Getting our ducklings in a row

As investors, we can never know exactly what the future holds. Instead, we can only make a realistic assessment of risk and reward. At the moment, many of the risks facing investors top the daily news agenda. Faced with trade wars and Brexit uncertainty, there is a growing consensus that global growth is slowing. Meanwhile, the US Treasury yield curve has recently inverted – an ominous, though not infallible, signal of looming recession. Companies, industries and economies all move in cycles. Our contrarian approach seeks to anticipate changing conditions.

Confidence boost

Despite signs of fading economic growth, stockmarkets have marched higher this year, notwithstanding a few summer wobbles. In fact, at the time of writing, global equity indices sit close to their all-time highs. The main reason for this being the dovish turn taken by central banks in response to faltering economic data. In July, the US Federal Reserve cut interest rates for the first time in almost 11 years. Other central banks are poised to unleash fresh stimulus.

Such monetary easing seeks to boost the economy by providing cheaper loans to businesses and putting more money in the hands of consumers. But it also gives markets an artificial boost – because it makes speculative investments more attractive and because it makes depositing money in the bank less rewarding.

Central bankers can’t stop the turn of the economic wheel forever, though, we’re firm believers that all economies and industries move in cycles.  It’s difficult to predict exactly when any setback might happen but we believe that it’s important not to be caught off guard when it does.

Out of kilter

We’re much less alarmed by the economic outlook than by the way in which the market’s risk and reward calculations appear so wildly out of kilter. The dislocation between investors’ appetite for risk and the economic facts can only stretch so far before the elastic snaps back.

As we see it, many investors have become increasingly blasé about risk. The market’s enthusiasm for unprofitable technology companies is a case in point. History shows that new and alluring investments are often met with initial excitement. But even successful technologies can ultimately become poor investments as shares reach levels that cannot be justified by the underlying profitability. Such bubbles can deflate under the weight of changing economic conditions.

An active approach to risk

Passive investors have no choice but to go along for the ride – buying more of what has already become inflated and less of what has fallen out of favour. Active managers, like The Scottish, can take a different course of action.

One way we do this is by avoiding stocks that look overpriced and investing instead in ‘ugly ducklings’– unloved companies with potential to recover. Their share prices already factor in a lot of bad news. We like getting our ducklings in a row in this way because having valuation on your side can be an advantage when conditions take a turn for the worse. It also means that they are much better placed to surprise the market positively.

Plucky ducklings

At the same time, we’ve been finding opportunities in companies that offer products and services for which demand is relatively stable throughout the economic cycle. They include gold and telecoms stocks.

We’ve seen undervalued opportunities in gold miners for some time. But the latest twist in President Trump’s trade war has brought this opportunity into even sharper focus. The president’s accusation of currency manipulation by China has prompted fears of competitive devaluations. Gold’s ability to act as a reliable store of value shines through here. Governments can’t manipulate the gold price, and nor can they create the precious metal in unlimited quantities – unlike fiat money. So, as the value of money falls, gold benefits. The prices of gold stocks have perked up in response to this new environment.

We have recently added a number of telecoms stocks to our portfolio. With the internet now an integral part of our lives, it is a service that we would struggle to give up, even in leaner times. With new 5G and fibre services emerging, we see signs that the regulatory cycle is moving in favour of these companies – incentivising operators to invest through the prospect of better returns. Meanwhile, the robust finances and compelling valuations that can be found offer considerable attractions – as do their solid dividends.

A sustainable dividend income can cushion the blow of a bear market, providing a steady source of returns. In turn, we aim to reward our investors with a robust dividend through thick and thin.

Favourable balance

Risk always goes hand in hand with returns. It can be easy to be seduced by the prospect of exciting returns but without paying sufficient attention to the associated risks. Striking a favourable balance is at the heart of our contrarian ethos. By selecting investments that have already priced in bad news and by avoiding those priced for perfection, we aim to keep portfolio risks to a minimum while seeking opportunities that look ripe for improvement.

Please remember that past performance may not be repeated and is not a guide for future performance. The value of shares and the income from them can go down as well as up as a result of market and currency fluctuations. You may not get back the amount you invest.

The Scottish Investment Trust PLC has a long-term policy of borrowing money to invest in equities in the expectation that this will improve returns for shareholders. However, should markets fall these borrowings would magnify any losses on these investments. This may mean you get back nothing at all.