Prepare, don’t predict: your blueprint for building a resilient investment portfolio of global equities

With many indicators signaling an economic contraction ahead, there’s lots of chatter (and in some cases even fear) in the investment community about how markets will respond to a sustained period of instability. But what if predicting that outcome mattered less? What if there was a way to prepare your investment portfolio for any challenges that come your way?

Time is on your side

History has shown that unpredictable events can make global markets swing wildly. Take COVID-19 for instance; nobody could have ever predicted that a novel virus would have completely altered the workings of society. Even more so, nobody could have predicted the swiftness of how global equities pulled back and recovered in the outbreak's aftermath.

Because unpredictable events can have equally unpredictable consequences, we don’t think trying to predict the future is efficient. Predicting market movements is next to impossible on a consistent basis and by constructing a resilient investment portfolio that can deliver in a variety of market environments, you can avoid much of the guesswork that goes into timing the markets.

So if using a non-predictive decision-making model that exploits time in the markets is a reliable way for investors to meet their long-term goals, why would anyone choose to put their wealth in jeopardy by trying to predict the market’s next big move? 

Is sound planning a more realistic approach to investing in global equities? We believe so. By investing in quality businesses from around the world that are expected to do well over the long term, investors can better navigate market ups and downs. But that’s only scratching the surface. How can investors be sure that a truly resilient portfolio is in the making?

Resilient, not brilliant

Building a resilient investment portfolio from the ground up has nothing to do with buying into the latest investment fad and everything to do with adhering to a repeatable, time-tested investment process. By taking a deep dive into corporate fundamentals, relying on meticulous security selection, and tapping into the global investment universe, we believe it’s possible to create a portfolio that can steer through a variety of market conditions.

Identifying vulnerabilities and triggers

Apart from ensuring your investment portfolio is invested in the best possible ideas, gauging fragility is also important. What is it that could break your portfolio? One way to assess this is by examining a portfolio’s vulnerabilities and triggers. 

While vulnerabilities are often measurable now, triggers are unobservable future catalysts that can turn vulnerabilities into real threats at any given moment.

To understand this, take a hypothetical example of two investors looking to buy a forest. One could choose to invest in a “dry” forest (one that is highly susceptible to destruction from wildfires) while another can choose to invest in a rainforest (where the wildfire risk is considerably lower). The investor eyeing the dry forest can choose to buy it despite its vulnerability to wildfires, opting to hire a specialized team to monitor the forest for lightning strikes, campfires, and other fire hazards in the hopes of being able to react quickly when disaster strikes. For the investor that chooses to buy the rainforest, its resistance to wildfires may offer more resilience. Investing doesn’t have to be brilliant in order to be effective. 

Using the recent U.S. sovereign bank debacle as a real-world example, the unprecedented rate increases that propelled institutions such as Silicon Valley Bank into default territory is a classic example of what can happen when vulnerabilities and triggers converge. Higher interest rates were a trigger that ultimately exposed the bank’s vulnerabilities, which in all likelihood, were identifiable long before the bank collapsed. Uninsured deposits, a concentrated customer base, a duration mismatch, and interest-rate-sensitive liabilities were just some of the vulnerabilities that investors could have factored into their decision-making process way ahead of time.

Vulnerabilities aren’t always synonymous with avoidance

Does uncovering a vulnerability mean avoiding the company altogether? Not necessarily. Because investors are rewarded for taking on risks—and not avoiding them entirely—identifying company vulnerabilities should be more about finding mispriced risk. By doing a company assessment that involves the accumulation of red flags and looking at the materiality of them on a stand-alone and cumulative basis, investors can get a sense of risk they may be exposing themselves to and price those risks appropriately.

Evaluating company fundamentals can also help you weigh the vulnerabilities of a company and gauge whether or not you’re comfortable with the risk you’re undertaking. For instance, if the price of a company reflects the expectation that it will be unable to pass on inflation costs, a further evaluation could reveal that its competitive advantage and pricing power suggest otherwise. An example of this involves one of the world’s largest coffee marketers. After green coffee bean prices rose, there was concern that the company would be unable to pass on those costs to consumers. However, an assessment of its competitive advantages suggested cost advantages from scale and sticky customers from strong brands. Because coffee demand is generally inelastic and consumers tend to be brand loyal, according to our estimates, 80% of the company’s revenue stems from dominant #1 or #2 market positions. Indeed, the company’s pricing power was showcased roughly two to three quarters later.

Accept uncertainty, invest in quality, and trust the wait

One of the most common questions asked by investors is, where are markets heading? The question should rather be, how can we build a portfolio that delivers regardless of where markets are heading?  Because trying to predict the next bout of uncertainty is futile, the focus should be on accepting uncertainty and bolstering your portfolio’s defenses long before a storm hits.  

Pinpointing quality businesses that have competitive advantages, are stable and well-run, and sell at a discount to intrinsic value is one way to position your investment portfolio for all market environments, regardless of where markets are heading.

Other ways to plan ahead and trust the wait include:

• Positioning yourself against multiple scenarios: If you’re concerned about an economic contraction but aren’t sure if and when it will materialize, positioning your portfolio to deliver in both an economic contraction and economic expansion can be a worthwhile exercise. For instance, companies in the healthcare and consumer staples sectors tend perform well during periods of uncertainty—given the fact that consumers don’t stop spending on these products and services in tough times. Conversely, cyclical names tend to perform better in periods of economic expansion. Are all of these sectors well represented in your portfolio? By embedding inherent contradictions in your portfolio, you can bolster resilience to any scenario.
• Expanding the breadth of your selection universe: Investors often exhibit a home bias, which narrows their opportunity set. Looking beyond your borders can give you more benchmarking context to inform better decision-making, help you avoid concentration, and open the door to global opportunities that the market may be ignoring. But this isn’t just about investing in companies that are headquartered in different parts of the world, it could also be about identifying companies that have revenue streams from different parts of the world. Where is that revenue coming from and what's the risk? Is it concentrated in one area or more at risk due to geopolitics, natural disasters, or other factors? Nestlé S.A., for instance, is an example of a company that is listed in Switzerland—one of the most developed markets in the world —but has approximately 40% of its revenue from emerging markets. Understanding your risk exposure requires proper fundamental analysis.

• Diversify, don’t diworsify: Everyone knows a lack of diversification can be a vulnerability for your portfolio. But is there such as thing as overdiversifying? Diworsification—adding too many investments with similar correlations to a portfolio—can limit your upside potential. Is it worth adding two similar businesses to your portfolio? What about similar businesses from the same country? The goal is to ensure that there are no sharp edges in the portfolio, which is when several investments act like one because of their similarity in exposures (e.g., several different oil and gas companies may all be correlated with oil prices). 

Lastly, preparing a portfolio for all market environments is also about doing your homework. Conducting an honest assessment about a company not only requires hearing it from the horse’s mouth but also involves obtaining validation from sources other than the company itself (such as competitors, employees, and other stakeholders). This due diligence should be conducted periodically and can take the form of manager interviews, performing forensic accounting, evaluating ESG considerations, building discounted cash flow models, and writing up the findings so that the team can debate the investment merits.  

“One of the most common questions asked by investors is, where are markets heading? The question should rather be, how can we build a portfolio that delivers regardless of where markets are heading?”

Have no fear if uncertainty is near         

What if we were to tell you that an economic contraction could come with a silver lining? As you focus on strengthening your portfolio for the future, the idea that uncertain economic periods tend to offer a reset should also provide solace. In our opinion, volatile periods provide opportunity for long-term fundamental investors because they offer the greatest potential for a mismatch between the price we pay for a stock and the value we receive in return. Always remember, prepare, don’t predict!