After pollsters for the UK general election got it so wrong, Allianz Global Investors considers how investors should approach such unknowns in the future.
The run-up to the UK's general election on 7 May 2015 - almost a month ago already! - made for one of the most uncertain pre-election environments the nation has seen. The opinion polls showed a neck-and-neck election race between the Labour and Conservative parties, which had people rule out a majority win and defer any major investment moves. So when the Conservatives came to power with an outright majority vote, the reliability of polls was rightly brought into question. The author of this article, Marcus Morris-Eyton, vice president of European equities at Allianz Global Investors, discusses ways of navigating such unpredictable investment landscapes. The views expressed here are those of the author, but WealthBriefing is pleased to share them. If readers wish to respond, they should email the editor at firstname.lastname@example.org
In society, despite the best efforts of technology, there remain many areas of life that are seemingly still difficult to forecast accurately, from the weather to England’s sporting performance and now arguably elections. While it is possible that this unpredictability makes our daily lives exciting, the same search for excitement should not be applied to our investments, where visibility and predictability remain two of the most desirable traits in any investment.
Just as weather and sporting results can create volatility in our daily moods, elections and other macro surprises can generate volatility in financial markets, impacting portfolios in the short term. As an investor, there are two ways of playing this volatility. The first is an attempt to do what many election pollsters have previously tried, tested and failed to do; forecasting a predicted outcome and positioning the portfolio based on the forecast of this unknown event - such as an election. The second method is to recognise the fallibility in reliably forecasting these unknowns and instead focus on the few areas of the market where we as investors can have genuine visibility.
The first method can work, but I would argue that it is difficult to sustain consistently over the longer term. It not only requires skill but also an element of luck to consistently forecast macroeconomic, geopolitical or policy/ regulatory influences that are often out of our control and frequently vulnerable to the unpredictable influence of human nature. This was recently highlighted by the UK elections where 0 out of the 92 polls accurately forecasted a 7 per cent Conservative lead. A year ago, the number of investors who successfully predicted oil falling to below $50 a barrel, or the dollar/euro rate falling to 1.05 wasn’t much higher. These episodes demonstrate that even with many of the world’s brightest minds and most technical modelling software, many macro factors will always lie beyond our predictive capabilities.
An alternative method of investing is to recognise the challenge of predicting the short term and instead focus on the one area of the market with the greatest predictability: market leading companies. Within the Allianz Europe equity growth team we accept that we may not always be able to forecast precisely where the dollar/euro rate or the oil price will stand a year today. However, we have demonstrated that long-term outperformance is possible through focusing our analysis purely on the underlying companies.
Investing for the long term in high quality European companies with distinct competitive advantages and clear structural (as opposed to just cyclical) earnings growth potential means holdings are able to achieve a degree of earnings and cash flow visibility rarely found at a macro level. These companies benefit from their competitive edges to position their products or services as indispensable to their clients' needs. The products or services can range in nature from insulin products for diabetes sufferers to actuators for industrial plants, but all share the key merits of largely stable demand patterns and secure pricing power. These factors combined allow a company to sustain or ideally grow their margins, while generating attractive recurring returns and cash flows that can be compounded over the long term.
Geopolitical peace or an election campaign could disappear into dust overnight, but it is rare to find genuine company competitive advantages such as a stellar brand (which has perhaps taken decades to build up), product leadership (often patent or knowledge protected) and network or scale advantages dissolving suddenly. It is for this reason that we believe much of the best analysis is done not through modelling on a spreadsheet but by developing a clear understanding of many of the softer factors, such as: the existence of barriers to entry, pricing power and competitive advantages that may or may not make a company unique.
Such an approach requires firm commitment to a process, experience and most crucially patience. Speed and indeed often timing are substituted for depth of knowledge. By taking the long-term view and focusing on the structural winners in their respective industries, a bottom-up investor can give themselves the best possible chance of success, with a level of visibility that many macro investors can only dream of.