Liontrust Insights: Why innovation is important to income investors

Storm Uru, fund manager at Liontrust, shares his views in a short article below.

 

In 2011, Marc Andreesen famously penned “Why Software Is Eating the World” in the Wall Street Journal. Today, the idea that “every company needs to become a software company” is almost considered a cliché.

No matter your industry, you’re expected to be re-imagining your business model to make sure you’re not the next local taxi company or hotel chain caught completely off guard by your equivalent of Uber or Airbnb.

The playbook used to be simple – size and market power mattered – and the strategy was to create value by controlling the value chain and re-deploying capital to grow your competitive position. From retail to manufacturing, this concept is now broken, and more companies than ever are required to pivot and innovate in a digital world to keep pace with a new generation of software companies.

Business model innovation is not a new concept (just ask Clayton Christensen). It has occurred frequently, reshaping entire industries and redistributing billions of dollars of value. Retail discounters such as Wal-Mart and Target entered the market with pioneering business models and quickly grabbed powerful market positions in the retail sector only to bow to a new dominant player, Amazon.

Even with a backdrop of business model innovation, one theme has remained consistent, spanning across sectors from retail to manufacturing to healthcare: the benefits of economies of scale. It is often used by companies in strong competitive positions to capture the economic profit in a value chain and exploited by linear growth. Importantly, these companies tend to use size and market power to exploit suppliers, essentially meaning the firm with the biggest cheque book and strongest market position won.

During this time, industry dynamics tended to change at a rate that incumbents could respond to − but not anymore. Enter a new cohort of a well-funded, highly motivated group of software focused entrepreneurs intent on disrupting every industry, armed with new business models that tend to have a near-zero marginal cost of manufacturing and therefore near-zero marginal cost of distribution.

The velocity and breadth of innovation has caught many incumbents by surprise and has resulted in many lowering expectations for future growth. For evidence, you only need to look at a company’s proxy statements to see how management’s incentivised growth targets have collapsed over the last decade. In response, management teams are now aggressively reallocating capital to digital transformation, and, in some cases, missing the structural change by continuing to pursue old strategies from tried and tested playbooks.

One of the key themes starting to emerge is that digital transformation just isn’t that easy. In fact, McKinsey recently published a report highlighting that most companies fail to achieve a return on investment in digital transformation initiatives greater than the cost of capital.

Some compelling research conducted by the OECD adds some weight to these findings by showing that digital transformation is leading to a confounding outcome. Those with leading digital capabilities are simply extending their lead while laggards show no sign of convergence, historically a key characteristic in key technological shifts, such as lean manufacturing.

This “productivity paradox” is creating a backdrop where it’s becoming increasingly risky to rely on reversion to the mean or investing in strategies that have historically withheld the test of time. This is why it is important to invest in Global Leaders who do not just rely on size and market power, but also have a culture of innovation and are able to extend their market leadership position and increase dividends long into the future.


Liontrust Key risks and Disclaimers

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Global Fixed Income team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The value of fixed income securities will fall if the issuer is unable to repay its debt or has its credit rating reduced. Generally, the higher the perceived credit risk of the issuer, the higher the rate of interest. Bond markets may be subject to reduced liquidity. The Funds may invest in emerging markets/soft currencies and in financial derivative instruments, both of which may have the effect of increasing volatility.

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Issued by Liontrust Fund Partners LLP (2 Savoy Court, London WC2R 0EZ), authorised and regulated in the UK by the Financial Conduct Authority (FRN 518165) to undertake regulated investment business. This document should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Examples of stocks are provided for general information only to demonstrate our investment philosophy. It contains information and analysis that is believed to be accurate at the time of publication, but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Liontrust as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. It should not be copied, faxed, reproduced, divulged or distributed, in whole or in part, without the express written consent of Liontrust. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.  


MeDirect Disclaimers:

This information has been accurately reproduced, as received from Liontrust Fund Partners LLP. No information has been omitted which would render the reproduced information inaccurate or misleading. This information is being distributed by MeDirect Bank (Malta) plc to its customers. The information contained in this document is for general information purposes only and is not intended to provide legal or other professional advice nor does it commit MeDirect Bank (Malta) plc to any obligation whatsoever. The information available in this document is not intended to be a suggestion, recommendation or solicitation to buy, hold or sell, any securities and is not guaranteed as to accuracy or completeness.

The financial instruments discussed in the document may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed herein.

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Morningstar Views: How to Stay Disciplined (and Why It’s Important Now)

By Alex Bryan, CFA, director of passive strategies for North America at Morningstar.

 

A look at how the coronavirus has affected the market and what to do about it, if anything.

These are scary times. Even though the market has partially recovered from the sharp sell-off in late February and March 2020, there is still considerable uncertainty about the economic fallout from the novel coronavirus. It’s unclear how long the pandemic and social distancing measures will last, how much unemployment will rise, or how much it will hurt business. That uncertainty is a big part of why the market has sold off and why it’s especially risky to double down on stocks now.

The risks are real, but it’s important to keep calm and stay focused on the long term. Making big changes to a portfolio out of fear often does more harm than good. For most, the best course of action is to stick to your long-term investment plan.

But sticking to a long-term plan isn’t the same as doing nothing. This is a good timeto revisit high-fee and tax-inefficient mutual funds that you held on to because of unrealized capital gains. That’s probably less of an issue now, and harvesting losses in other parts of the portfolio can help offset capital gains. It may also be necessary to rebalance into beaten-down assets, like stocks, to bring your portfolio in line with its target allocation. That said, it probably isn’t prudent to overweight stocks until things have calmed down a bit.

Don’t Buy the Dip

While many fight the urge to sell, the more intrepid among us may be tempted to load up on stocks after a large market pullback and trim back as the market runs up. This seems consistent with the most fundamental of all investment principles: Buy low and sell high.

It turns out that buying the dips isn’t an effective strategy over the long term. To test this, I devised a “buy-the-dip” strategy that starts with a 60/40 allocation to U.S. stocks and Treasury bills. For every 10% decline in the value of the U.S. market from the most recent high, the portfolio would increase its allocation to stocks by 10 percentage points. For every 10% increase from the most recent low, it would trim its allocation to stocks by 10 percentage points, though it wouldn’t take the stock allocation below 60%. Exhibits 1 and 2 show how this strategy performed. Exhibit 3 shows its asset allocation over time.

06.05.2020 Article Image 1

06.05.2020 Article Image 2

06.05.2020 Article Image 3

This strategy posted slightly higher returns than a passive 60/40 stock/bond portfolio rebalanced to its target allocation annually, as Exhibit 3 shows. However, that’s not a fair comparison because the buy-the-dip strategy had a higher average stock allocation (66%) over its life. Its return was almost identical to what investors would have earned if they started with a 66/34 stock/bond allocation and rebalanced annually. That said, buying the dip was riskier than the 66/34 target allocation. It exhibited slightly higher volatility and a larger maximum drawdown.

This elevated risk isn’t surprising. Volatility tends to increase during market downturns. Market declines are also usually indicative of deteriorating business conditions. Increasing stock allocations during these times increases exposure to these risks.

The real question is why this strategy didn’t earn greater compensation for assuming more risk than the static allocation. As risk rises during bad times, valuations tend to fall. All else equal, that should lead to higher returns. However, valuations alone don’t tell the full story. There is an opposing force at work that this strategy bets against: momentum.

In the short term, performance tends to persist. Recent market losses are often followed by more losses, while recent gains often portend more to come. These trends may emerge because investors can be slow to react to new information, causing prices to adjust more slowly than they should. Bad news often clusters, and investors may not fully appreciate the potential impact of each piece of information. For example, weak consumer confidence tends to lead to weak spending and corporate profits, which can lead to higher unemployment, an increase in bankruptcies, and tighter lending, perpetuating the cycle. This process can also work in reverse.

Additionally, investors’ comfort with risk is procyclical, creating a knock-on effect that further contributes to performance trends. Investors are willing to accept higher valuations when risk seems low, but when risk picks up, lower valuations are usually required to find a willing buyer.

The buy-the-dip strategy has intuitive appeal, but it doesn’t work well because it is an anti-momentum strategy. It doubles down on stocks while conditions are deteriorating and trims them while things are improving. While it doesn’t appear to hurt performance much either (when done in moderation), it’s probably better to stick to a long-term strategic asset allocation that aligns with your risk tolerance. Buying the dips probably won’t help boost returns. But using momentum to your advantage with trend-following could help reduce risk.

Trend-Following

Trend-following is a market-timing strategy that, in many ways, flips buy-the-dip on its head. It owns risky assets, like stocks, when they have recently offered positive returns, otherwise it moves to short-term Treasuries or other low-risk assets. This strategy could be implemented is several ways, but one simple approach is to compare a broad market index’s closing price at the end of the month against its average over the past 12 months. If it’s higher than average, hold U.S. stocks for the next month, otherwise move to T-bills. Exhibits 4 and 5 show how this strategy would have performed.

06.05.2020 Article Image 4

06.05.2020 Article Image 5

This strategy delivered similar returns to the stock market, even though it was invested in stocks only 76% of the time. More importantly, it cut downside risk and exhibited considerably lower volatility than the buy-and-hold approach.

There are a few important caveats: 1) This strategy is less tax-efficient than buy-and-hold, so after tax, it will probably deliver lower returns. 2) Trend-following can lag the market for years because it tends to miss out on the early part of a recovery. 3) This strategy doesn’t work as well when high volatility prevents a clear trend from forming. Still, this strategy would have suggested a move out of stocks at the end of February 2020, which could have saved a lot of pain in March.

Other Strategies to Cut Risk

There are good alternatives for those looking for a more hands-off approach to cut risk. The simplest and most effective approach is to shift to a more-conservative asset allocation. Market downturns naturally give most investors more-conservative asset allocations, as stocks tend to underperform bonds during those times.

Even if a more-conservative allocation than the market has given you is appropriate, it may feel dumb to trim back on stocks when they’re trading at a discount to where they once were. However, risk tolerance should be the primary driver of asset-allocation decisions. If you need the money soon or are at risk of panicking if things get worse, it’s probably prudent to realize some losses, which can help lower your tax bill, and reposition.

Stick to the Plan

Whatever investment plan you craft, it’s important to stick with it and avoid making big changes out of fear or greed. That often means sticking to your long-term strategic asset allocation, regardless of what’s going on in the market, and populating it with low-cost, broadly diversified funds. That’s easy to understand but can be hard to do. Checking in on your portfolio less frequently and keeping the plan simple can help. With investing, less is usually more.

Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.


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The opinions, information, data, and analyses presented herein do not constitute investment advice; are provided as of the date written; and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar makes no warranty, express or implied regarding such information. The information presented herein will be deemed to be superseded by any subsequent versions of this document. Except as otherwise required by law, Morningstar, Inc or its subsidiaries shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. It is important to note that investments in securities involve risk, including as a result of market and general economic conditions, and will not always be profitable. Indexes are unmanaged and not available for direct investment.

This commentary may contain certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

The Report and its contents are not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation or which would subject Morningstar or its subsidiaries or affiliates to any registration or licensing requirements in such jurisdiction. 


MeDirect Disclaimers:

This information has been accurately reproduced, as received from Morningstar, Inc. No information has been omitted which would render the reproduced information inaccurate or misleading. This information is being distributed by MeDirect Bank (Malta) plc to its customers. The information contained in this document is for general information purposes only and is not intended to provide legal or other professional advice nor does it commit MeDirect Bank (Malta) plc to any obligation whatsoever. The information available in this document is not intended to be a suggestion, recommendation or solicitation to buy, hold or sell, any securities and is not guaranteed as to accuracy or completeness.

The financial instruments discussed in the document may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed herein.

If you invest in this product you may lose some or all of the money you invest. The value of your investment may go down as well as up. A commission or sales fee may be charged at the time of the initial purchase for an investment and may be deducted from the invested amount therefore lowering the size of your investment. Any income you get from this investment may go down as well as up. This product may be affected by changes in currency exchange rate movements thereby affecting your investment return therefrom. The performance figures quoted refer to the past and past performance is not a guarantee of future performance or a reliable guide to future performance. Any decision to invest should always be based upon the details contained in the Prospectus and Key Investor Information Document (KIID), which may be obtained from MeDirect Bank (Malta) plc.

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