Taking a stake
The typical shareholder does not like underperforming companies. However, where he only sees loss of profits, others see an opportunity.
John Leach, chief executive at Hermes Focus Asset Management, says the idea behind Hermes' Focus funds was to intervene early in underperforming companies. "Analysis has pointed to bad governance as a cause of underperforming companies, but most pension funds do not have the resources to analyse governance in detail," he says. "And because we believe that active engagement leads to much better share prices, we started our Focus funds."
Hermes has four Focus funds, all with a similar universe: the UK Focus fund, consisting of FTSE350 companies; the UK Small Companies Focus fund, consisting of FTSE350 and AIM companies; a continental European Focus fund; and a joint venture activist fund with Japanese investment manager Nissay. Each fund contains an average of 15 stocks.
"It takes a lot of work to convince the management or the board of the problem, the urgency of the problem and potential solutions, which is why we have an average of two stocks per executive," says Stephan Howaldt, chief executive at Hermes Focus Asset Management Europe.
"We look at companies that appear sound, but have underperformed from a shareholder's point of view by 5-10% over a one-to-five year period in comparison with their sector peers," Leach says.
"First they are analysed bottom-up by our in-house research team," he adds. "Secondly we look at what the chances are of the market re-rating the company if we get the company to fix its problems. And then we decide how much of a shareholding we need to acquire to put ourselves in a position where the company board will listen to us."
Leach says his team does not work with other shareholders but ensures they are not strongly opposed to the actions it proposes.
"One of the advantages we have over hedge funds and private equity is that we are looking for sustained shareholder value, meaning that we will keep stocks in the fund for longer periods," Leach says. "We tend to average-weight rather than overweight the position and typically hold a stock in that position for two-and-a-half to three years because it takes us a while to build up the stake, talk to management and make a change. And because they are such unloved companies the market will often only re-rate the shares after several sets of numbers have come out."
The introduction of corporate governance codes in many markets over the past decade has helped the funds as it has created a framework of general improvement in the relationship between shareholders, management and company boards, says Howaldt. "However, it does occasionally feel that corporate governance goes in waves, especially in some continental European countries where shareholder rights have been used since their introduction," he says. "There will always be corners of the market where nobody has looked for a while. Current market conditions have created a wider spread between well-regarded and not-so-well-regarded companies so we have a bigger delta to work on."
Investor demand for the funds has been increasing steeply. "When the UK large cap fund started in 1998 it was 100% funded by the BT Pension Schemes," notes Leach. "However, today's BTPS only accounts for 20% of the funds under management, while 80% come from institutions such as other UK, US, continental European and Japanese pension funds, as well as a French bank and a university endowment."
"They like the funds because they are diplomatic in their engagement and because they add option value to the stocks over the long term," says Howaldt. "If we are successful the share price will go up, if we are unsuccessful it does not change much. That systematically helps performance and we often manage to consistently outperform although there will be odd years when we fail to do that."
Due to the concentration of stocks, volatility is very high in these funds, but Leach says this irons out over time. However, to mitigate this volatility some discipline is applied to the funds.
"In the UK large-cap fund, for example, we would not have any more than two stocks from one sector at a time. We would also not invest more than 15% of the fund in any one stock. We look at how we balance the portfolio although we do not scientifically set out to achieve that," says Leach.
The European fund - whose stocks are spread widely across Europe and roughly reflect the European Economic Area's market weightings - also tries to avoid an undesired overweight in styles and sectors.
Leach says Hermes Focus' expertise and experience - around 70-80 cases in the UK large-cap fund and over 40 cases in the European fund since inception - gives its engagement-only fund operations a competitive edge. However, as Hermes is considering launching a pan-European and absolute return fund, more and more competitors are arriving on the market.