Fay Ren compiles a glossary of questions asked in recent investor meetings and the related answers.
Would you discuss your idea generation screen?
Our permanent source of ideas is a screened universe of companies. We narrow the global universe of publicly listed companies by applying liquidity, size and profitability parameters. We also exclude banks, energy and basic materials companies given the leverage inherent in the former and commodity price sensitivity of the latter two groups. This screen provides a list of approximately 500 companies which are qualitatively reviewed for Global Leader characteristics. This list is not restrictive and analysts are free to generate ideas from multiple sources, however the screen ensures there is always a ready supply of ideas to work on.
Do you have positive ESG filters?
We anticipate holding our companies for very long periods of time and therefore look for those businesses which embrace sustainable practices. While we have not set ethical screens, we have found that our positive screening rules out many of the sectors most associated with ethical screening, for example, our growth criteria rule the tobacco companies out of consideration.
Do you invest in utility companies?
We do not invest in utilities as the characteristics of the companies and the industry do not meet our criteria. While the companies offer attractive cash generation prospects there is often a lack of controllable growth and levered balance sheets. The parochial nature of the provision of utilities also means a lack of companies of a truly global scale. Finally, we are uncomfortable investing in circumstances where returns are dictated by governmental regulation.
Would your sector exclusions change if the characteristics of the sector changed?
Our exclusions reflect issues we believe are endemic within the structure of the industry. For example, the leverage component within the modern banking model. As such, should these issues no longer be relevant, a substantial shift away from the status quo is likely to have occurred. Nevertheless, we endeavour to not be biased by the past. As such we try not to judge a sector on its past characteristics and would give due attention should circumstances change. Often apparent sea changes are only superficial -> mining companies for example where CEOs appear to have ‘found religion’ and instigated capex discipline. We perceive this as largely a function of the desires of the current cohort of shareholders and when growth is back on the table in China a new group calling for expansion is likely to drive a mean reversion in behaviour.
Please give an example of where you might adjust weights within your discretion as a result of a style trend in markets?
Most likely this would happen when a group of stocks start to rise strongly in sympathy in response to some new growth spurt. In such cases we might see share prices rise beyond what is merited as fund managers crowd into a theme. If the rest of the market was becalmed, we might consider a discretionary rebalance within the 20% limit. A 20% relative move (based only on portfolio % weights) triggers a hard rebalance, that is no discretion.
What is your approach to corporate governance? I note you own Samsung Electronics.
Management integrity, including corporate governance, stands as a central tenet in our investment philosophy. Our comfort in the ability, and tendency, of management to act in the best interests of all shareholders helps to navigate around investments which may ultimately destroy value. However, we are also sensitive to the cultural pathways that may have led to the formation of certain ownership structures, for example, in the case of South Korea, the chaebol. Therefore, while the complexity of the Samsung’s ownership is a concern we believe the direction of travel is more pertinent. In this regard, the signs have been encouraging with increasing cash returns to shareholders and the recent cancellation of treasury shares. We are comfortable in our holding but continue to keep a close eye on developments.
From the stocks on the ‘approved not invested’ list, how do you determine what goes into the portfolio?
The approved list is already longer than the opening portfolio so not all approved stocks will be owned in the early phase of the fund’s life and we have specified we will own only 25-30 over the long run. We are comparing business models, growth profiles and valuations. Selection becomes easier if we gain a conviction that a given business model and growth profile is somewhat undervalued. This is not often the case in current markets but companies do stumble sometimes and the sell-side gets very exercised about it. As we have done our work and know we want to buy then we can be in like Flynn. When companies miss their profit, estimates can often be an opportunity for us.
What is your sell discipline?
A stock will be sold if it fails one of our criteria. Novo Nordisk was sold when we observed new entrants undermining the company’s competitive position. Our equal weighting discipline results in stocks being trimmed as their relative valuation increases. A stock will be trimmed automatically if it crosses a +/-20% threshold versus its target weighting.
How do you distribute coverage of the universe? Are you all generalists?
Yes. I am a great believer in generalisation. It means we can have a broad debate about all the stocks. We have notional coverage where the stocks are split roughly equally between the four of us but we rotate coverage every 18 months so that there is no ‘ownership’. This makes sense as we discuss all holdings and the format for that discussion is not hierarchical. It also means that new angles and emphasis take place. When I was a sell-side analyst, I got very tired of the way in which analysts would corral their unique authority around their stocks. All of the investors I have admired through my career have been generalists.
In terms of new idea generation, it’s much more entrepreneurial. The quant screen reduces the global equity universe to a long list of 550 names based on consistency of margins, profitability and diversity of sales. We, between us, have a free hand as to what to investigate but a basic screen is then presented to the group and we decide which ideas to pursue. We meet weekly to formally work through these ideas.
What did you do during the Sept-Dec 16 period, do you adjust your portfolio for different market conditions?
2016 was the year where value came out of the closet and trumped growth. As I think back, my understanding of this is that China re-upped their economy and the collateral effects fanned out over the commodity complex and materials stocks. That resulted in some distinct performance across stocks so labelled. We noticed, at that time, that PPG, Givaudan, Praxair and Novozymes were being sucked up by a mix of sector and style effects. All these companies are labelled ‘Materials’ under the standard, broad sector GICS classifications. Later in the year we were scaling down some of these holdings as they had deviated 20% above target weights. We recognise that styles may operate across markets and whilst this strategy is correctly construed as a ‘quality’ strategy, we are in our minds style agnostic. We are looking to buy great businesses at fair prices.
What is the geographic breakdown of the portfolio?
Our investment process espouses companies over countries. We therefore focus on the geographic revenue breakdown as an indicator of the global scale of the businesses we invest in, as opposed to the country of domicile. On this basis, the portfolio exposure is roughly 40% North America, 20% Europe and 40% Asia, Latam and RoW.
Do you do attribution analysis for your portfolio?
Yes, we do attribution analysis in the standard format, but can to dissect the portfolio in other ways upon request.
Do you undertake stress tests and what would they show to be the risks taken versus MSCI World?
We run stress tests on the portfolio to understand likely outcomes in extreme events. Given the ‘quality growth’ bias of the Global Leaders, scenario testing indicates that the portfolio is expected to underperform a momentum driven bull market, and provide some relative protection against a bear market. A test resembling the 2008 Lehman Crisis, indicates less than 50% capture of the downside, with the ability to participate strongly in the subsequent recovery. Short-term shocks to the equity market such as the US Debt Ceiling in 2011, according to scenario tests, show the portfolio providing some relative protection. In a style driven environment, the Global Leaders would lag a rally in value due to its higher than market valuation (as it did in late 2016), but will benefit from a return to growth. As a global portfolio, any UK centric woes would have little impact on the portfolio, with weakness in the Sterling typically a net positive for the portfolio.
Bond-like equities – impact of bond yield on the portfolio?
All our companies are characterised by a positive growth dynamic which is lacking in bond proxy equities.
What has been the turnover to date?
The annualised turnover since Oct 14 is 14.5% for the GLS portfolio. During this period, we added 11 stocks and sold 2, noting that we were still building the portfolio to its 25-30 stock target.
What is the volatility on your portfolio?
Close to that on the world equity index. It is not a stat that we would normally be concerned about nor has information for our investment process which is all about driving outperformance in the long run.
What is the yield on the portfolio?
The current dividend yield on the portfolio is 1.7% net. We like companies that distribute dividends as it is an indication of creating value for shareholders. However, the portfolio itself does not adhere to a dividend target.
What is your stance on MIFID II?
It has cost money but we are ready. We will be absorbing research costs at the firm level.
Will costs be taken from income?
Is there a Dilution Levy?
The prospectus is at draft stage. It would be normal to include one but we have not made a final decision on this.
Who are your seed investors?
The cornerstone investor is a family who we have worked for since 2009. They have an historical ownership in Nestle which dates back over 100 years and asked us, in 2012, to build out a portfolio that would allow them to gently diversify. They are joined by 4 other families that we have also been working for many years. They are all investors in the strategy since 2013.