Balance is central to investment management; it is the opposite of putting all of your investment eggs in one basket. Building a portfolio that is balanced – whether that is across different asset classes or within an asset class – is key for solid, consistent returns.
For example, consider the equity portfolio manager who owns an airline stock. The thesis behind owning this position is likely to include, at least in part, the belief the company can grow versus its peers, or that it can cut its costs and so improve its profit margins, or that the market is structurally undervaluing it. For most portfolio managers, though, the central thesis is unlikely to be that the oil price is likely to fall which, all other things being equal, should result in an increase in profitability since the cost of fuel is such a major part of the cost base for an airline. Moreover, if a portfolio manager did want primarily to play a falling oil price, there would be far better (and more direct) ways to access this in a portfolio. But the problem for the equity portfolio manager is that in buying an airline, it is entirely possible that the single biggest factor that will dominate performance in a given period will be a move in the oil price – something out of their control (and probably beyond their predictive abilities) and yet whose (binary) outcome may have a major impact on the success of their investment. How can a portfolio manager solve this? Well, in a simple world, they could either select an airline that effectively immunised short-term oil price moves through hedging – but this would reduce the opportunity set and so not be a sensible solution – or, alternatively, they could ‘pair’ this position with one that – again held for sound investment reasons – had the opposite economic/exogenous sensitivity.
Many fund managers therefore might own both an airline stock and a major oil stock. When sized appropriately (and by no means should this be considered a one-to-one ratio), the gain to one stock of a rising oil price will be offset by the losses from the other. What is then left is stock-selection alpha – excluding this exogenous and uncontrollable factor – that detailed, fundamental analysis combined with some skill should be able to deliver. What is removed is basically risk – and so the efficiency of the portfolio rises. And, even better, if the fund manager does want to express a macroeconomic view, he or she can do so by ‘tilting’ towards either side of the binary bet, without this ever dominating the risk in the portfolio. While my suspicion is that too many portfolio managers do not think like this – or are comfortable taking major macroeconomic risks however binary their outcomes – there are some who implicitly or explicitly take this approach, to the benefit of their performance and their risk-adjusted returns.
But this is all really preamble – if half of an article in itself – on the joys of finding a stock that does all of this for you. Pairing stock ideas with different macroeconomic sensitivities is hard and while finding ones that do much of this work for you might not be simple, they do exist. I was reminded of this recently by Whitbread’s latest set of results. On one side of the business is a coffee chain, Costa, which benefits from increased consumer spending/consumer incomes (since buying coffee out is essentially a luxury) but also benefits from poor weather (as more coffee is consumed when it is cold and wet). On the other side, the company owns Premier Inn which, however much Lenny Henry might try to convince us otherwise in his TV ads, is a budget option that people trade down to in tougher economic conditions. But, even more importantly, all other things being equal, Premier Inn should see higher demand – at least in some locations – when the weather is good. In other words, Whitbread does the diversification of exogenous factor impacts for you. Whether the weather is good or bad, or whether the economic situation is improving or deteriorating, part of the business should be seeing tailwinds and part of it should be seeing headwinds.
I am not sure there are enough stocks in the world with this sort of in-built balance to construct a portfolio, but those that do exist are, at the right price, attractive investments. As Euripides said, “The best and safest thing is to keep a balance in your life.” Perhaps today he would have applied the same thinking to his investments.
James Bateman is head of multi-manager and multi-asset portfolio management for Fidelity Worldwide Investment
