Event risks will come and go, but a well-structured balance sheet should withstand short-term volatility sparked by these events, writes Craig Gradidge
The conversation over the past six months has been dominated by the prospect of a ratings downgrade by S&P Global at the beginning of this month. For many, the downgrade was a forgone conclusion, and they wanted to know what our plans were. It got easier to have the conversation as the year went on, but the prospect of the downgrade remained firmly in the conversation.
Typically, when you have a risk event (such as a credit downgrade) dominating the conversation or mobilising one to review a portfolio, it is a good time to conduct a strategic assessment of your balance sheet.
A strategic assessment typically entails a number of different analyses. We are looking for information such as the size of the balance sheet, the strength of it (assets versus liabilities) and its diversity (concentration risks).
Once flagged, we start a series of analyses: a gap analysis; a liquidity analysis; a cost analysis; and a risk analysis. The aim of this is to get a deeper understanding of the client’s balance sheet, which is ultimately the context in which we provide advice for new investments or restructure the existing portfolio. ARE THERE ANY INVESTMENT GAPS?
A gap analysis is simply an assessment of the balance sheet to see if there are any gaps that exist. Given the various asset classes and investment products that a person can invest in, are there any missing from the client’s balance sheet?
A client we saw a few years ago had two clear gaps in his balance sheet: no offshore exposure and no listed property exposure. Once we identify gaps, we have to ask: Will the client benefit if these gaps are filled? If the answer is yes, we make a recommendation, but if not, we continue with the process.
In this particular case, the answer was yes, and we invested this conservative investor’s additional money in an offshore fund, and in a listed property fund. Naturally, the client and I were both nervous, him of the volatility, and me of the possibility of finding myself standing in front of the Financial Advisory and Intermediary Services ombud, having to explain this obvious paradox.
That nervousness stayed for a bit when the portfolio returned less than 6% in 2013, while the rest of his portfolio soared.
At the end of 2014, however, we reported returns of almost 40% for the year. That was again the case in 2015, with listed property being the top-performing local asset, and offshore the clear winner thanks to three finance ministers in four crazy days. The value of the process led to the advice, not a prediction. DO YOU HAVE ACCESS TO CASH, QUICKLY?
One of the most important strategic analyses is the liquidity analysis, where we look at how quickly an asset can be turned into cash without having to offer a price discount. A very liquid investment would be cash in the bank, while an illiquid asset would be property or a business.
Typically, investors focus on how quickly they can convert to cash, and ignore the possibility of having to offer a discount.
I often get told by investors with multiple properties on their balance sheets that they have access bonds on those properties, so they do not need liquid investments. However, as many investors found in 2008, those access bonds were not as accessible as they thought they were. Many of the banks simply blocked access to funds as liquidity became a major issue for the banks.
We usually recommend a minimum of 30% exposure to liquid assets, which allows investors to take advantage of opportunities that may arise from time to time. UNDERSTAND THE REAL RISKS
We look at the level and types of risks that already exist in the balance sheet to ensure that there is sufficient risk in the portfolio for the client to achieve their overall investment objective.
Too often, we find that investors have a regimented approach to risk management and do not consider the overall riskiness of their portfolio or balance sheet.
Too many investors define risk as absolute capital losses, whether those are short or long term in nature. There are two bigger, more important, risks: the risk of underperforming inflation and the risk of permanent capital loss. Conservative investors typically run the risk of underperforming inflation, particularly on an after-cost and after-tax basis. Because their capital is protected in nominal terms, they only really wake up to the real risk they are exposed to when it is too late.
It is a slow process for investors to awaken to this reality. The risk of permanent capital loss is one that the risk seekers tend to face. It often involves taking speculative bets on the next big thing.
But all investors are exposed to the risk of permanent capital loss when it comes to investment scams. ARE YOU GETTING VALUE FOR MONEY?
Fees have increasingly become a focus point for many investors, and rightly so.
If a person began an investment strategy more than 10 years ago, they would benefit from a review of the cost structure of their portfolio now.
The increasing popularity of index-tracking products, and the subsequent response by a number of forward-thinking asset management firms, means that investors can find themselves saving as much as 50% on their portfolio fees.
With each of the various analyses, it is clear what value could potentially be added. Often, the outcome of such a process is a more resilient and refined portfolio and balance sheet.
I once heard someone say that “a good strategy builds empires”. I tend to agree with that sentiment. Gradidge is CEO of Gradidge-Mahura Investments. Visit gminvestments.co.za