When Small is Beautiful
Chris Brown, CIO.
As a smaller, partner-owned firm, we think we have a couple of key advantages over the bigger boys (and girls) which we particularly value today. First, we are able to own a wider variety of assets as we are not size constrained when evaluating investments. Second, if and when the investment climate does change and we have to switch our portfolios around we think we can do so quicker and with less pain than the larger firms. This blog post sets out why.
One major challenge for investors today is that many asset markets – including most obviously equities – are at or near all-time highs. Today’s low yields also mean that government bonds will struggle to beat inflation over the next few years. This means that future investment returns look harder to come by than they have been in the past. A second challenge is that the investment community as a whole has done a pretty poor job recently of forecasting the future. Brexit and Trump were both surprises. Pretty much everyone thought longer term interest rates would rise throughout 2017. In fact, on average, they have fallen. And this is not unique to this year.
The chart below shows professional forecaster projections for the US 10 year interest rate versus the actual rate each year since 2003. Pretty much every year they have been wrong – and this is only really a 12 month forecast! Similarly, each month recently one expert or another has tolled the death knell for equities. In fact, markets have continued to march higher as the news from the broader economy has remained generally positive.
If our job as investors is getting harder, then forgive us if we comfort ourselves with a couple of advantages we think smaller asset managers such as ourselves have over our larger rivals. The first point starts with the observation above that forecasting is hard. Economies get locked into virtuous circles (as we are seeing today) that drive economic growth, earnings growth and so equity prices. These virtuous circles can, however, quickly flip into vicious ones. The turning points can be hard to spot in real time and, once they get going, central banks have been pretty powerless to do much about them. Market timing remains a hard way to make money in equities.
If you can’t predict the future, however, you can react to it quickly when changes start to happen. And this is where size helps. First, it is easier to move smaller sums around as and when market conditions change. Second, smaller firms often have quicker, more flexible and less bureaucratic decision making processes. For the last eight years we have been in a world of falling interest rates slowly driving asset prices higher. If and when that trend reverses it is likely that tomorrow’s optimal portfolio will look very different from todays. Better to be with a firm that is at least in theory able to exploit these new opportunities.
The second advantage we think we have comes from the observation that equity returns – after a great run in the last few years – are likely to be lower in the future than they have been in the recent past. We are pencilling in maybe 5% to 6% p.a. returns over the medium term for many developed markets. This means if we can find investments that yield around these levels and which from a bottom up perspective are independent of the broader business cycle then they look very attractive risk-adjusted to us. As an example, infrastructure assets – including solar power, wind farms and government backed PPI projects – meet this criteria. A 6% or so total return looks very achievable and much of the revenue is inflation protected and/or government guaranteed. The key point is that as the economy turns down there is no reason to think the bottom up fundamental investment returns from these assets will react much. Returns are at heart linked to the underlying asset performance or operator performance under very specific infrastructure contracts. This makes them great diversifying assets.
The catch is that these sorts of investments are fundamentally illiquid. This leaves investors with two options: tie up clients’ cash in illiquid private equity style vehicles with 5 to 10 year lock-ins or invest in equities (typically listed trusts) backed by the assets. We prefer the equity route so as to preserve our clients’ liquidity. And it is here that size helps. A 2% position for a £10bn asset manager means a £200m investment. At this investment size, listed trusts remain inaccessible and private equity is the only way to go. Even if you could get your £200m in, getting it out at any reasonable speed would be nigh on impossible and starting down this road would be an irresponsible mistake. The good news for us is that at our position size we can still build meaningful positions in these investments while still having access to some decent liquidity if we change our minds on the asset class. Sometimes, small can be beautiful.