many believe the future is ‘more uncertain’, investments often become less, not more risky. We discussed this in our second quarter 2018 letter.

If no one can foresee the future (especially what equity markets have in store for us over the next 12-months), it is reasonable to ask how then can we prepare for it? The answer is to focus on the one thing that nearly 150 years of stockmarket history has proven to be the key determinant of future returns irrespective of the market environment: valuations. Regardless of whether in a bull or bear market, when investors pay over the odds for any asset – however justified – it damages their long-term wealth. Since the Dutch tulip bubble of the early 1660s, investors have ignored fundamental valuations at their peril.

The price of perceived safety

We are not benchmark relative investors so rarely talk about stocks in the index that we do not own, but on this occasion, we shall break tradition. Not holding British American Tobacco (BAT) was a big tailwind for our clients in 2018, as the share price halved and it carries a high weight in the index.

BAT, as well as other ‘bond proxies’ – equity investments with bond like characteristics - have been seen as a sanctuary for investors looking for safe and stable earnings streams in a low yield environment. The issue is that investors prioritised BATs dividend characteristics overs valuation. As more and more investors bought shares in the reach for that safe and reliable income, the share price was driven higher and higher until it was unsustainable. The business eventually became too expensive for many to justify owning it. BAT is not an anomaly either. Other ‘bond proxies’, such as Unilever, Reckitt Benckiser, have experienced similar painful outcomes.

Where do investors go for safety? 

Historically, when markets fall the common argument is to move into defensive stocks, as these businesses are believed to be more resilient to drawdowns. Looking at our portfolio, we would not say we are invested defensively, and yet in 2018 performance has been resilient. Who would have thought a portfolio with material exposure to miners and banks – unarguably cyclical sectors – would outperform in the toughest year for UK investors of the last decade? 

Whatever the moniker, be it defensive or cyclical, it does not really matter. We sought out cheap businesses with sensible balance sheets, where the share prices already had a host of negative outcomes priced in before the market fell.

We also run high conviction portfolios that are more concentrated than many of our peers. By remaining judicious and not succumbing to the market’s animal spirits in the good times, we give ourselves a higher probability of being rewarded in the bad times.

A (very) quick word on Brexit?

Many may be reading this outlook expecting to hear how we are specifically preparing the portfolio for Brexit, as after all, it is only around the corner.

When we look at stocks, we are not doing anything markedly different today from what we have done in the past. We always rigorously stress test businesses that screen as cheap. We spend the vast majority of our time pouring over company reports and accounts answer the question, is the balance sheet good enough? We need to know the profile of company’s debt; what are the covenants? When will it mature? Is it bond debt or bank debt? Arrangements that appear sustainable today may become onerous in a different economic environment, so it is imperative that we critically appraise the balance sheet in a wide range of possible future environments. Similarly, knowing what the profits are today as well as their long-term average is imperative as understanding the nuance of the economic cycle and the impact that has had on balance sheets is crucial.

This detailed work is not a ‘Brexit test’, it is a severe financial stress test, akin to the conditions that businesses endured through 2009 global financial crisis, and it is work that we do on every single candidate for investment irrespective of the prevailing market environment.


[1] . Multiple studies have shown that economists and pundits predictions are no better than tossing a coin.

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The Value Perspective team


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