Quality meltdown

Inflation has been consistent theme in my posts for a while now, to the extent that it has become rather boring to talk about. However, it is unfortunately still the most important macro issue at the moment and the signs of how disruptive and persistent its effects might be are getting worse. Central bankers are starting to express concern that it might be less transitory than they hoped and asset markets have reacted badly with yields rising again and equities resuming their rotation from growth to value. Last week was pretty dire for my portfolio (down around 9%) as many shares turned down at the same time.

Having become more optimistic, or perhaps complacent, about inflation concerns and their effects on the stock market, I’ve had a reality check. That causing large scale disruption to the supply side of the economy while propping up the demand side with huge sums of money might lead to the sorts of problems we are seeing was not especially hard to predict. I’ve been considering this as a likely outcome for at least a year. The challenge has been that it has taken a long time to play out. I had taken some small steps to diversify my portfolio towards some cheaper stocks but didn’t have the conviction for a more decisive shift. In hindsight I could probably have played this better, perhaps by holding more cash or switching my strategy more decisively, but these would have been difficult calls to take. I think the reality is that you just have to accept periods of underperformance from time to time. This is clearly not a great time for quality investing but drastically switching strategy has its risks too.

How best to go from here? I had already been taking some profits from some of my more highly rated holdings and on Friday I decided to raise cash more broadly from across the portfolio, selling about 25%. With the market looking weak but not yet having fallen far, supply chain issues and inflation looking likely to get worse before they get better and higher rated quality shares still looking relatively expensive, the risk of further falls seems fairly high. My recent track record for this sort of market timing decision isn’t great but I feel it’s only a matter of time before one of these small corrections turns into something worse. Having a small but significant proportion of cash available carries a psychological benefit as it means I’m more ambivalent about whether the market falls further and can stay on the front foot. I intend to see how things play out over the next month or so before deciding whether to reinvest.

Another reason for the hit to my portfolio last week was that Boohoo was hit by profit warning. I had been getting a bit apprehensive about the likely impact of supply chain difficulties on Boohoo’s results in advance and reduced my holding a little, but in hindsight clearly not enough. Even then I was disappointed by Boohoo’s results – cost increases I anticipated but demand was also much weaker than I was hoping. The shares now look decidedly cheap but the risk that full year results are also disappointing seems high. Given this, I decided there was insufficient reason to go against my default approach of selling in response to the profit warning.

I also decided to sell out of AO Smith and replace it with IGG. The rationale is straightforward. AO Smith looks exposed to the sorts of supply chain issues that have been causing so much havoc of late. IG Group looks very cheap, its last results were better than I feared and should benefit if volatility continues to pick up.

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