Why process must prevail over emotion in volatile markets 

by | Aug 9, 2023

Malcolm Schembri, manager of the EPIC Global Equity Fund comments on why process must prevail over emotions in volatile market conditions, the statement can be found below:

Adhering to investment rules can be challenging in tumultuous conditions, but it can be the difference between positive and poor decision-making 

Dogmatic processes can test fund managers to their limits in certain market conditions. 

In falling markets with seemingly no end in sight, investors can be tempted to ditch stocks that were diligently and painstakingly selected. 

And when hype around a particular story is at its most fervent – as we are seeing with artificial intelligence (AI) right now – it can be difficult to know when to leave the proverbial party. 

Making the right calls when presented with these two situations can be critical to maintaining relative long-term returns. 

The test has hardly been greater in the past 18 months, with the combination of uncertainty and volatility in tandem with isolated pockets of hype pushing fund managers’ discipline to the extreme. 

Shifting sands 

Inflation arriving more rapidly and proving more persistent than commentators had expected has prompted a marked shift in global fiscal policy, with interest rates rising faster and higher than they have for decades. 

Rising volatility suggests many investors may be spending their time trying to predict how this inflationary and rate rise cycle plays out. 

In contrast, we have focused on process rather than noise, which we believe will allow our portfolio to emerge stronger. 

This approach meant that when markets were falling in the second half of last year, we were able to increase our exposure to some of our favoured stocks at depressed valuations. 

These included Nvidia, arguably the current leader in the AI revolution, as well as Amazon and Microsoft

All of these companies saw downward pressure on their share prices in 2022 as investors began to question whether their dominance could persist in a higher interest rate environment. 

They have all rebounded in 2023 as the global technological revolution continues its seemingly unstoppable progress. 

Disciplined process 

We are not being contrarian for contrarian’s sake. 

The in-depth, bottom-up research we carry out on the companies and industries we invest in creates a deep understanding which is independent of market consensus. 

This arms us to identity opportunities when our understanding and expectations of value diverge from market pricing.  

As well as allowing us to spot overly pessimistic market reaction, this approach is equally as effective at exposing excessive optimism.  

Assessing opportunities 

Whilst many Nvidia investors have attracted by the gaming and cryptocurrency aspects of its business, its advantageous position in AI has always been our primary reason for backing the stock. 

Jensen Huang, Nvidia’s chief executive, believes his firm’s capabilities give it access to a $1 trillion addressable market across various segments, including AI, automotive, and chips and systems. 

We think this is a reasonable assessment of the opportunity, but does not incorporate an assessment of the execution risks. 

Nvidia’s share price in the year-to-date is nearing 200%, which suggests the party remains in full swing. However, as every party-goer knows, choosing not to stay too late can be a helpful hangover avoidance strategy! 

Being mindful of this, we decided to trim our exposure to Nvidia in June, taking the opportunity to increase other existing positions and introduce oversold shares such as US-based healthcare firm Danaher.  

Having received a huge boost during the pandemic due to its important role in testing, Danaher has suffered in recent months as investors adjust to a post-Covid world. 

However, in our view Danaher remains a world-class business. The Danaher Business System, which focuses on continuous improvement, has allowed the company to relatively quickly establish itself as a top-tier player within the lucrative life science and diagnostic tool markets. 

Filtering the noise 

Last year’s pessimistic sentiment towards the US economy has continued to unduly punish certain sectors, which led to us establishing a position in United Rentals. 

As the world’s largest equipment rental company, it has a roughly 17 per cent share of the US market. 

The market dynamics in equipment rental mean United Rentals is well-positioned to overtake its smaller competitors. 

We believe investor negativity is overdone in the context of the combined $2 trillion dollar tailwind of the Inflation Reduction Act, the development of the North America LNG infrastructure, the onshoring of semiconductor manufacturing, electric vehicle investment and the Infrastructure Bill. 

And just as we observed that Danaher was being overly punished as Covid-19 receded, we identified that Pool Corporation was being unfairly linked to fears surrounding the US housing market. 

Pool Corporation, which is the world’s leading wholesale distributor of swimming pool equipment and parts, saw its shares plunge by half from $566 on 31 December 2021 to $283 on 20 October 2022, yet most of its revenue comes from consumables and maintenance rather than relying on new installations. 

The share price is back to 2020 levels, although given Pool’s revenues are almost double 2019 with operating income having tripled, we believe there remains a compelling rationale for topping up our existing position. 

We have conviction that our bottom-up approach, which seeks to fully understand the business model and opportunity as distinct from market sentiment, is the key driver of the 10% annualised return of our sterling retail share class over the last five years to 30 June. 

Consistently adhering to the investment process is paramount. Applying this discipline will hopefully lead to continued success for the next five years and beyond. 

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