Backing the Underdog

September 2010

The financial media constantly tells investors that in volatile markets, they need to pick the best companies with the strongest balance sheets – which is sort of like backing Italy in a World Cup soccer match against New Zealand.

Given New Zealand had only qualified for the World Cup once before (in 1982) it was no surprise that most fans picked top-ranked Italy as the favourite to win the pool match against the Kiwis who were ranked 78th.

As it turned out the All Whites’ one-all draw with Italy (and exit from the competition as the only undefeated team) was one of the biggest upsets of the World Cup.

In investment terms, the Italian side was a growth stock - very familiar, highly popular and with a good track record. These solid prospects, however, were reflected in a lower than expected return compared to the Kiwi team who, being largely unknown and untested, were a risky proposition that offered higher than expected returns as compensation.

Online betting surrounding the World Cup is an example of a highly competitive market where information is quickly incorporated into prices. To make a consistent profit on your bets it is not enough to know who the best teams are, you also need to know how the odds that are offered are “wrong”.

Taking a bet on a “sure thing” is still no guarantee of a return. The fewer bets you make, the more you leave yourself open to specific events that can blow your strategy apart.

Australia’s BRW magazine recently put together a list of “10 Must-Have Shares in a Tricky Market”. It included picks that “provide a mix of balance sheet strength, exposure to upside growth potential and an ability to weather any further erosion in economic conditions”.

The chosen stocks were solid, well-known, highly reputable, blue-chip companies with good prospects, but does that make them good investments?

Building a portfolio around glamour blue chips (the equivalent of Italy’s soccer side) often means accepting a much lower expected return for the supposed surety they provide. A good company is often priced at a premium to the market.

It’s best to diversify your portfolio, accept that good prospects are almost always in the price already and understand that low prices relative to fundamental factors mean higher expected returns. The mix of “good” and “bad” companies in your portfolio will depend on your appetite for risk.

Using the World Cup analogy, you may have to accept that you need both blue-chip Italy AND value New Zealand in your portfolio.