Liquidity is the coward
Liquidity is a fair-weather friend. It's there for the good times, but absent without leave when market volatility hits.
For Chris Wallis, CIO at Vaughan Nelson Investment Management, "liquidity is a coward."
But who needs friends, anyway?
In this episode of Expert Insights, Wallis takes us through the ways to invest when volatility is high and liquidity is absent.
"While we're talking about small and mid-cap stocks, we're not talking about speculative positions, we're not talking about balance sheets that need to be able to refinance debt or can't handle an increase in interest rates."
So what are the kinds of companies Wallis wants to buy? In the following video, you'll hear about the qualities he looks for in companies worthy of investment by Vaughan Nelson. Wallis also couches that conversation in the issue of the day, inflation, and the role of cash in a portfolio.
LW: To what extent is oil driving inflation and input costs for companies?
Chris Wallis: Oil and fossil fuels, in general, are really important because they're the input for carbohydrates and food and all the things we know we're short. At the same time, they're the number one factor in inflationary pressures and unfortunately we've begun another upcycle in commodities. We have a little bit of a respite here. The US federal, the US central bank has been adamant that they're going to deal with these inflationary pressures. They've been very aggressive at reducing M2. For the first time since 2009 on a month-over-month basis we're seeing declines in M2, which is really unheard of. That's pressuring commodities right now. We're also getting relief because the Biden administration is releasing about a million barrels a day from the Strategic Petroleum Reserve. That was going to happen anyway, but it's going to come to an end.
Once we stop releasing those million barrels a day and we get sufficient economic growth, we're going to be tight in the supply and demand imbalance and we're going to see much higher oil prices. Whether that begins from a much lower price because of the tightening liquidity conditions or not, it does mean we're going to see higher oil prices in the future and that's only going to reinforce some of the inflationary conditions we're already experiencing.
LW: How do you get comfortable trading against the market?
Chris Wallis: We never suffer from FOMO at our firm. We really spend our time focused on the economic realities versus the narrative. Narratives are always driven around price. We see price, we wrap up a story around it. Other people get involved. Because the price keeps working in that direction they get really convicted in the narrative. That does two things.
One, it takes value away from fundamentals, or it draws capital away from other areas, which means I get good opportunities elsewhere. So when I see the herd going one way, I'm automatically going to start looking the other way. And again, we're fortunate. We have clients that respect the need to trade time for value. That gives us the comfort, the confidence to execute on that strategy.
LW: How do you manage liquidity in the small cap space?
Wallis: So let's talk about liquidity. Liquidity's a funny thing. Liquidity's a coward, which means it's never going to be there when you need it. So when times are difficult, you know you can't count on liquidity so you have to address that upfront in your investment process. So while we're talking about investing in small and mid-cap stocks, we're not talking about speculative positions, we're not talking about balance sheets that need to be able to refinance debt or can't handle an increase in interest rates.
We're talking about companies as high as 20, 25 or even 40 billion. These are already companies that kind of own their space. And again, when we need liquidity and it's not going to be there, you better have a good underlying fundamental business. And we always run it with that in mind. We'll go down and buy a billion dollar company, but our sweet spot's kind of that billion to 20 billion, kind of a good average for those top 10 or seven to 10 billion. These are big companies. These are big liquid positions. Look, when you have liquidity problems, when you have problems in credit markets, every stock, the entire beta universe is going to be impacted. But we're not in an environment where we need access to liquidity in order to execute our strategy, we're in good positions.
LW: What role does cash hold in 2022?
Wallis: Yeah, when you think about 2022, there's a couple of things that are unique about it.
One, we know central banks are aggressively fighting inflation. We also know we're going into an economic downturn. We knew that at the end of 2021. That meant central banks are going to be pro cyclical. They're raising rates into an economic slowdown and they're coming from unbelievably low levels and we've been trying to hide out and find yield anywhere we can. So what does that mean when you're constructing a portfolio? Normally, the way we would treat cash is it's kind of a frictional cost. We want to stay invested as much as possible. Coming into 2022 that really wasn't an option. We said, we're going to have big downside volatility in the equity markets. The same time, we're going to have big downside volatility in bond markets and bond proxies.
So cash has a role. So we've held more cash this year. Let's say we had six or 8% cash in the portfolio through the first four or five months. At the same time, we have companies that are being acquired for a cash purchase price. They also act like cash. Normally, we would sell those positions and reinvest quickly. Not this year. We've been patient. Let's let the market correct, then let's start selling out of those companies that are being acquired and then we'll start deploying the cash. Cash has a unique role in the first part of 2022. Hopefully we get back to an environment where it's just a frictional cost and we can deploy it aggressively.
Small caps for big thinkers
Vaughan Nelson recently launched Australia’s only global active SMID cap ETF (ASX:VNGS) to give investors access to their best ideas in global small-mid caps. Learn more here.
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