US Equities: Style bias
Joseph Mariathasan uncovers a wide range of strategies among top performers in US equities
The elephant in the room for any European institutional investor is the US equity market: too large to ignore, and representing something much more than the US economy and US domestic demand. As Kevin Ng, client portfolio manager at Goldman Sachs Asset Management (GSAM) points out, one in three of the dollars capitalising companies in the S&P500 is sourced from outside the US.
Yet European institutions still struggle with setting an appropriate strategy for investment in US equities. While style has never been a particularly strong input into management of European equities, it can play a dominant role in looking at US managers. European investors, Paul Chew, CIO of Brown Advisory finds, tend to favour US value strategies over growth. In the case of his own firm, whilst the majority of US equity assets is in its growth strategy, Chew finds that it is the value strategy that European institutional investors have bought. This probably reflects the lack of experience European investors have with the tech sectors that have dominated growth investing in the US as well as perceptions of lower risk and higher dividends in value-oriented investments.
And although the US market is characterised by managers with a strong style bias, it is not clear today whether growth or value looks more attractive. Indeed, in this environment, attaching too much significance to the labels can be misleading as managers such as Janus - that could be labelled growth - find themselves investing in high-yield stocks. While some managers may choose to ignore style when constructing portfolios, others adopt a strong style bias, and some such as GSAM choose to run core portfolios by strictly allocating 50/50 to value and growth stocks, chosen by analyst teams themselves differentiated by style.
Janus is a good example of how style labels can be misleading. John Eisinger, manager of Janus Capital’s All Cap Growth fund, sees that one attractive group of stocks are those that offer high dividend yields as well as growth: “The market is not differentiating between the valuations of businesses that will grow at vastly different rates,” he says. “Buying growth stocks with high dividend yields offers both downside protection and the opportunity to participate in the growth of cash flows.” But it is not just high yield that growth managers like him are seeking, but stocks with high yields that should not be trading at those levels: “I do not differentiate between growth and value. Growth is one of the factors on the value of a business. A year ago, excess performance came from buying the cheapest companies. Today the opportunity is to find companies with more growth than expected.”
Not surprisingly, a year ago the fund was tilted to value, it now has a definite growth bias. The investment philosophy is based around the belief that outperformance over the benchmark can be obtained by investing in companies that are creating value through strategies that improve their economic profit margins but trade below their intrinsic values. What this translates to is a philosophy of looking for companies that trade below the value of their economic profits justifies. Here the economic profit margin is seen as the return on invested capital less the weighted average cost of capital and as such, it measures the firm’s ability to create, or destroy, value. One screen that they find useful in this analysis is the relationship between EPM and the ratio of enterprise value to invested capital (EV/IC). The latter measures the value or multiple assigned by investors to each dollar of capital invested in a company. Plotting one against the other for the S&P500 shows a high correlation, but companies that have high EPMs while lying below the trend line are worth looking at further. “This is just an overlay as 85% of the methodology is based around our analysts’ best ideas,” notes Eisinger. This approach is completely benchmark agnostic and with just 30-50 stocks, comparisons against benchmark weightings do not determine the fund’s holdings.
GSAM have a core portfolio that aims to balance value and growth styles, but as Ng argues, there are more similarities than differences in the type of companies they are seeking. “We are looking for companies with earnings improvements and for value. This would be through a recovery whilst for growth companies, it would be through growth in the business,” he says. The firm uses its 35-strong research team to sift through the universe to produce recommendations for the fund managers with a very bottom-up methodology. Every company selected is valued over 1-3 years, and the 40-50 growth stocks in the portfolio are selected on the basis of three factors: firstly, having a strong business franchises which means an established brand name, a dominant market share giving pricing power, a recurring revenue stream with good free cashflow and a high return on invested capital. Secondly, the companies should have favourable long-term prospects, which means having predictable and sustainable growth, long product life cycles, enduring competitive advantage and favourable demographic trends. Finally, companies should have excellent management, which means having rational capital allocation, a consistent operating history and incentives aligned with shareholders.
The 40-50 value stocks that make up the rest of the portfolio are selected using a combination of valuation metrics and understanding future prospects. They seek companies where uncertainty exists and the real economic value is not recognised by the market. A multi-faceted valuation analysis is undertaken that incorporates industry-based screens to identify valuation anomalies combined with detailed scrutiny of financial statements. To avoid value traps and ensure companies have quality, they need to have sustainable operating or competitive advantage; excellent stewardship of capital and the capability to earn above their cost of capital; strong or improving balance sheets; and cash flow. The analysis includes management meetings, analysis of competitors, suppliers and customers and identification of agents of change.
Roger Hamilton, US equity portfolio manager at MFC Global Investment Management, who is strictly a bottom-up stockpicker seeking companies trading at discounts to their ‘intrinsic value’, is also wary of style labels. The portfolio is built stock by stock without recourse to index comparisons. “We believe our philosophy helps us avoid paying too much for growth and helps us avoid value traps,” he says. “We are very flexible. One might say we end up with a ‘core’ approach, but we don’t specifically take account of style.”
What the firm does focus on is ensuring that there is a ‘margin of safety’ for the entry price into any investment — and in the nature of the business itself. This could be barriers to entry, or strong balance sheets and high recurring revenues. “We had a lot of energy companies in 2007 when oil was trading at $60-70/barrel,” says Hamilton. “While we focus almost exclusively on individual companies, with the marginal cost of production at $75, we felt that gave us an additional margin of safety.” What they also seek are catalysts for change that will ensure exceptional returns. Quant screens such as valuation metrics are used as an adjunct: “Let’s say hypothetically that Apple has had a P/E ratio that has traded between that of the S&P500 and double the figure, so when it has traded close to the S&P500 valuation, it may be cheap. The metrics may put a company like Apple on our radar. We did, in fact, buy Apple. The stock was on sale because of fears of CEO Steve Jobs’ health. In addition, we believed that even if Jobs had to take an extended leave of absence, the catalysts were that the company had many revenue levers to pull to keep growth strong for years to come.”
Another example is Microsoft, which MFC bought in 2008, believing the sustainability of its cash flows was much greater than the market was giving it credit for because they are so entrenched in the enterprise space. “At the time, they were talking about launching the cloud computing platform, which they were calling Azure, and last year, they rolled out the product line,” notes Hamilton.
Taking such high conviction positions is not without risks. MFC’s holding in Qualcomm, a provider of technology for 3G mobile phones, fell 10% in April. Nevertheless, Hamilton is still excited about the company: “This is a case where we get to use volatility as an ally. We are buying a company we like at a lower price. Mobile phones have been sold at lower prices than we modelled, but there is a good tailwind for the firm. As 3G and 4G phones are rolled out across the globe, Qualcomm will do well out of the royalties.”
Some companies have an approach that leads inevitably to a strong style bias. Sands is a good example of a company with a highly structured approach to investing with a growth style. As CIO Frank Sands explains, whilst emerging markets see growth through the rapid increase in middle income households that are then able to move up the consumption ladder, looking for sustainable growth in the US means looking for companies that grow through innovation. “We believe that we have seen a systematic under-appreciation of that innovation,” he says.
The firm has six criteria to select businesses that they wish to invest in. Firstly is sustainable above-average earnings growth - the projected earnings growth of its portfolio is around 21% pa whereas the Russell1000 Growth universe has an average of around 12% and the S&P500 around 10%. For Sands, this means businesses with high visibility and broad suite of products rather than a single product entity. He picks Qualcomm as a good example, picking up royalties indefinitely from 3G telephony technology which is licensed globally. Second is a leading position in a promising business space: Sands sees Amazon as the epitome of this, with not just a predominant position in e-commerce, but creating massive retail innovation on a global scale. Third is significant competitive advantages. Here Sands picks out Intuitive Surgical, a company specialising in robotic surgery with essentially no competitors, which Sands topped-up on during Q4 2008. Fourth is excellent management with a clear, common-sense plan of execution. Fifth is financial strength and transparency around revenues: “We never bought Goldman Sachs as whilst it is a great brand, we could never figure out the business model,” says Sands. Finally, there have to be rational valuations relative to the broad universe of stocks, relative to the businesses specific peers, and relative to the strength in conviction that they have on the businesses future earnings.
There are many arguments over whether style is so powerful a driver that firms would find it difficult to offer both value and growth products. Brown Advisory does, but Paul Chew admits that they are not deep value or extreme growth portfolios. Brown is another bottom-up stockpicking firm built on fundamental investment research. But whilst its analysts are expected to offer suggestions for both growth and value portfolios, Chew finds that he has to recognise that many analysts would have a bias towards growth or value. The four tenets of their approach are first, that fundamental research is the way to analyse attractive businesses; second, that portfolios need to be fully diversified across all sectors; third, that portfolios need to be concentrated across 30-40 names; and last, regardless of style, valuation is the key to success. Its portfolio turnover of 30-40% is modest relative to most firms: as Chew says, “Our goal is to invest in companies that we never have to sell.”
Value stocks are chosen on the basis of finding high quality businesses that are facing short term disruptions. Chew picks out Medtronic, a leading producer of heart pacemakers which has had some problems with connection leads to power supplies. “We spent time with the company understanding what the strategy for dealing with this was and as a result, added it to our value portfolio, despite that fact that it was usually seen as a growth stock,” says Chew. With growth stocks, the objective is to buy stocks at attractive valuations that are able to grow their earnings at a rate of at least 14% pa, double the 7% seen in the S&P500. Few firms can do this indefinitely, so despite Chew’s hope to keep a firm forever, only Cisco, still held after buying it in 1995, comes close to this ideal. As Chew explains, Microsoft, Dell, Intel and Cisco were the four horsemen leading the tech boom but each took a different part. Microsoft had a business model that focussed on just growing the business, but every investment it made was destroying shareholder value. Then it realised it had to start paying dividends instead and is now part of Brown’s value portfolio. Intel essentially did nothing and became a mature company. Dell has not been able to adjust its business model to the changing environment. In contrast, Cisco managed the company during the hypergrowth period and then during the downturn it switched from focusing on growth to operating margins. Now it finds itself in an environment where growth is returning: “The CEO’s management of the firm could be a textbook Harvard Business School case study,” says Chew.
As for the macro picture, close-to-zero interest rates stoking up the equity markets make any investment decision look dangerous. Yet for long-term investors, after the rally in corporate bonds, the yields still available on high-quality US blue chips can appear attractive, and huge rallies across all other risky assets certainly do not make them look any more attractive. It is not surprising that Chew, returning from a European marketing trip at the end of April exclaims: “This is the first time in six years that European clients we have spoken to would rather be invested in the US than in Europe.” Uncertainty over Greece and other debt laden European economies may have cast a cloud over prospects for European equities, but the US also has a mountain of debt. “I am not sure that the government is willing to take the medicine we need to live in a world of 1.5% GDP growth - that is not the way to get re-elected,” he adds. “But if we continue along the current path, the debt will pile up and eventually lead to higher interest rates.” For European investors looking at their global equity asset allocations, that may still be a risk worth taking, in some measure at least.