Looking back to early 2007, Australian Securities Exchange (ASX) indices were bloated and trading on historically high forward earnings multiples with small companies at premiums to large companies. Many investors were enjoying their healthy share price gains coming into the global financial crisis (GFC). There were a large number of initial public offerings and elevated levels of acquisitions and capital raisings in the market. Investors had become comfortable with higher levels of company debt and expected continued capital gains.
This environment quickly changed as the cold winds of the GFC took hold in 2007, with highly leveraged and over-engineered companies, such as Babcock & Brown and Allco, rapidly imploding and the wider market aggressively sold down.
The S&P/ASX 200 Index plunged more than 43 per cent between 31 October 2007 and 31 March 2009 (the period of the GFC), catching many investors completely off guard. To quote investment guru Warren Buffett, it is “only when the tide goes out do you discover who’s been swimming naked”. Indeed, many companies relying on leverage with questionable earnings were caught out.
Pleasingly, the Australian Ethical Australian Shares Fund held onto its bathers, significantly outperforming the broader market by 20 per cent and emerging from the GFC stronger in long-term performance against its peers and benchmarks. The fund benefited from our distinct mix of defensive healthcare and utility names combined with better-quality business models, a model that held up strongly compared with the wider market.
This GFC taught us three important lessons.
1. Staying true to fundamentals
In the period approaching the GFC, equity investors took a glass-half-full view of the world, with stocks valued at higher earnings multiples than had been the case historically.
Investors were complacent, with momentum and excessive confidence driving markets. There was less reliance on fundamental investing disciplines in the pursuit of quick money. The primary concern was missing out on returns, rather than the fear of losing money.
In that environment, there was little emphasis on properly differentiating between the quality and robustness of company business models. When the GFC came along, it was a brutal reminder that fundamental investor discipline is incredibly important and is sometimes only truly visible when the tide goes out. It’s therefore critical investors understand and actively assess not only the quality of a company’s business model, but also understand its earnings trajectory.
At the same time, the GFC taught us that crawling into a shell during periods of extreme sell-off is the wrong reaction. In hindsight, plenty of opportunities were presented for active investors willing to back their view and add to their fund positioning over time. We picked up a few bargains in 2008 and 2009 when the market was capitulating. For example, we progressively added to our position in clean energy company Energy Developments at prices as low as $1.30, revisiting our valuation to support and reinforce our conviction. This company was ultimately acquired by Duet for $8 per share in 2015.
2. Avoid over-indebted and over-engineered businesses
The GFC provided an extreme reminder that highly engineered and over-levered companies can be very damaging to your portfolios. We saw a spectrum of listed infrastructure names, over-indebted real estate investment trusts and highly engineered financiers that required emergency capital raisings at significantly discounted prices during the GFC.
Our key takes here are that leverage matters, so ensure your investments have a sufficient margin for safety in servicing their debt obligations. The old investment adage ‘cash is king’ resonates with us, which is one of the reasons we happily avoided all the forestry managed investment schemes. We believe in keeping it simple and avoiding business models that are over-engineered and can’t be accurately explained in a five-minute interval.
3. Importance of true diversification
All our investments must pass our stringent ethical charter, which has guided our investment decision-making for more than 30 years. The charter’s positive and negative screens provided a shield from the brunt of the GFC’s sell-off and alleviated risk due to a focus on long-term sustainability and assessment of companies through a broader lens.
From a diversification perspective, ethical investing also creates a very different line-up to the broadly used market index, for example. We have zero exposure to mining and a focus on renewables, healthcare and information technology. Our portfolios have defensive characteristics, which in part explains the lower absolute volatility measures exhibited by the fund. We spend little time looking into heavy industry, mining and mining services and plenty of time looking into healthcare and information technology investments, which tend to be progressive, forward-looking, intellectual property-oriented companies.
It is our firm belief that adding ethical investments to your portfolio can provide an important layer of diversification and resilience.
Andy Gracey is a portfolio manager at Australian Ethical Investment.