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Constructing a portfolio in uncertain times

We are certainly living in interesting times. The last few years have seen unprecedented disruptions to the global economy, from the impact of COVID to the war in Ukraine to the seeming increase in extreme weather events and natural disasters. Further, many long-established macro trends such as falling interest rates, low inflation and increasing globablisation have now reversed. While there have always been periodic crises such as the dot.com bust and the GFC, the current situation seems a far cry from the general backdrop of peace and prosperity that has dominated the world since the end of the Cold War.

So how do we invest in this environment of heightened uncertainty, where Black Swans seem to be coming in flocks? In our view, such high levels of uncertainty create both risk and opportunity. When constructing a portfolio against this backdrop, we try to achieve a balance between stocks which have upside potential regardless of the prevailing conditions and stocks which will prove defensive should things take a turn for the worse. With this in mind, the following are some of the key themes that we are reflecting in the portfolio.

Growing while the economy is slowing – Looking at the economic backdrop, clouds are clearly gathering, as rising interest rates slows growth and high inflation pressures both consumers’ discretionary spending and companies’ profit margins. In this environment, we are seeking companies which can deliver growth despite these headwinds. One group of such companies are those whose earnings are yet to fully recover from the disruptions associated with COVID. A prime example of this is Qantas, which is experiencing extremely positive conditions, as strong demand meets constrained global airline capacity. This is likely to continue due to pent-up demand, even as spending in other sectors of the economy begins to slow.

Geopolitical beneficiaries – Rising geopolitical tensions are another feature of the current environment. This has led to an increased focus on the resilience of supply chains for critical products. One way to benefit from this in a portfolio is to look for companies which can meet the desire to source products from suppliers who are “strategically aligned”. Good examples are critical minerals such as rare earths. Currently, the bulk of rare earths are supplied by China and alternative sources of supply are in strong demand. Australian-based, Iluka Resources is in prime position to meet this demand.

Leverage to rising rates – While rising interest rates put a dampener on most sectors of the market, some sectors benefit from higher rates. The Financials sector is the best example of this, with banks experiencing expanding interest margins as the cash rate rises, and insurers earn higher returns on their investment portfolios.

Genuine defensives – Rising rates also pressure the valuations of expensive stocks. Therefore, when looking at the defensive part of the portfolio, it’s important to avoid expensive stocks which could de-rate significantly, should rates continue to rise. We opt for stocks which have both defensive earnings characteristics and are trading on reasonable valuations. For us, Telstra fits the bill, with the NBN impacts behind it and a positive outlook for the mobiles business.

Uncorrelated stocks – It’s nice to have stocks in the portfolio which march to a different beat and are not directly influenced by GDP growth, interest rates and inflation etc. The agricultural sector is a prime example of this, with earnings more closely driven by seasonal rather than macro factors. This has been a fertile ground for investors, with companies such as Graincorp benefiting from several years of very positive conditions.

Oversold opportunities – Finally, high uncertainty often leads to indiscriminate selling, and this is where the greatest opportunities are often created. One area where this has been the case in the smaller end of the market, which tends to bear the brunt of selling when the market moves into risk-off mode. Over time, we’ve often found some of the best opportunities in the smaller cap names as these generally offer more growth than larger stocks. The recent sell-off has seen many of these names trading on very depressed valuations and presenting very significant upside over time.

In summary, while risks are elevated and a high degree of caution is warranted, there are ways to construct a portfolio to benefit from the current environment and be well-positioned for the eventual recovery.

By Stephen Bruce, Portfolio Manager, Perennial Value


Disclaimer: Please note that these are the views of the writer at the time of publication and not necessarily the views of Perennial. This article does not take into account your investment objectives, particular needs or financial situation. The information herein shall not in any way constitute advice or an invitation to invest. It is solely for information purposes and subject to change without notice. This information does not purport to be a comprehensive statement or description of any markets or securities referred to within. Any references to individual securities do not constitute a securities recommendation. Past performance is not indicative of future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.