Global equities: maintain concentration

Hamish Douglass, lead portfolio manager for global equities at Magellan Asset Management, isn’t afraid to shoot from the hip. “Fund management firms running benchmark-aware strategies don’t have a value proposition going forward,” he declares.

Many would agree that he has a point. Seeing that index funds and ETFs provide cheap beta, why pay extra to generate mainly beta exposure? Furthermore, many of the best-performing global equity managers over the past few years have been boutique managers with essentially unconstrained, absolute-return strategies, often with very concentrated portfolios - the antithesis of the index-plus strategies that asset gathering machines, with one eye on their own business risk, tend to adopt.

A global equity index, for example, does not represent the minimum-risk portfolio for any institutional investor, so while they may see an index benchmark as the tool with which to measure managers’ performance, the tendency to stipulate tight tracking errors might be counterproductive to their own interests. Running concentrated portfolios does enable talented fund management professionals to focus on where they believe they have real expertise. But there are also many downsides. Warren Buffett and Charlie Munger of Berkshire Hathaway are often quoted as the role models, but firms still have to differentiate themselves by adopting something beyond the Buffett mantra of choosing ‘strong castles with a deep moats, preferably filled with sharks’.

One man’s sustainability….

Perhaps one of the downsides can be seen in Morgan Stanley Investment Management’s Global Franchise strategy which, as Bruno Paulson admits, takes Charlie Munger as its inspiration in the search for quality value companies. Of its 27 stocks, four are tobacco companies - an industry that is not capital intensive but which enjoys a virtually impregnable moat, given the almost total elimination of the advertising that might boost new competitors. While sales are steadily declining in developing markets, they are growing at 3-4% a year in the emerging markets (where BAT now gets 60% of its revenues). As 80% of the price of cigarettes is tax, and tax increases are frequent, these companies are able to raise their prices and increase margins regularly.

“So what you end up with are businesses growing revenues at 4-5% a year and increasing margins at a very attractive 7-9% free cashflow yield,” explains Paulson.

A less controversial example of MSIM’s approach is its holding in Nestlé. “If you own Nestlé, every year you are pretty sure to grow 5% bigger and generate 5-6% free cashflow, giving a predictable 10% plus underlying return,” he says. Indeed, he points out that Nestlé’s annual growth rate over the past two decades has been remarkably steady at 3-7% every year, with margins of 12-15%. “If I tried to write the P&L for Nestlé for the next 5-10 years, I wouldn’t be far off.”

Nestlé has been in Paulson’s portfolio since 1996 and he sees only two reasons for selling this kind of name. Firstly, management misbehaviour breaking the model - for example, by making big acquisitions or cutting back on advertising expenditure. “The latter, in particular, would be an indication of pandering to the analysts’ focus on short-term earnings,” he says. And secondly, of course, if valuation becomes too expensive - for example, free cashflow yield falling some way below 5%. “We are sitting here with the most reliable cashflows in the world at three-times the free cashflow yield of US treasuries,” Paulson reasons.

If Nestlé’s sustainable high returns on capital are in, banks, insurance companies, utilities, energy companies and mining companies are generally out. The team usually cannot find the right combination of quality and value in emerging markets, either - although over 30% of the aggregate sales of their portfolio companies are to emerging markets. Pharmaceutical companies meet the requirement of high returns on capital, but the returns are generally not sustainable once patents run out.

Tech features if returns are sustainable: the portfolio includes Microsoft, although not Apple. “Microsoft may be under pressure with tablets and phones and the growth of the Apple ecosystem, but the Windows business franchise will not disappear overnight,” says Paulson. “Microsoft is also strong on the server software underlying cloud computing. In contrast, Apple is all about the new, continuing to delight customers with radical creations. They are very good, but we look at how sustainable this is long term.”

Consumer staples are the most natural sectoral fit to MSIM’s strategy, and indeed they constitute two-thirds of the portfolio. But the price has to be right, and in the current environment some of these names are over-loved. “At 20-plus times free cashflow, down from 50, Coca Cola’s too expensive for us,” says Paulson. “The quality is okay, but not the price.”

…. is another’s ‘sin’

One of the few benchmark-oriented funds that has performed well on a three-year horizon relative to the best of the concentrated portfolios is perhaps the antithesis of the MSIM strategy. Legal & General Invesment Management’s (LGIM) Ethical Global Equity index fund tracks the FTSE4Good Global Equity index, which includes all companies within the FTSE Global Equity index that comply with a set of ESG requirements. That reduces the number of companies from the 2,000 or so in the global index, to around 780, almost 30 times more companies than Morgan Stanley.

While LGIM’s strategy is a passive index-tracking approach, a team of six covers ESG issues - which can be controversial and something of a moving target. Not surprisingly perhaps, the criteria for sector exclusions have evolved with time.

The five original exclusions were tobacco, weapons, nuclear power, infant formula and uranium mining. Excluding any company associated with nuclear power seems harsh if not bizarre today since, as Andy Banks, head of corporate governance, explains, it means that even an engineering company supplying a nuclear power station would have to be excluded. The infant formula exclusion clearly reflected the Nestlé boycott that spread in the US and Europe in the early 1980s the firm’s promotion of breast-milk substitutes in developing countries. We begin to see what an excellent diversifier this fund would have been against the MSIM portfolio. Indeed, while the MSIM fund is a top-five performer in the Mercer universes over both three years and one year, LGIM’s portfolio has found itself near the bottom of the league on the ‘flight-to-quality’ 12-month horizon.

The strategy is not as exclusive today: the sector list has been refined to just weapons and tobacco. But eligible companies must still meet requirements in five areas: working towards environmental sustainability; upholding and supporting universal human rights; ensuring good supply chain labour standards; countering bribery; and mitigating and adapting to climate change.

The absence of a company from the index does not necessarily mean that it is not complying with the criteria; companies must not only be complying but also be able to prove that they are complying. The oil and gas sector underweight is a good example of the principle: “Whilst the bigger companies have demonstrable policies in place, the smaller companies are less transparently good,” notes Banks. There are other biases evident in the portfolio. For example, perhaps reflecting greater interest in Northern Europe around ESG, the US is underweight by 12% while the UK is overweight by over 6%.

Macroeconomic

On this evidence, concentrated portfolios appear to be the better bet through good times and bad. But Magellan’s Douglass (whose portfolio contains 25 stocks) does note some potential downsides. Many boutique firms do not focus enough on macroeconomic risks that can be highly damaging to less-diversified portfolios, he observes. By contrast, both Magellan founders - Douglass and Chris Mackay - previously worked in investment bank M&A and corporate advisory, and their approach relies heavily on combining a Buffet-style value strategy with an integration of macroeconomic risk management. What really differentiates them is their preparedness to move to cash when necessary.

On 19 September 2008, four days after the Lehman bankruptcy, the largest money market fund in the US froze withdrawals. Douglass, Mackay and the lead financials analyst at Magellan held a conference call, following which they sold all of the fund’s banking stocks and went 30% into cash. Again in April 2010, Magellan went 12% into cash. Today it remains fully invested. The European sovereign debt crisis - the most significant top-down stress at the moment - will not result in Armageddon, Douglass maintains.

“We believe there is a very low probability of a Lehman-type event as, if it does occur, it would be absolutely catastrophic,” he says. However, liquidity issues for countries such as Spain and Italy could become solvency issues if bond yields are driven to such high levels that they cannot borrow. Douglass sees two solutions. The nuclear option is for the ECB to start printing money to buy the bonds. The second, more likely option, is for the European Financial Stability Facility (EFSF) to become a new sovereign bank with enough firepower and the mandate to buy the bonds. In this event, Douglass sees equity markets doing well.

While Magellan is therefore fully invested, it has positioned its portfolio defensively in predominantly consumer staples and consumer discretionary brands such as Coca-Cola, Nestlé, Unilever, Procter & Gamble and Yum!. The latter has 50% of its revenues in emerging markets, 40% in China where it has the franchises for KFC, Pizza Hut and Taco Bell. Non-consumer stocks include eBay, Google and Visa; Wells Fargo is the sole financial. Currently Magellan has no direct investments in emerging markets: “The issue for us is the much higher beta of most companies in emerging markets,” explains Douglass. “The companies we are interested in tend to be very highly priced at the moment and we see multi-nationals as being better priced.”

While Magellan’s is a classic approach to managing macro risk, another is the thematic investment style as pursued by Platinum Asset Management (PAM) in its global unhedged fund. As investment specialist Andrew Grimes explains, Platinum’s approach uses both quant screening, as well as the exploration of investment themes to define a universe of stocks that the team of portfolio managers and analysts can subject to more detailed fundamental analysis.

Current themes include: diversification into gold (an allocation to gold mines is seen as a leveraged play on the gold price in the face of deteriorating economic conditions); energy and selected commodities (positions in Shell and the engineering companies that supply oil companies represent a play on dwindling resources); Asian financials (to participate in increasing demand and sophistication, with companies such as Bangkok Bank that have a large deposit bases and few credit issues); demand for increased bandwidth (which translates into a positions in names such as Cisco in the tech sector; PAM sees demand for bandwidth increases favouring companies such as Cisco); bio and pharmaceutical sectors (where the firm sees many companies engaged in work whose far-reaching implications are not yet fully understood); and price makers versus price takers (which favours companies with strong brands which can charge premium prices, like BMW, Adidas and Pernot Ricard, against those trading commoditised goods and services whose prices are dictated by the market).

Grimes explains that themes that are well understood are usually reflected in the prices. Battery technology is a case in point. “Two years ago, there was a step change in technology by Chinese manufacturers whose stocks became overpriced,” he recalls. “So we tried to find areas of the supply chain that were neglected and the market had not piled in - such as a couple of Japanese suppliers. It does not matter who wins the battery war, as the Japanese suppliers supply them all.” Another example is the Chinese domestic consumption story, which has had a material impact on the success of BMW.

Capacity

Another issue that can affect concentrated portfolios is, of course, capacity. Tradewinds Global Investors, for example, has closed a successful global equity fund at just $10bn, according to client portfolio manager, Michael Mullane. Its fundamental bottom-up value strategy applies a corporate finance perspective that emphasises absolute valuation, in addition to extensive cash flow and balance sheet analysis. Its approach is to identify companies with strong or improving fundamentals, sustainable competitive advantages, industry leading positions, and so on. Tradewinds also requires a favourable risk/reward and downside protection in a portfolio context. It has around 80 holdings and monitors 300 or so companies on an approved list selected by its 14 industry analysts.

What are favoured are companies trading at a discount to the replacement cost of their assets. As Mullane explains: “In the gold sector our analyst did a mine-by-mine analysis of where the gold price needs to be for the mine to be profitable and we can then work out the intrinsic value of the mines. For Barrick and Newmont, we can buy these at a significant discount. Similarly, you would need to spend a lot more to build nuclear power stations in Europe than you can buy them through EDF.”

Tradewinds’ portfolio has a 20% exposure to Japan but is very underweight US and UK: “Focusing on value and undervalued companies means that the portfolio can perform well on the downside. If you buy at a discount, the stock will fall less when the market falls. The UK is made up of bunch of very large multinationals which we would buy at the right price but there are better opportunities elsewhere.”

Going for concentrated global portfolios can certainly throw up some interesting fund managers. Deciding which will survive and prosper over the long term through the ups and downs of a few business cycles might be the challenge.