What do Equities Low Volatility have in common with playing tennis?
In our Equities Low Volatility strategy, our aim is to invest in equities with low share price volatility and to protect wealth in declining equity markets. You can compare that strategy to playing tennis. Most amateur tennis matches are won by the player making the fewest unforced errors and not the one making most winners. It is about avoiding mistakes – getting the ball over the net – not making fantastic winners.
Investors put too much emphasis on picking winners
Most people are looking for stocks with a lottery like return profile – i.e. a small likelihood of a large gain combined with a large likelihood of a small loss – when investing in the equity market. Investors often want to find the next cool thing and are attracted to equities with an interesting story. They are looking for the next stock that turns into multi-baggers – the next Apple or Amazon. Far too often the emphasis is on “picking winners”, because we want to get rich quickly. It is far more exciting for investors to tell their family and friends about how smart they were picking this or that biotech company with a potential blockbuster that surged over 100% in a short time. The problem with this approach is that few people succeed – instead they end up with a poor return because they have taken too much risk. Interestingly, history has shown that it is easier to add alpha to a portfolio by minimizing mistakes and avoiding torpedoes than by picking winners. Some of the best investment decisions can be the ones you do not make – avoiding those equities offering a poor risk versus reward opportunity.
Thorough risk analysis to minimize mistakes and avoid torpedoes
To minimize mistakes and avoid torpedoes, the due diligence process in Equities Low Volatility is built around risk control and downside protection, trying to eliminate left-tail risk as much as we can. Therefore, the portfolio managers are devoting a lot of time to a thorough risk analysis with focus on the fundamental stability of the company and the sustainability of the business model. The overall risk analysis is decisive for whether we want to invest in the company at all, but also for sizing the individual stocks in which we invest. In the risk analysis, we, among other things, pay special attention to:
- Diversification: We prefer companies with a certain diversification of activities measured by business lines, geography, products, customers etc. This is one of the reasons we have a higher exposure to Johnson & Johnson than Novo Nordisk, due to the latter’s concentration of sales and earnings from diabetes and obesity.
- Earnings and cash flow stability: We invest in companies with high stability in earnings and cash flow – typically companies with some form of competitive advantage or economic moat that allow them to generate a higher return on invested capital than non-moat companies.
- Quality of growth: We look at whether the company is growing and not least how the company is growing. We consider the quality of growth – is the growth organic or driven by financial engineering and acquisitions, and are the acquisitions value accretive or destructive.
- Financial leverage: We are paying attention to the gearing of the company but controlling for the nature of the business – utility companies like American Electric Power can have more debt than highly cyclical industrial companies with variable earnings and thus a variable ability to meet interest payments.
- Sustainability: We emphasize that the company meets basic governance requirements, acts as a responsible citizen and has incentive structures that ensure that management acts in accordance with the interests of minority shareholders. At the same time, it is imperative that the company is not involved in controversies that could threaten the sustainability of their business model.
- External environment: What does the external environment look like in relation to regulation and disruption? We look at both the current level of government regulation in the industry and the potential for the government to increase regulation. We also assess the risk that new players or new technologies disrupt the industry to the detriment of current players.
- Company specific risks: Are there any company specific risks we should be aware of? This could be product liability lawsuits, like the Bayer glyphosate legal cases in the United States, the outcome and economic consequences of which are difficult to predict.
Case in point: Technological disruption in the tobacco industry
The tobacco industry is a clear example of how changes in the external environment have affected our investments. For years, the tobacco industry has had a very stable business model characterized by a high and increasing dividend. However, technological disruption in the form of new products – i.e. e-cigarettes and heat-not-burn – combined with increased regulation in the United States, has changed the rules of the industry and led to a significant derating of tobacco stocks. This is why Equities Low Volatility no longer have investments in the large established tobacco companies. The only exposure is a small investment in Swedish Match – a company that acts as a disruptor through the rollout of the oral tobacco product Zyn, which, unlike snuff, does not contain tobacco.
Share price development for tobacco stocks versus the global equity market since January 2018
Source: Bloomberg and Jyske Capital
Back to tennis
So is the aim to avoid unforced errors borring? Maybe, but it is effective. In both tennis and investing, you can win by making fewer mistakes. Since inception in December 2013, the Equities Low Volatility strategy has had an upside and downside capture ratio of 86% and 46% respectively, meaning the strategy participates in positive markets, but captures much less of the downside when markets are weak. As an investor you win by avoiding the biggest losers – we call it "winning by not losing".