Economic Overview

The geopolitical risks that dominated for much of 2019 faded in Q4, supporting global share markets. Trade uncertainty faded with the US and China’s phase one trade deal announcement, while economic data remained stable. The trade deal, signed on January 15 means planned new tariffs will not be imposed, while US tariffs imposed in September on $120 billion Chinese goods will be reduced by half. The 25% tariffs on $250 billion of Chinese goods will remain. China also agreed to increase purchases of US goods, with agricultural produce highlighted.

The US Federal Reserve cut interest rates once in the quarter before indicating that “the current stance of monetary policy is appropriate”. The US economy expanded by 2.1% (annualised) in Q3. A result better than expected and stronger than Q2.

In the Eurozone, the confidence measure among German executives, improved in December, yet the Eurozone purchasing managers’ index remained unchanged at 50.6 in December – a level that indicates weak growth. Annual inflation was 1.0% in November, up from 0.7% in October but still well below the European Central Bank’s target of close to 2%. Christine Lagarde, in her first major speech as president of the European Central Bank, urged governments to boost public investment in order to increase domestic demand in Europe.

In the UK, the Latest GDP figures confirmed the economy had avoided entering a technical recession in the third quarter after contracting in the previous quarter. GDP growth was 0.4% quarter-on-quarter. Overall, the data suggests that the economy is coping with the uncertainty from Brexit. After the landslide election victory for the incumbent Conservative Party, the government is set to use its large majority to take the UK out of the EU by 31 January 2020, entering a transition period when the next stage of negotiations will begin.

Japan’s economic data continued to show a significant divergence between the strength in service sectors and the weakness in manufacturing. There were also signs that the long-running trend towards an ever-tighter labour market had finally reached its natural limit. The main economic event for the quarter was the consumption tax increase on 1 October.

In Australia, the RBA cut the official cash rate to 0.75% in October. Despite predictions of further cuts, none eventuated during the quarter. Eyes now turn to the RBA’s first meeting in February. While the RBA noted in its December minutes that, “the Australian economy appears to have reached a gentle turning point” it also finished those minutes by noting, “the Board is prepared to ease monetary policy further if needed to support sustainable growth in the economy, full employment and the achievement of the inflation target over time.”

Market Overview

Asset Class Returns

The following outlines the returns across the various asset classes to the 31^st December 2019

Overall, it was a mixed quarter to top off an extremely strong year. The majority of the Q4 gains came from global shares. US markets pushed higher as trade uncertainty faded, while Eurozone markets advanced with better economic data emerging from Germany. Bond markets reflected the better mood in the quarter as government bond yields rose (prices fell) and corporate bonds performed well.

Across the year it was hard to miss a good return, both Australian and global shares returned 20%+ returns, while Australian listed property was pushing 20% and fixed interest was given a shot in the arm as yields fell and prices increased. The asset class doing no one any favours? Cash.

In the US, the tech sector was a major beneficiary of easing trade tensions. Energy companies, which had lagged the broader S&P 500 index in 2019, rallied as the oil price rose on lower-than-expected supply.

Eurozone shares notched a strong return in the final quarter of the year, with the region’s MSCI EMU index returning 5.1%. Listed companies were supported by better economic data from Germany as well as the phase one trade deal agreed by the US and China. Gains were led by sectors that generally fare well when the economy is strengthening; top performing sectors included information technology, consumer discretionary and materials.

UK equities performed relatively well, and domestically focused areas benefited significantly as they responded favourably to the reduction in near-term political uncertainty.

The Japanese market rose in each month of the quarter to record a total return of 8.6%. Asia ex Japan delivered a strong return in Q4, supported by easing geopolitical risk as the US and China reached a phase one trade deal. US dollar weakness also provided support to returns. Against this backdrop China, South Korea and Taiwan all outperformed. In Taiwan, strong performance from technology sector companies boosted returns, as earnings expectations were revised upwards following solid Q3 sales figures

Emerging market shares posted a strong gain in Q4, benefiting from easing geopolitical concerns. The MSCI Emerging Markets Index increased in value and outperformed the MSCI World.

After a double digit first half of 2019, you might say the ASX coasted home with lower returns in Q3 and a meek 0.75% return for Q4. Notably, it did pass its previous record high in November. Q4 was hampered by a weak December with concerns over Christmas retail figures, the strengthening Australian dollar and improving employment figures, which paradoxically became a negative with the ASX counting on the support of further interest rate cuts. Meanwhile, three of the four big banks, NAB, ANZ and Westpac, struggled through Q4 with either more scandal or cuts to earnings and dividends, proving another drag for the ASX in Q4.

2019 Take outs

As we’ve noted, it was hard to go wrong in 2019, unless you had a bank account stuffed with cash or a poorly diversified portfolio stuffed with bank shares – or worse, a combination of both! Major asset classes all delivered stellar returns and when combined into a balanced portfolio of 60% growth assets/40% defensive assets the return was 16.74% for 2019, after a 1.01% return in 2018. Remarkably, the 2017 return for such a portfolio was 8.17% and the 2016 return 8.01%.

How reliable is that consistency? The average annual return for this portfolio is 8.27% for the past decade. The worst return came in 2011 with a -1.00% return, with 2019 being the best. Which shows if you’re prepared to ride out the sub-par years the realignment can eventuate, along with the rewards.

The on again off again trade tensions have proven somewhat farcical. A sniff of negative would take the market down and a whiff of positive would drag it back upwards. When the trade issues move into the background it will be interesting where global markets will take their cues from next. The US presidential race will likely be a focus. Just remember 2016 and the damage Donald Trump was supposedly going to inflict on world markets.

Whatever the focus, it should remain as a matter of interest, not a matter of concern. 2019 was a reminder that we should never react because our expectations may not align with market responses. There was significant concern as 2018 ended. Economic momentum was slowing, earnings growth was in question and optimism was low.

2019 returns were unexpected and more than anyone could hope for.

Does it mean anything for 2020? No. 2020 will have no memory of 2019, just as 2019 had no memory of 2018.

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With material from Schroders & DFA Australia.

This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person or entity. Accordingly, to the extent that this material may constitute general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. This is not an offer or recommendation to buy or sell securities or other financial products, nor a solicitation for deposits or other business, whether directly or indirectly.

“The markets haven’t been very good lately,” the investor said with some concern. “Should we be doing something?”

Markets were off their highs. Trump was being Trump. August had been one of those months. Off nearly 5% in a week. Sideways for the next three. A slight upward burst at the end, but the media had been salivating at the prospect of more losses. The wind had stopped blowing and the seas had calmed. The investor was still thinking about those storm warnings.

“Well the ASX All Ords is up about 19% until the end of August,” the adviser said, bringing up a returns chart.

“That’s strange, I could have sworn we’d been doing pretty badly this year,” returned the confused investor. “Interesting.”

August, and its last day, is an interesting study on why that might be.

Earlier in the month these are some of the headlines leading broadcasts, gracing newspaper front pages and taking the top left on news websites throughout August:

Bloodbath for share markets: Here’s how it affects you

ASX drops 128 points in worst loss of 2019

Trade war wipes $38b off ASX

Aussies’ super smashed as USA-China trade war hits ASX

Australian stock market slumps after US-China trade war prompts Wall Street plunge

Investors told to brace for more volatility as ASX sells off

Yes, it could be recency bias. The tendency to let the most recent events weigh heavily in one’s mind, but that’s only able to occur if a person is confronted by all information.

Below are the homepages of four well known Australian newspapers on that last day in August. The ASX All Ords finished up 93 points that day or 1.4%. It was up over 100 points when these screenshots were taken. You’d think such a great day would have warranted some interest by the media; telling us how many billions had been ‘wiped on the ASX’, what the gain ‘meant for us’ and how important it was for ‘our super’.

After all, those top left corners are usually reserved for important stories reminding us how much we’ve lost on the down days.

Nary a mention.

The day’s gains were buried much further down the page. Positive market news relegated to the business & finance section. Flicking through the nightly news it was a similar story.

Media bias by omission is why investing is so hard. It explains why some people are scared of the sharemarket. It also explains why sharemarket investors regularly think they’re doing worse than they are.  If we use months as our guide, 63% of the time the ASX is heading upward. It’s 72% of the time if we’re using years.

The likelihood of a 100-plus point down day leading the news? We can only guess, but we’re assuming it’s very high.

The likelihood of a 100 point-plus up day leading the news?

Looks like zero.

_{This represents general information only. Before making any financial or investment decisions, we recommend you consult a financial planner to take into account your personal investment objectives, financial situation and individual needs.}

June 6, 2019

Neil Woodford has a neck thick like a rugby player and a head shaped like it was chiselled out of granite, it could be mounted somewhere on Easter Island. Imposing is an appropriate word to describe his appearance. Woodford is a man screaming conviction.

Charlie Aitken is almost the opposite, but no less memorable. His features are sharp, he’s thin. Hair slicked back, often wearing a smug smirk; he appears supremely confident, giving the impression you should be listening to him. Aitken is a man screaming conviction.

While Woodford looks like he could be cracking heads outside a nightclub and Aitken cracking jokes on a late-night talk show, they’re both in the same business. They both manage money and lately it hasn’t been going so well.

Woodford was known as a star stock picker during his time at UK investment manager Invesco, so in 2013 it was time to set up his own fund. He started off strongly.

In his first full year on his own, Woodford’s flagship fund returned 16 per cent, beating all 50 of its peers tracked by Bloomberg. That has all changed, with the fund down 7 per cent this year through May 31 and down 18 per cent in the past 12 months.

And those falls have caused panic with Woodford’s investors.

Neil Woodford’s problems are a fund-management version of that old-fashioned bank run. Investors in the Woodford Equity Income fund have been asking for their money back at a rapid rate – about £10m a week. Unlike a bank, the fund has all the money – but it is invested in a series of companies.

To come up with the cash at once, the fund would be forced into a fire sale, with the result that investors would almost certainly get back less – much less – than they put in.

To stop the rot, this week Woodford suspended trading in his flagship fund in the UK.

Back in Australia, Aitken was one of Australia’s better-known stockbrokers before he made the leap to start his own fund in 2015. He attracted high profile investors such as billionaire Kerry Stokes and was said to have $300 million in funds under management. The fees were 1.5% and 15% of any outperformance over the fund’s benchmark.

Aitken’s Global High Conviction Fund started off promisingly enough. It outperformed its benchmark, the MSCI World Index, until 2018 when the fund fell almost non-stop throughout the year.

Aitken Investment Management’s Global High Conviction Fund suffered a 23.8 per cent loss in 2018 after being defeated by macro conditions that undermined the strategy’s pro-Asia bets.

This year it has lost further ground as the MSCI World’s recovery has been much stronger than that of Aitken’s fund. With that stinker of a return fresh in the memory, things are also happening at Aitken’s fund. The biggest investors apparently want change.

Rather than expand the stock picking team, we’ve heard the telegenic Aitken — we gather after some nudging by Stokes and Rankin — is going to recreate the business as a branded global index fund, with some high-conviction calls on the side.

Sounds like a fund available for 0.3% from a regular fund manager. Unless the pencil is sharpened on fees, any investor will pay Aitken an extra 1.2% for a little speculative indulgence. Hardly seems warranted.

Both Woodford and Aitken are known as conviction investors, but there is a problem with convictions. When you have convictions, investors expect your convictions to be right and they don’t give a damn about your convictions when they’re wrong. They have zero patience for theories on why something should have happened and yet didn’t.

They don’t want to accept a financial crisis type return in a year when there’s no financial crisis just because something happened in Asia or Europe that you didn’t foresee.

One of the more famous conviction stories is that of Michael Burry. It was memorably featured in the film The Big Short. Burry (played by Christian Bale) bought credit default swaps on subprime mortgage bonds. Doing this ensured Burry’s hedge fund performance was terrible for a considerable period of time due to the cost of holdings the swaps.

His investors were frustrated at the returns and apoplectic when Burry suspended redemptions and froze his investors’ capital until he believed the CDS market was acting as it should. If you’ve seen the film, Burry continually writes the percentage decline of his fund on a whiteboard.

In the end the payoff was spectacular. The number Burry finally wrote on his whiteboard was a two fingered salute to anyone who doubted him.

Michael Burry’s final return.

While it’s a great story, it’s not particularly helpful for everyday investors. In the film the audience is meant to sympathise, and cheer Burry on. In real life, the audience would be the investors screaming at Burry demanding their money back.

And for every Michael Burry who survived, recovered and delivered a monster pay off, there are an array of funds that have been shuttered after abysmal performance, the managers slinking off into the night. If an investor is down 20%+ in a fund based on a manager’s convictions, you can be assured they’re losing their convictions in the manager’s abilities.

Neil Woodford has been great in the past. Charlie Aitken has been great in the past. As we see time and again when it comes to investment returns, reputations mean nothing. Investors banking on previous conviction success won’t know the manager they’re investing with is right or wrong until after the fact.

Not that it stops the media giving them endless free publicity. Both Woodford and Aitken have been media darlings in their respective counties. In many investors’ minds media exposure equals skill and legitimacy when it’s only an indicator of the past and a willingness to provide a colourful quote.

But here’s a more important quote from some investors in Neil Woodford’s fund, “we trusted Neil Woodford with our money”.

Investors can trust a person, or they can trust capital markets and the factors that are known to drive returns. There are no guarantees, but in the past markets have been able to price in bad news and eventually keep providing returns.

The same can’t be said for every star manager’s fund.

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Neil Woodford explains to his investors.

_{This represents general information only. Before making any financial or investment decisions, we recommend you consult a financial planner to take into account your personal investment objectives, financial situation and individual needs.}

Economic Overview

I watched this film again recently and it made me think about the similarities with our investment philosophy.  In case you missed it, Moneyball was a 2003 book by Michael Lewis (later a 2011 film starring Brad Pitt) following the Oakland Athletics baseball team.  The team had the third lowest player payroll in US baseball, but general manager Billy Beane attempted to overcome this through using analytics and evidence based strategies to find undervalued players and compete with larger teams.

Despite losing star players, Oakland’s 2002 season was famous for besting their previous season, going on a 20 game winning streak and having the second best winning percentage in the league. A winning percentage only bettered by the New York Yankees who spent three times more on player salaries than Oakland.

How does this relate to investing?  The concept of finding players who are undervalued by the market isn’t so different to tilting a portfolio to incorporate value companies that are out of favour with the market for some reason.  The end goal is a better return through increasing risk, but using historically compensated risk, to achieve that better return.

There are three givens when it comes to compensated risk factors.  These givens are all based on academic research.

First, the market itself. Shares are riskier than bonds so they offer higher expected returns.

Second, small companies have higher expected returns than large companies because they are more of an unknown quantity.  Think an established star player vs a first year player.  Superstars tend to perform according to their pay packed so there may not be much upside.  For the first year player, expectations are low, so the pay is low, but they may provide a significant upside.

Finally, value companies offer higher expected returns than large and successful companies because they are out of favour with the market for some reason. In this instance you might think of a player recovering from a long term injury, maybe one with offield issues or just misused by a previous team. For value companies, they may have been poorly managed, missed guidance or have been going through a restructure meaning their shareprice has been dented, but their potential remains.

In Oakland’s case, GM Billy Beane found certain important statistics were underutilised in baseball and the players who ranked highly in those statistics were often undervalued and not well regarded in the league. This meant Beane could build a high performing, albeit unfashionable team, within Oakland’s salary constraints.

On the back of the book and the film, Billy Beane became a much more widely known figure and his and his team’s methods attracted a lot more scrutiny. Oakland hasn’t performed as well since, so some assumed it was a fad and a flash in the pan. Not the case. Essentially Oakland was pulled back to the pack because many other teams began incorporating the same statistical analysis into their team building.

So long term in baseball it becomes harder to find value and outperform the market. In contrast when investing, the outperformance from value generally appears over the longer term – if an investor maintains discipline.

As the following chart shows with Australian and Global value returns vs their respective benchmarks since 2000. To note, the red lines represent Australian and Global value funds while the blue lines represent their respective Australian and Global market benchmarks.

Now you don’t build your whole portfolio on value funds because value premiums are not always available.  Sometimes yearly returns will fall behind market returns and value funds also come with higher volatility. However, as part of a diversified portfolio a tilt to value can help increase overall return.

In baseball the increasing use of statistics and research has meant a change from scouting and recruiting players based on intuition by scouts and managers.  Much as statistical analysis has contributed to less guess work when investing.

As Billy Beane notes when comparing baseball’s changes to the investment industry, “thirty years ago, stockbrokers used to buy stock strictly by feel. Let’s put it this way: Anyone in the game with a 401(k) has a choice. They can choose a fund manager who manages their retirement by gut instinct, or one who chooses by research and analysis. I know which way I’d choose.”

Wise words.

_{This represents general information only. Before making any financial or investment decisions, we recommend you consult a financial planner to take into account your personal investment objectives, financial situation and individual needs.}