The concentrated, high-conviction portfolio has become increasingly popular in asset management. Given how many markets around the world have recently been driven by just a handful of stocks, it is easy to understand why.
However, speaking at the Meet the Managers event hosted by The Collaborative Exchange this week, Prudential head of equities Ross Biggs said it is important to appreciate what this means.
“People focus on a number of factors to try to gauge the conviction of a portfolio manager,” said Biggs, who co-manages the Prudential Dividend Maximiser fund. “They look at the number of shares in the portfolio, the active share and tracking error.”
In Biggs’s view, this only shows how differently the fund could perform relative to the index. It is difficult to evaluate whether these are good or bad things on their own.
“Being highly convicted, holding few shares, or having a high tracking error could mean very strong outperformance,” Biggs said. “But it could also mean very poor performance.
“We spend a lot of time not only being different, but also trying to deliver outperformance under a number of different scenarios.”
One of the key elements Prudential focuses on is not taking on risk just for the sake of taking on risk.
“For example, if you look at the price-to-book of the South African market over the last 40 years, the odds of making money when the price-to-book was close to one times was very high. It might have felt very uncomfortable to buy the market when it was down at those levels, but the odds of making money were pretty certain. Those are often good opportunities to take on risk.”
Source: Bloomberg, Datastream and Prudential Investment Managers
An uncertain future
Biggs is also aware that the most dangerous risks are often the ones no one has thought about.
“If you go back a year or two, no one would have thought of a global pandemic’s effect on their portfolios. Neither had we. But we always try to structure our portfolios for an uncertain future.
“When the pandemic came, we had quite a few companies in our portfolios that benefitted from the dislocation in the market – companies with strong balance sheets that could buy back shares, because share prices had fallen so much.”
In the South African context, Prudential is also wary of how resource stocks can influence portfolio outcomes.
“It is a big sector in our market, so it’s an issue you need to consider because the return probability distributions of the resource sector can be very wide-ranging,” Biggs said. “You just have to look at the platinum sector to see how wide-ranging those returns could be.
“Two to three years ago, a lot of investors had given up on the platinum sector. Now there’s massive returns from platinum companies. That shows that, when you are putting together a portfolio, you need to consider how you position yourself within resources.”
Prudential’s approach is to always consider how a portfolio would perform under the broadest range of scenarios.
“What is critical for us is to construct portfolios that are risk-conscious, considered, and take into account different potential outcomes,” Biggs said. “What you don’t want to do is construct a portfolio based on a particular view. You always want to think about what would happen if this particular outcome doesn’t come to pass, and what else you have in the portfolio to protect clients’ capital.”
In his view, the local market currently offers good potential to do just this.
The graph below shows the valuation disparity between the dividend yield of the 25th percentile stock and the 75th percentile stock on the JSE.
“If that’s a very large gap it means there are lots of opportunities in the middle to make good stock-picking money,” Biggs said. “And we are now at levels that we last saw during the financial crisis and the early 2000s.
“At the moment, there are lots of opportunities to construct a well-considered portfolio with lots of opportunities that could pay off in future years.”
This is about taking on the right kinds of risks.
“Today, we sit in a very uncomfortable and uncertain position,” said Biggs. “We are still going through a global pandemic, and in South Africa particularly we have other issues like rising unemployment, debt-to-GDP levels that keep increasing to fairly alarming levels, and state-owned enterprises that are struggling. So, if we look at the South African market today, there is lots to be very uncertain about.-
“During these points of uncertainty often the most certain thing is how good the odds are on offer.”
Patrick Cairns is South Africa Editor at Citywire, which provides insight and information for professional investors globally.
This article was first published on Citywire South Africa here, and is republished with permission.