European equities: Never out of style
Managing European equities has to be about avoiding style biases, finds Joseph Mariathasan. He speaks to five managers who have squeezed alpha from very different markets with very distinct strategies
Finding a competitive advantage in European equities is far tougher than in US equities - but that is not because the equity market itself is more efficient. It is because European institutional investors, the predominant investors in European equities, are very different to their US counterparts.
The US has a much more developed capital market, it is larger in size and has more depth in asset management, so there is much more scope for specialisation by fund managers to create competitive advantages over the long term. In the short term, however, there can be considerable volatility associated with specialist approaches, and so large investors typically have a portfolio of managers allocated across many styles. "But in Europe, institutional investors typically make more general allocations to equities, cash or bonds," says Adrian Darley, European investment manager at Ignis Asset Management. "The pots of money are usually not large enough to allow the degree of granularity seen in the US."
Since most clients will not tolerate persistent underperformance a fund manager will have no business left if it sticks too rigidly to a single style. Even in the US, Darley argues, the growth of passive managers such as State Street and Vanguard has been driven by the underperformance associated with style-biased managers. "What people want is consistent outperformance with low volatility. Strong style bias will not deliver that," he says.
Finding a competitive advantage in Europe through an investment process therefore requires something very different from a style specialisation, and which allows the flexibility to adapt to changing market conditions. This is true for both the bottom-up pure stock pickers and for those managers with a top-down approach.
The Ignis European team is an example of a traditional bottom-up stock picker that ultimately seeks to find competitive advantage through relying on the experience and expertise of its staff. Darley argues that few firms were recruiting during the 2001-03 bear market, so there are now a lot of investors and analysts with fewer than five years' experience attempting to add value in an increasingly challenging investment environment. "We often share management meetings and many of the questions asked by competitors won't add to investment thinking," he declares. "Questions we ask are always focused on the key issues that we believe will drive share price development."
An example would be granularity on restructuring plans. For example, if a company is saving €1bn in costs, where are the synergies going to come from and will they be able to keep those cost savings into the future if, say, half of them can be attributed to cancelled capex? Darley makes the point that the more experienced fund managers generally have a far better understanding of which issues are already discounted in a share price.
As head of a small team of three with more than 40 years' experience in continental European equities, Darley describes his team's approach as pragmatic GARP (growth at a reasonable price). This does not fit stylistically into any box, with Darley arguing that getting stuck in a growth or value niche would have been very hazardous in many of the past 15 years. "Style is now clearly seen [by clients] as secondary to genuine alpha generation," he says.
Darley argues that Ignis team's success in both 2008 and 2009 - two very different environments - is evidence of the soundness of its approach. Initially it focuses on the largest European companies - although the portfolio tends to be overweight small and mid-caps. "If we get Roche and Novartis badly wrong, it's a real hurdle to outperform, so a core 50-70% of assets are invested in high quality growth stocks that we view as undervalued," explains Darley. These are supplemented with 20-30 mid and small-cap holdings reflecting a number of themes, including growth, restructuring and even value. "Examples include Julius Baer, Nutreco, a global leader in fish and animal feed, and Tiscali, which has changed management and refocused on Italy, competing with the sleepy Telecom Italia."
Free cashflow and revenue growth are a key focus. As Darley points out, cashflow is not just a value metric since the best companies generate sufficient cash to reinvest in growth while also rewarding investors with growing dividends and share buybacks. Those companies relying on cheap finance to grow usually run into trouble. "If a company has poor free cashflow, we spend a lot of time with management asking how they can improve and, if not, how they expect to expand, because otherwise the shares are likely to be a value trap for investors," he explains. It is not led by top-down themes as it believes it possible to have good companies in poor industries - such as Arcelor Mittal and Ryanair - as well as bad investments in growing industries.
BlackRock's European Dynamic fund has a slightly different twist on strict bottom-up. As portfolio manager Alister Hibbert explains, its approach is geared to reconciling two competing goals: first of all, the idea that any trades will only be undertaken after a great deal of analysis and thought; and second, the need to move quickly. The European team builds on the research of the group, to produce five-year historical metrics for the 60 or so stocks in the portfolio. Ideas are generated using a set of quantitative screens looking at value and growth as well as customised areas - such as the Scandinavian consumer, for example, who is seen to be very active currently.
While this combination of quantitative screens and qualitative analysis is not unusual, the approach to trading arguably is. Although the holding period for stocks is 9-12 months, the turnover of the portfolio is 200-250%. As Hibbert explains: "What you see is an aggressive strategy in resizing positions." The size of holdings moves up and down reflecting the trade-off between longer-term strategic rationale for holding the stock, and shorter-term tactical positions.
Hibbert gives as an example UniCredit Group, bought to give a 2.5% overweight when Q1 2009 earnings figures were released and the team could understand the extent of non-performing loans on the balance sheet. By the time Q3 earnings had been released, they could see the company had done well (confirmed at lunch with the CEO), so they increased to a 5% overweight. But three weeks later it was back at 2.5%. As Hibbert says, the rationale for this type of trading was simply that the first 2.5% holding represented a long-term view based on their analysis and templates, with the extra based on views that there would be positive catalysts in the next three months. Once these had occurred, the position was brought back down to the long-term core holding. Such an approach, Hibbert argues, gives more upside potential than the benchmark but with less downside risk.
RCM is another bottom-up firm without a strong style bias. But there is no doubt about where it sees its competitive advantage. As well as having a 65-analyst research department, RCM also owns Grassroots Research, which commissions investigative research around concerns from portfolio managers and analysts about company or industry-specific issues.
Neil Dwane, RCM's European CIO, cites a typical example - how well European supermarket groups such as Tesco and Carrefour are doing in Asia. "Sitting in London, we cannot tell," he says. So RCM can ask one of the Grassroots personnel sitting with the research team to formulate a hypothesis and contact freelance journalists and researchers in Asia to undertake the field research and write a report. "We hand that back for affirmation or non-affirmation of a hypothesis and figure out whether if it was more widely known, it would move the share price. We can also use it to challenge management."
One discovery made through such research was that Tesco's Asian operation was not selling anything from its top shelves because they were too high. "We were pleased to find that management had already noticed this," says Dwane. "They were undertaking a store redesign, so that gave us confidence that the management understood their customers."
RCM conducts 350-400 Grassroots studies a year, which analysts use to supplement their own bottom-up research to rank stocks in the sectors they cover from one to five, with stocks ranked four or five selected. All the recommendations are monitored so that the performance of the stocks with a ranking of five should be better than that of those ranked four, and so on. "In 2009 there was a ‘trash rally' in the second quarter, so we did not expect our analysts in aggregate to do well," explains Dwane. "As a fund manager, we need to know there are times when the process will work and times when it will not and hit hard when the process is working."
In contrast to the managers described so far, Neptune Investment Management's process is very much driven by top-down global industry-sector analysis. As well as a team of fund managers and analysts, led by founder Robin Geffen and head of research Chris Taylor, Neptune also has an economics team helping to provide an economic overlay around its global sector process. The economic research looks at social, political, economic and capital market factors. It summarises this by a global matrix of countries and sectors that ranks the attractiveness of each sector in each country, based on fortnightly discussions between the economic and the fund management teams. The fund managers are then guided to the stocks worth analysing in much more detail for possible inclusion into the portfolio.
The European portfolio has 30-50 holdings, each between 1% and 4%, so that any stock rising above 4% is automatically cut back. That limit can give rise to turnover of over 100%, but the majority of the portfolio is kept for 3-5 years and if market volatility is low, turnover will be low. Turnover has been higher during the past two years due to a need for more active management in the challenging market conditions.
The process proved itself during the financial crisis, when the firm recognised the macro-economic factors that were affecting the banking sector, says Paul Broughton, head of continental European business. By August 2007, the firm had no exposure to financials until the end of Q1 2008 when, just following the demise of Bear Stearns, it bought ETFs in banks and insurance as well as UBS as a risk-control measure given the risk/return profiles that it saw for the sector. That position was held for just three weeks before being closed out.
While pure bottom-up and top-down approaches represent two extremes of a continuum, Nordea has found a competitive advantage through an approach that Charlotte Winther, head of Nordea's European equities, claims is different from that of 95% of other asset managers.
Nordea uses what it describes as a thematic approach to building its concentrated portfolio of around 35-45 stocks. The background to adopting this strategy was quite simple. During the 1990s, it was asked to manage global equities but had scarce resources to cover the world. However, at that time, there was a very country focused approach to investment. "We discovered that themes moved from one country to another in whole regions," explains Winther.
She herself covered the UK then and gives, as an example, the introduction of barcodes by supermarket chain Sainsbury, which led to a large productivity increase. "We took that knowledge from the UK and applied it to French supermarkets such as Carrefour which was considering using the technology," she recalls. "This would impact their earnings but was not reflected in their share price at the time."
The world has moved on since then and the market outside emerging Asia and Latin America is now much more sector-based. But Winther argues that very often, sell-side analysts and industry consultants look at sectors from a regional perspective, with one person covering, say, European banks, another focusing on the US and someone else looking at Asia. Winther sees Nordea's competitive strength as its ability to look at the world using a thematic structure across regions and sectors.
"We can get information and use that information in a better and more efficient manner," she argues. Nordea typically has around a dozen themes with the three largest - emerging consumer, industrial renaissance and environment and resource efficiency - accounting for around 50% of the portfolio.
Each theme gives rise to individual thematic strategies. For example, the emerging consumer theme holds that the global urbanisation process leads to significant trends in consumer behaviour. Around two billion people are in the middle of urbanisation. "This is not just China and India, but also Latin America, Eastern Europe and Africa," notes Winther. "Consumption patterns change in this process, with a pyramid of the largest number at the earliest stage of urbanisation, moving from unprocessed food to processed - from rice to corn flakes, for example.
"In the second tier, areas such as healthcare, skin cream and electronic equipment are taken up. And in the third stage, we have areas such as consumer finance, and travel. Further up the pyramid, areas like luxury goods become part of the spending patterns. It is not a given at each step of the pyramid, whether it will be a local or a global company that takes market share. At each stage you can find both local and global players. We find European companies in Asia and Latin America that are beneficiaries."
Each of the firms described has managed to find a competitive advantage in a different way, without resorting to a style niche which, in the European context, can become a tomb when the style is out of favour. But the future is still very uncertain. As Dwane argues, money has been very cheap and investors have had few attractive places at the margin to invest in, so risk assets are finding support. Dwane does not see a V-shaped recovery: "The market is getting carried away with a recovery, but the only sectors doing well are those with a massive government subsidy." The question he poses is, how much are fund managers paid for the short term and how much for the longer term? The next year may provide an environment where that question may be key.