This year is no exception to the rule that investing through a fundamental lens often requires patience, but we are optimistic that these fundamental opportunities may be realized in the coming quarters.
Fundamental value is the foundation of our philosophy and process, and because value is a long-term concept, investing through a fundamental lens sometimes requires patience. This year our patience has been tried as markets, sectors, and currencies that are fundamentally inexpensive—and where we tend to have long exposures—have yet to reward us, while those that are fundamentally expensive, and that we are generally avoiding, have continued to perform well.
But we are optimistic that these fundamental opportunities may be realized in the coming quarters. Here’s why.
1. We are taking considerable active currency risk.
We de-risked our portfolios significantly in the first quarter across markets and currencies. Since then, we have been less cautious in rebuilding currency risk than we have been in equities. In fact, some of our currency exposures are larger than they have ever been.
The reason for this is that a few currencies, such as the Russian ruble, Brazilian real, Colombian peso, Turkish lira, and South African rand, are at extreme levels of undervaluation in real exchange rate terms (according to our valuation model).
We have stepped into attractive opportunities that we believe justify significant exposures, but we have yet to be rewarded.
Those currencies, and others, have also regrettably continued to move against us since we’ve reestablished the exposures and since we’ve increased the exposures to their current size, but the forward-looking opportunities appear to be very large.
We have stepped into attractive opportunities that we believe justify significant exposures, but we have yet to be rewarded for these in terms of year-to-date performance. Right now, we believe it is important to have patience.
2. We are taking on equity risk where the opportunities appear large—and have gotten larger.
There has been quite a wide dispersion in market performance over recent quarters, and those places where we are taking and increasing the risk are, in general, the ones that have moved further away from fundamental value of late.
Some prime examples of this can be found in equity markets such as the United Kingdom, Spain, Chile, Brazil, and Singapore. These markets have not rallied to the extent that some markets, like the United States, have.
This has been a relative drag on performance, but also means the forward-looking opportunities appear to be large, and we have accordingly increased risk in these markets through the course of this year.
3. We are not taking on equity risk in those markets that seem fully valued or expensive.
There is really quite a large difference in year-to-date performance, and in our view the spread between the fundamental attractiveness of markets like the United Kingdom, Chile, Singapore, and Spain compared the relative unattractiveness of markets like the United States, Switzerland, and Japan isn’t trivial.
We want to be in (long) the first set of markets—as we are—and not so much (short or underweight) the latter set. We are not “spending” risk capital where the compensation, according to our analysis, is not reliably there.
4. We have fixed-income exposure that is contrary to valuation signals.
Sovereign fixed-income exposures across the developed world are uniformly expensive from a purely fundamental perspective. But we have established and currently maintain an aggregate long exposure due to the second (Why) and third (How) stages of our investment process.
This has been helpful year-to-date given the strong rally of government bonds as yields have fallen amid central-bank-driven rate declines and persistent economic weakness. This aggregate exposure has, thus far, provided adequate diversification, and we believe it is important to maintain the exposure—at least over the near term—given our increased risk in the equity and currency portions of our portfolios.
Reasons for Optimism
So, it boils down in large part to us doing what we have been doing for more than 20 years—increasing risk to large, fundamental opportunities that we believe will be rewarded over the near and intermediate term and that have unrelentingly grown as 2020 has unfolded.
In those places where we are currently taking risk, our conviction is high.
This does not involve taking high aggressive risk across the board, but it does involve us stepping into opportunities that have had significant underperformance thus far this year. In some instances, the underperformance has continued after we initiated, or increased, our exposures.
It can be painful in the short term, but it is what fundamentally based investing is all about. And in those places where we are currently taking risk, our conviction is high.
As of today, we believe the relative and absolute decline of fundamentally attractive markets and currencies may be slowing down. The decline is erratic, of course, and it has not yet turned around on a sustained basis. But it seems to have slowed, and our conviction that value will once again begin to exert a stronger pull on prices has steadily increased.
Thomas Clarke, partner, is a portfolio manager on William Blair’s Dynamic Allocation Strategies team.