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11 April 2012

What an investor should always ask themself 

There is one question that I always ask myself above all others – what if I’m wrong?

Even the most logical reasoning can prove incorrect, or can be undermined by unexpected risks. An important lesson for investors is that sometimes they will simply be just plain wrong.

Some years ago I rented a house in Tauranga at the bottom of a hill. My landlord lived behind me in his own home and also owned the house in front of me. These three adjacent properties represented the vast bulk of his wealth. He was convinced that residential property in Tauranga was a sure thing.

In 2005 the region suffered heavy rain and flooding. Part of the hill slipped onto these houses below, and all three became uninhabitable. The rental income stopped, the timing of rebuilding became questionable as did the valuations of the properties.

If he had questioned his rock-solid investment thesis more, he may have diversified into a different street or suburb. Some Christchurch landlords might suggest this is still a risky strategy, and that focusing on just one city is too concentrated. Better still, he might have owned less houses and more businesses, shares or fixed interest.

It’s great to have strong conviction in your investment decisions. But, when this confidence becomes an unwavering belief that what you’re doing is a no-brainer, it can become your downfall.

For every investment decision we make, we should always ask ourselves what happens if we’re wrong? How much of an impact will it have? Have I mitigated this risk in any way?

For example, I’m fairly certain that interest rates are going to go up from here. The OCR is the lowest it’s ever been, and six-month term deposits are only paying about 4.2 per cent, close to their lowest point in 25 years. While interest rates might languish at these levels for a bit longer, I’m confident that in a year’s time they will be higher than they are now.

Because of this expectation, I would be keeping more of my fixed interest portfolio in short-term deposits, rather than locking it up for three, five or seven years at interest rates that look good today, but won’t be quite as attractive in 2013 when market interest rates have increased. I would also want to keep some of those funds on hand to be able to take advantage of those higher interest rates when they start to creep up.

But what if I’m wrong? My logic is based on a gradual recovery in the economy that leads the Reserve Bank to increase the OCR. That could take longer than I expect, so I should hedge my bets by stilling own a range of longer-term securities from good quality issuers, even though the interest rates might look uninspiring.

I also think shares have a good period ahead of them over the next few years, despite all of the risks out there. Most companies have low debt levels, dividend yields are very attractive and shares look good value against historic averages. As the world recovers from its current problems, confidence will return and investors will move out of low-risk assets such as cash, gold and government bonds and back into good quality shares that can grow their earnings.

But again, I could be wrong. Spain or Portugal could become the next Greece and we could see a relapse of the issues we saw last year. So I wouldn’t bet the whole farm on shares, only a part of it, and I would keep a good cornerstone of low-risk fixed income assets.

I would also stick to those companies that will benefit from an economic recovery but will also be able to withstand another downturn. I would focus on the ones that are paying growing dividends, because if we see markets face another rough patch at least I will be collecting some income while I wait for a recovery.

I also ask myself the same questions when it comes to stock-picking within a share portfolio. A share like Apple is a good example. It’s a brilliant company with a huge future ahead of it and I still believe it to be good value, even at US$600 a share.

But Apple has risen 53 per cent in the last year, while the rest of the US market is up only 5 per cent. Apple will have become a much bigger proportion of my portfolio than it would have been this time last year, so if I’m wrong about its growth prospects it will have a bigger negative impact than it would have before. At some point I should probably consider selling a few Apple shares and re-investing the proceeds into other companies to the portfolio’s weightings back in check.

I have a strong view that inflation will re-emerge as a problem over the next few years. Even though it’s barely 2 per cent in New Zealand today, I don’t expect it to stay this way. My costs of living seem to be going up by more than that, so I don’t completely believe the official inflation data anyway.

Because of this I would be happy to own assets that deliver an earnings stream that can grow every year and keep pace with inflation, such as some property and a portfolio of shares. Inflation in New Zealand has averaged 2.7 per cent over the last decade, while NZ shares have returned 6.3 per cent per annum. In Australia inflation has averaged 2.9 per cent over the last decade, while Australian shares have returned 7.1 per cent per annum, so shares do work well as inflation protection.

But many would disagree with me about the risks of inflation. Many people believe it is more likely that we face deflation, which is when prices fall for an extended period of time. Under this scenario, real assets like property fall in value and the spending power of money actually grows over time.

I don't think this will happen, mainly because I think central banks around the world will print money if deflation becomes a real threat. But just in case, that longer-term fixed interest will provide a locked-in income stream (which can buy more each year as prices decline). I would also have this partially covered from my shares that pay good dividend yields.

I also believe that the strong NZ dollar is here to stay, at least relative to historic averages. We have a fundamentally stronger economy and better prospects than the UK, Europe or the United States at the moment. Our interest rates are higher, Government debt is lower, we have stronger export partners and we produce agricultural products for which demand continues to grow.

But I could be wrong about this and if I am, it would probably have a much bigger impact than anything else I have mentioned so far. We are a tiny country sitting on a major fault line and we are very reliant on our agricultural industry for our economic well-being.

A significant natural disaster or some form of virus that threatens our farming sector would devastate our economy from all angles. House prices, share prices and even the ability of some corporates to meet interest payments on their fixed interest could all be affected.

If this happened all of my New Zealand assets would fall in value, some quite heavily. Our currency would also collapse from its current US$0.82 level to somewhere that is probably closer to the US$0.50 it reached in 2009.

So I’m happy to hold some shares in some large, well-known, multinational US companies without any currency hedging in place, even though I expect the NZ dollar to remain high. If I’m right, I’ll be wealthier overall in a global sense, even if gains in my global shares might be offset by a strong NZ dollar. And if I’m wrong, I’ve got an insurance policy of sorts.

 

Mark Lister is Head of Private Wealth Research at Craigs Investment Partners. His disclosure statement is available free of charge under his profile on www.craigsip.com. This column is general in nature and should not be regarded as specific investment advice.

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