In portfolio management, risk is a key element; too much risk and you end up with volatility which will concern clients and with too little risk, you tend to underperform which equally upsets investors. So where is the happy medium? We believe it is where you take adequate positions and balance a portfolio to smooth the risks whilst adding to performance over and above a given target or benchmark.
This is where our investment process comes into play and our process has to cover a number of negative differing situations while enhancing the probabilities of outperformance. We utilise our Net Foreign Asset (NFA) proprietary scoring system as our first level of portfolio creation. Restricting our exposure to only the wealthiest countries of the world ensures that our holdings have the financial backing of a robust government balance sheet to alleviate the pitfalls when certain sectors of an economy falls into difficulty, and the credit agencies subsequently start to downgrade issuers. A perfect example of this has been the recent issues associated with commodity exporting countries and the latest moves by both Moody’s and Standard and Poor’s. When these agencies take action, the market quite often has already more than priced in the bad news than actually results. This is where ‘buy the rumour sell the fact’ comes into play and this strategy has helped us deliver excess returns but has also hurt investors who seem to deviate from their investment process or didn’t enjoy a robust process to start with.
We calculate that Russia, a 4-star rated country under our NFA scoring system, was put on negative watch by Moody’s on the 4th March this year due to the fall in the price of oil and of course the impact of the sanctions on the government balance sheet. Moody’s moved Russia down to sub-investment grade in January 2015 but have retained its Ba1 rating. Russian Railways, the government owned national railways system known as RZD is one of our firm favourites and we hold the sterling denominated 7.487% issue maturing 2031. With Moody’s action these bonds were also put on watch and traded at a price of 97.74 on the 4th of March - today they are bid at 99.50, a yield of 7.54% and a spread off of gilts of around 564 bps. The action by Moody’s actually caused a rally in most Russian names as underweight investors scrambled for exposure. Our RZD holding is now priced higher than when Russian names were downgraded to non-investment grade, and all this time we have taken in the very attractive yield.
Another prime example is Saudi Electric Company (SECO), the wholly owned and dominant government utility supplying electricity to the Kingdom. We hold the US dollar denominated SECO 5.06% issue maturing 2043. On 22nd of February this year Standard and Poor’s dropped the sovereign and of course SECO’s rating by two notches from A+ to A-. Around that time this bond was priced at a price of 86.00, today it is priced at 90.50, higher that it traded at the turn of the year and yields 5.76%, 316 bps off of US Treasuries, 212 bps over “fair value” according to our Relative Value Model.
There are many examples where the market has priced in much more downside than is practical especially during the last year or so with commodities falling hard, but the fact is if you invest with a strong financial backdrop to your process many opportunities do present themselves as other investors take flight based on unfounded judgements and flimsy investment processes which add risk and lose returns.