Principles to steer you through investment shoal

The following article appeared in the ASX investor update on February 5, 2021

Investors beware: 2021 is filled with uncertainty!

Historically low interest rates, rising inflation risks, an appreciating Australian dollar, geopolitical and trade uncertainties among global superpowers, an out-of-control global pandemic, and market distortions from the greatest fiscal and monetary stimulus the world has ever seen are among the many dangers.

Predictions on these topics yield a low probability of real insight for most investors and little ability to control outcomes. Fortunately, there are some investing principles you can apply to tilt probabilities in your favour during these uncertain times.

First, put time on your side. There’s always something to worry about, and 2021 is no different. History has shown that despite economic recessions, depression, terrorist attacks, world wars, epidemics, pandemics, and much more, it has paid well to remain optimistic and maintain a long-term investment horizon.

According to analysis by Lakehouse Capital, since the inception of the S&P/ASX Small Ordinaries Accumulation Index over 20 years ago through to 31 December 2020, the index has yielded a positive return over a one -year holding period 67 per cent of the time.

Extending the holding period to three years increases the probability of positive returns to 68 per cent, five years to 78 per cent, and 10 years to 90 per cent.

Despite market gyrations, probabilities tell us you are likely best served by remaining invested in a well-diversified portfolio in the face of uncertainty.

Second, seek out businesses with strong positions in growing markets. Perhaps the most distinctive characteristic for this is recurrent, strong revenue growth.

A study by Boston Consulting Group and Morgan Stanley on the long-term drivers of investment returns for the S&P 500 from 1990-2009 highlighted that:

  • over one year, revenue growth accounted for 29 per cent of investment returns
  • over three years 50 per cent
  • over 10 years a compelling 74 per cent

At Lakehouse, some of the opportunities we see in the early stages of long revenue growth trajectories include e-commerce, digital payments and cloud computing.

Third, align yourself alongside founder-led management teams. Numerous studies have revealed companies led by long-term founders yield superior results.

A 2012 publication by the Harvard Business Review (“What You Can Learn From Family Business”) concluded that founder-led businesses often outperform externally managed firms.

More recently, the Credit Suisse Research Institute found that since 2006, its proprietary universe of 1,000 “family-owned” companies outperformed “non-family-owned” companies by an annual average of 3.7 per cent.

The power of compounding means this outperformance is equivalent to a further doubling of a patient investor’s wealth over a 20-year time horizon. Fortunately, ASX has an abundance of founder-led small- cap companies to invest in.

Fourth, pay careful consideration to balance sheets. A leading cause of corporate, as well as personal, financial failure is excessive use of credit.

At Lakehouse, we pay careful attention to the financial positions of the small-cap companies in which we invest. Strong balance sheets offer optionality and allow companies to play offence when market or financial conditions inevitably turn, often to the detriment of financially stretched competitors.

Lastly, ensuring you pay a reasonable price in 2021 relative to the business’ prospects is paramount as it heavily tilts the odds of long-term outperformance in your favour.

While the uncertainties of 2021 may contrast with history, the fundamental investing principles of long-term investing should not.