I was reviewing our company financial statements recently. We are facing the board soon so I need to make sure I have a firm grasp on the numbers. Most business owners will agree that 2016 has been a tough year. The economy has practically stalled, and consumers find themselves under increasing pressure. The heightened levels of uncertainty are affecting business and consumer confidence and negatively impacting purchasing and investment decision making. The result is that businesses are struggling to meet revenue and profit budgets. Our company is no different.
However, I was surprised to see that despite being behind on revenue and expense budgets, we were not as far behind on profit estimates. Our saving grace has been the investment portfolio we set up for the business about 4 years ago. Had we not established that portfolio we would have been almost 30% below profit estimates! This line item on the Statement of Income and Expenditure was the one stand out feature, and an item that I have not really noticed in the past when things were going well.
As a financial planning business our performance is inextricably linked to the South African economy. A slowing economy has a major impact on our business. With this understanding, we sought to mitigate this risk, and built of portfolio of investments that would yield a return profile different to that of our business. It was only this year that this decision has yielded results. When the economy and the markets were growing well, we did not need the portfolio to perform. In the declining market that we now have, it is adding over 25% of the profit that we are expected to produce this year.
Our investment journey
Our initial strategy was to build a portfolio that was liquid and that we could access at short notice, but that would yield a higher return than that offered by the banks. Our current account at the bank offered no interest, and we were required to give up liquidity to earn a return. As a young and growing business we could not afford to go without liquidity. As the business grew and started to produce more cash, we soon reached a level where we had a high enough cash reserve. With additional funds that followed we invested in higher risk investments with better return prospects. We also diversified away from South African focused investments.
How does an SMME practically go about creating an investment portfolio? The first thing is to find a competent, appropriately qualified and experienced adviser. We are a financial planning business and have created such portfolios for many of our SMME clients. It is important that you build a long term relationship based on trust. From a product perspective a portfolio of unit trust funds should suffice. Unit trusts are able to accept relatively small amounts, and have the flexibility and liquidity needed by businesses over time. They can also be cheap which should equate to higher returns for the investor. Investors should interrogate costs and ensure that they are paying a fair fee. Typically fees range from 1% to 3.5%. A well-diversified portfolio should cost between 1.4% to 1.7% (plus VAT) including advice, administration, and asset management fees. The portfolio will likely be on an administrative platform which allows the investor to invest in the funds of different asset managers.
Investing for yield
The most common investment strategy we put together for SMMEs is a low risk, yield enhancing portfolio. This portfolio is suitable for funds that may need to be accessed at short term notice, but could be invested for as long as 2 years. In business things do not happen quickly, or as planned. So it is important that the investment has the flexibility and liquidity so that the investor does not have to be changing strategies too often. Below is the historical performance of a typical yield portfolio relative to a bank money market investment.
The portfolio has delivered better returns than a money market investment, and with high levels of liquidity. It is important to note that there are numerous 6 month periods where the portfolio underperforms the money market, so it is important that the investor is able to invest for at least 9 – 12 months.
Investing for growth
Investing to earn a higher return requires the investor to take on some investment risk. The best way to manage risk is to have a well-diversified portfolio and to remain invested for a long period of time. From a practical perspective we have chosen to invest in a growth portfolio on a monthly basis, and make ad hoc contributions to the portfolio. Below is the historical performance of a typical moderate risk portfolio similar to the one we created for own company. This time it is benchmarked against the JSE.
While it has underperformed the JSE since inception, it has delivered returns at much lower levels of risk. It protected capital much better during the financial crisis of 2008/09, and has lower volatility. The end result is a similar return, but much lower risk.
While the primary aim for most business owners is to generate income from their normal business activities, it is prudent to diversify and reduce risk in the business. During the good times it is hard to imagine that things will get worse, but it is those that take action then to prepare for the tough times ahead that are usually able to make it through those tough times. It is easier to do so than most SMMEs realise.