‘Upside down’ – Jack Johnson

If my last note was an ‘ode’ to resilience and patience, this note is an ‘ode’ to optionality.

Last week I read a fascinating piece called ‘Complexity Investing’ by Brad Slingerlend and Brinton Johns.

I took a lot from their work, but the one thing that really struck me was the section on resilience and optionality. Clearly investors need to be resilient, so we can withstand set-backs, but do we also need to embrace optionality?

Slingerland and Johns discuss optionality in the same way a venture capital firm might, with the potential of a large pay-off from a small number of investments, recognising a number of these investments may also go to zero. They argue that by optimising for both resilience and optionality investors can avoid the illusion that they can predict the future. It is an interesting concept and one that seems particularly appropriate when investing in new technology. Indeed, we can see this essential philosophy in action when we look at the portfolios of a number of strategies we invest in to capture innovation and disruption.

However, this is not the only thought that came to me when reading their piece. Since the start of the year we have met many clients and the level of caution amongst investors continues to strike me. Despite very strong returns last year, it seems investors remain quite cautious. You simply don’t see the euphoria or optimism you would expect after such a strong year.

Furthermore this is not just an Irish phenomenon. The cover of Barron’s, a US investment publication, in early January struck a cautious, conservative tone, with ‘Safety First’ the headline message.

With most investors seemingly focussed on what could go wrong, should we also ask what could go well? It is fair to say valuations for equity markets are not cheap in an absolute sense, but the starting free cash flow yield today from US equities is higher than US 10 year bonds, and pretty much the same as US corporate bond yields. This doesn’t happen very often and when it has future returns from equities have been quite strong.

I’m also intrigued by the idea that we are still relatively early in a very long term bull market. Over the last 100 years, we can observe that markets have periods when they deliver very strong returns and periods when they essentially deliver nothing.

This may strike readers as somewhat simplistic analysis, but it is interesting to note that these periods typically last 16-20 years and arguably markets only broke out from one of their ‘nothing’ periods in the middle of the last decade, following essentially no return from 2000 to 2016 for global markets, in price terms.

I’m further intrigued by the idea that a number of technology platforms are converging today and that we are on the cusp of a leap forward in productivity and growth for a number of sectors.

Maybe this is too optimistic, but shouldn’t we explore the potential positives, as well as the negatives? Perhaps we should only assign a small probability to the most optimistic case, but we shouldn’t dismiss it entirely.

As long as we build resilient portfolios for clients, allowing us to withstand set-backs, we can retain optionality and then ask “what could go well?”

As always, please do not hesitate to contact us with any queries or questions you may have.

Ian Quigley
T: +353 1 421 0300
E: ian.quigley@brewindolphin.ie

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