James Inglis-Jones

Should investors protect against further falls or position for a rebound?

James Inglis-Jones

The coronavirus pandemic has now had a firm grip on global society and markets for a number of months and there remains no clear point at which we will return back to the pre-virus normal. Individuals and governments have drastically changed their behaviour to contain the disease and adapt to life under new restrictive measures. Our propriety measures have also shown a change in behaviour by businesses and investors as well, with both pointing to a more positive 12-month outlook for equity markets.


Going into 2020, we held a constructive view of equity markets. As a result of strong returns in Q4 2019, markets had become more expensive, but not worryingly so, and corporates in Europe were not showing any signs of aggressive levels of investment, which was another positive indication for equity markets in this region.


It goes without saying that a global pandemic of the kind we face today is a scenario that is extremely difficult to build protection against within an investment model owing to the unique scale of the shock and the resulting severity and speed of the sell-off. Bear markets almost always take time to develop – allowing trend followers with longer investment time horizons to reduce risk and protect capital. However, in this case, the sell-off – the fastest in history – was too sharp to allow for any meaningful repositioning by strategies with a trend-following element.


Although in hindsight we went into the sell-off with too much market exposure, now would be the wrong time to take risk off the table. Following the market rout, a number of our proprietary measures are aligned in indicating a very positive investment environment.


The severity of European and US stockmarket declines saw equities reach very cheap territory in short order according to our measures, which look at valuations using an equally weighted through-the-cycle method. Historic evidence shows that when markets are in a downtrend and are cheap enough to be in the lowest quintile of an equally weighted valuation – as they are now – the downtrend tends not to endure. In fact, these conditions tend to generate some of the most positive returns over the subsequent 12 months as they almost always capture market troughs. The caveat, however, is that these conditions also are marked by very high levels of volatility – so investors need strong nerves to capture these opportunities.


In addition, we have noted (using the same valuation approach) that the relative valuation of the companies that appear in the best quintile of our cash flow metrics has sunk to levels last seen at the depths of the Global Financial Crisis (GFC) and the tech bubble. As with our current situation, the GFC and tech bubble were highly uncertain environments for future company cash flows. However, our Cashflow Solution process does not rely on making sense of these uncertainties. Historically, after these instances of uncertainty, the process has subsequently generated the most attractive relative returns we have recorded, as the valuations of attractive cash flow companies revert to more normal levels.

Significantly, our measure of investor anxiety has also moved to a very high level in both Europe and the US. This is highly relevant as we know that when investor anxiety is very high, 12-month forward returns for our investment process have historically been strong.


Furthermore, the evidence shows that in these episodes the best returns are generated by focusing on our Contrarian Value and Recovering Value secondary scores. Value strategies tend to work best in these environments as the spread between the cheapest stocks in the market and averagely priced stocks widen to extremes.


The implication of this development is that investors are being paid a hefty premium to take on risk and uncertainty. When the level of premium on offer is of the kind we see today, it is almost always the right thing to do to take on the risk and uncertainty of a more valuation-based approach.


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Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Cashflow Solution team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The Liontrust European Growth Fund holds a concentrated portfolio of stocks, if the price of one of these stocks should move significantly, this may have a notable effect on the value of the respective portfolio. The Liontrust Global Income Fund's expenses are charged to capital. This has the effect of increasing dividends while constraining capital appreciation. 


The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Tuesday, April 28, 2020, 3:10 PM