This article covers some investing tips based on adjustments I’ve made to my defensive value investment strategy in response to the coronavirus pandemic.
So far this pandemic-driven downturn is nothing like a normal recession.
With high-quality companies suspending their dividends left, right and centre, the economic consequences of coronavirus are much more sector specific and much more devastating than we would normally see.
As a result, I’m sure that many investors have had to re-think their approach to buying and selling stocks as they attempt to minimise risks and maximise returns from their portfolios.
I’m no different. Over the last couple of months, I’ve made a few minor adjustments to my “defensive value” investment process which, I hope, will steer my portfolio through the storm and leave it well positioned on the other side.
These adjustments are based on sensible principles and I think they’ll apply to a wide range of investors.
Tip 1: Don’t sell at depressed prices
Until recently, my approach to buying and selling shares went something like this:
- January: Use my stock screen and investment checklist to look for a “special” company which is likely to be highly profitable and produce relatively consistent growth for at least the next ten years. If I find one where the share price and dividend yield are attractive, invest about 1/30th of the portfolio into that company.
- February: Look at the portfolio’s holdings (typically about 30 companies) and find the one with the least attractive combination of “specialness”, valuation and dividend yield. Sell that holding.
- March: Repeat the buying process from January, reinvesting the proceeds from last month’s sale.
- April: Repeat the selling process from February.
- Alternate between buying and selling each month until the end of time
I’ve followed this monthly buy/sell process since 2011, with virtually no deviation from its soothingly monotonous rhythm.
But now all that has changed, and thanks to the coronavirus pandemic I haven’t sold anything for months.
The last holding I sold was Aggreko, way back in January. You’ll have to read the article for the full details, but basically I sold it because its fortunes are heavily reliant on the highly cyclical oil and gas industry, which I’m no longer comfortable investing in.
In February, just before the market collapsed, I added another company to the portfolio as per my usual buy/sell schedule.
March should have been another sell month, but after looking through my portfolio I decided not to sell anything.
There are a couple of reasons why, both of which are tied in with my preference for selling holdings which are either a) high on valuation multiples or b) low on specialness.
Let’s start with highly rated stocks. Like many investors, my portfolio is basically devoid of stocks trading on high valuation multiples. This is not exactly a surprise as we’re in the middle (or more likely towards the end of the beginning) of a global pandemic and are potentially facing the most severe UK and global recessions we’ll ever see.
So from a valuation point of view, there’s nothing I want to sell.
As for holdings which lack specialness, I do have a few candidates.
Long-time readers will know I’ve had problems with Ted Baker and a disaster with Xaar in the last year, and both of those companies lack the special qualities I’m looking for. I thought they were special when I bought them, but they weren’t. The relevant lessons have already been learned and integrated into my investment spreadsheet and checklist.
Both of those companies are at the top of my sell list, so why haven’t I just manned up and sold them?
There are a couple of reasons (which I hope are more than just excuses to avoid locking in unpleasant capital losses).
First, their share prices are both down about 90% from where I bought them, and together they now make up barely 1% of my portfolio. With such a tiny allocation to each company, I don’t think it will make much difference whether I sell them now or in a few years’ time.
Second, given their disastrous results, I want to learn as much from the experience as possible. So rather than selling up and running away, I’d rather hold onto them because they could throw up some important lessons as management struggle to turn each business around. I won’t learn those lessons unless I have skin in the game, and that’s the main reason I’m holding on.
This “hold onto your disasters” strategy is somewhat like the story of Warren Buffett and Berkshire Hathaway (yes, I’m comparing myself to Warren Buffett), where Buffett kept the original Berkshire name for his expanding conglomerate as a reminder that buying Berkshire was perhaps the biggest investment mistake of Buffett’s life.
In summary then, I’m not selling anything at the moment either because a) most of my holdings are trading at depressed prices or b) I want to learn from disasters by watching their turnarounds succeed or fail.
So what am I doing if I’m not selling anything? I’m glad you asked.
Tip 2: Diversify more
For the last three months I’ve bought a new holding every month and this may continue for some time.
The main reason for this buying spree (if you can call one purchase per month a buying spree) is that I want to make the portfolio more diverse.
It was already quite diverse, with around 30 holdings operating in a wide range of industries and geographies, and with no single investment making up more than 6% of the total. But these are extraordinary times, and even the best companies in the wrong sectors (e.g. travel and retail) are suspending dividends and announcing rights issues.
So to err on the side of caution I’ve decided to add a few more holdings, partly to add some (hopefully) lower risk companies to the portfolio, but mostly to reduce the impact of any one company going bust (a not inconceivable event in the current environment).
Buffett says “diversification is a protection against ignorance” and I accept that entirely. I don’t have a crystal ball and I don’t have Buffett’s photographic memory or stratospheric IQ, so protecting the portfolio from my ignorance of how this pandemic will pan out seems like a good idea.
By default my portfolio has 30 holdings and after the latest purchase it’s up to 33. By investment fund standards that’s still concentrated, so I’m confident that I’m not over diversified just yet.
I could just keep adding one more holding each month forever, but that seems a tad excessive. More realistically, I think something like 40 holdings is as high as I would want to go.
If I keep buying one company every month then I’ll hit that upper limit near the end of 2020, so if the pandemic is still a major problem at Christmas then I may have to eject Ted Baker and Xaar to make room for some higher quality companies.
Okay, I’m buying rather than selling. But what am I buying?
Tip 3) Buy defensive companies
The basic gist of my defensive value investment strategy hasn’t changed.
I’m still trying to buy “special” companies at attractive valuations and with decent dividend yields, but as an added layer of protection in these highly uncertain and unprecedented times, I’m specifically focusing on buying defensive companies.
Traditionally defensive companies sell things that people need come hell or high water. Think toilet paper, cigarettes, car insurance, soap, food, electricity, internet access (more essential than food for some people) and so on.
When you’re facing a global pandemic where “non-essential” retail stores are forced to close and people are told not to travel, one thing you can be sure of is that people will still need to eat, drink and use the internet.
Unfortunately the idea of investing in defensive companies during a pandemic is pretty obvious, so most of the high quality (or at least fair quality) defensive companies that spring to mind (e.g. Diageo, AG Barr, Greggs, Reckitt Benckiser, Unilever) are a long way from being obviously cheap (which is not the same as saying they’re obviously expensive).
That’s a shame, but it’s the reality of investing in a very efficient market where obvious strengths and weaknesses are priced into stocks almost instantaneously.
Even so, I have added one traditionally defensive company to the portfolio in recent months and I’m actively looking to invest in others, as long as the price is right.
If you’re having trouble finding traditionally defensive stocks at attractive prices, one alternative is to invest in cyclical companies which are exposed to a significant part of the global economy.
Tip 4) Buy cyclical companies with industrial and geographic diversity
Take a look at these three example companies:
- A clothing retailer with one store in Basildon
- A clothing retailer with 500 stores around the world
- The global leader in highly regulated protective clothing which is mandatory for workers operating in a wide range of industries
The first company is geographically and industrially concentrated. Anything negatively impacting the economy in Basildon will likely have an impact on the company.
The second company is geographically diverse, but industrially concentrated as it only sells regular clothing. This company might be largely immune to a downturn in the UK, but a global downturn could still see many customers saving their pennies rather than spending them on fashion items.
The third company is both geographically and industrially diverse. It sells items which must be worn under certain conditions, and it sells them to customers operating in a wide range of geographies and industries.
For external events to have a serious impact on the the third business they’d have to severely impact many industries across a large part of the globe.
The current pandemic will obviously have exactly that sort of impact, but unlike the fashion retailers, the protective clothing manufacturer’s revenues won’t go anywhere near zero as long as we have a functioning global economy which needs people wearing protective kit to keep the wheels of industry turning.
A company selling highly regulated protective clothing to many industries in many countries is just one example. There are all sorts of businesses with industrially diverse global exposure and I think they should (hopefully) provide some degree of defensiveness against the worst effects of the pandemic, without being traditionally defensive businesses.
Having said that, do not be surprised if they suspend their dividends as a precautionary measure, and dividend suspensions alone are by no means a negative sign in the current crisis.
Of the four companies I’ve bought in recent months, three have fit this mold. They have traditionally cyclical business models, but they’re somewhat more defensive thanks to their industrially and geographically diverse products, services and customers.
Tip 5: Keep calm and carry on investing
My final tip is just a general point about not panicking and not running for the exit when markets get ugly.
Stock market history clearly shows that selling at the moment of peak fear is always a bad idea. In this latest crisis, selling at the bottom would have netted you a loss of about 36% for the FTSE All-Share.
If you managed to avoid selling then the few short weeks will have netted you a gain of about 20% from that low point, if your returns are anything like the FTSE All-Share’s.
My biggest gainer is up more than 200% since the market low, so clearly selling at that point would have been a very bad idea.
Tips for sensible investing
So there we have it. A handful of tips which may be useful for steering a portfolio through a global pandemic, while positioning it for the inevitable recovery a year or three from now.
If you’ve made any adjustments to your own investment process in recent months, feel free to mention them in the comments below.