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Beauty is in the eye of the beholder

Published: September 19, 2019 by Stuart Copley, Fundhouse

Over the long run, the fund management industry will survive on its ability to add value to clients over and above what the market can return. Over the short run, however, sub-standard fund managers can survive for surprisingly long periods. A combination of marketing efforts, market complexity and low levels of financial education conspire to make fund management one of the most opaque value propositions in modern day industry.

For the most part, investors are best served using a simple low-cost index tracker to implement their investment portfolios. In the absence of any meaningful ability to discern between good and poor options, the average investor is likely better off just shopping on price, and passive funds are the cheapest available. However, there is a minority of the active fund management industry who do have something valuable to offer. A combination of sound business management, corporate culture and strong investment competencies are a ticket to this game, but are not sufficient to fulfill the demands of investors long term. A decision making approach is needed which can separate the winners from the losers. So what is the magic formula then? If you spoke to 100 separate fund managers, they would provide 100 reasonable answers as to why they are able to separate winners from losers. The trouble is, many of these propositions are watered down versions of the genuine approach, or poorly executed, with the same net outcome – a poor one for investors.

Through our fund research process we are looking for the genuine fund managers who are absolutely clear on how they make decisions and why this is likely to separate winners from losers. Below we illustrate three examples of how a good fund manager can identify an approach to investing which adds value to investors. Importantly, in global equities, the market is sufficiently broad and deep to facilitate alternative approaches which each have merit. In South Africa we don’t have this luxury, and more typically see diluted approaches to investing in the local market to adapt to this constraint.

Approach #1. Quality Investing

We start with the Quality style, as it’s the easiest to consider and implement. Simply put, filtering for businesses which are well built, have strong market positions, stable clientele and a defendable long-term product or service fit into this category. Fundsmith’s investment strategy below (a Tier 1 rated fund) demonstrates their thinking on how to separate winners from losers:

This is quite intuitive: If I avoid the low quality businesses, surely the strong will outperform the weak? For the most part the answer is yes, however there are some pitfalls involved in Quality based investing:

  • There is a tendency to overpay, or get caught in a market where the small subset of truly high quality shares are commonly expensive. To access these quality and safety aspects, you need to pay up as an investor. At points, this means you can be exposed to high prices when market anxieties are high, as we find today.
  • The second pitfall is the ‘forever mindset’, illustrated by Fundsmith’s “Do Nothing” statement. The concept that the strongest businesses will remain that way forever is potentially misleading, and there are numerous examples of yesteryear winners not being in business today (Kodak would spring to mind). The risk of disruption is a key consideration here, as technology increasingly permeates all industries, the disruption potential to the “do nothing” mindset is real.

The opportunity set at this end of the spectrum is also small, as very few companies really do tick the various quality boxes simultaneously. This can also lead to holdings concentration at share or industry level.

All that being said, there is investment merit in sourcing a fund manager who can identify good companies with long term sustainable earnings which justify their relatively steep entry price.

Approach # 2: Value Investing

We follow with Value, being the most commonly known in SA, but also next easiest to implement. In short, the lower the price paid relative to a companie’s expected value, the better the outcome. These companies can be high or low quality, across any industry or region. Schroders Global Recovery (also a Tier 1 rated fund) illustrate their thinking on this ‘price paid’ point in the figure below. Basically history shows that the returns from shares on lower Price Earnings Ratios (PE’s) out per form those higher PE’s.

Quite clearly this is the opposite to the types of discussions which would happen within Fundsmith, so can they both be right? The answer is yes, as global equity markets are big enough and the two worlds don’t need to overlap.

The appeal of Value investing is a natural one – paying less than expected for something is a good deal, seemingly a much better deal than paying full price for something as Fundsmith would suggest. There is also much evidence to support Value investing, although there are pitfalls to take note of:

  • The Value based approach can also lead to the ‘value-trap’, where the cheap share stays cheap, and the recovery expectation doesn’t prevail.
  • Buying value is not instant gratification, in fact the opposite is true. Long periods of disappointing returns followed by short bursts of value realisation typically characterise value investors. These deep cycles also create issues around the managers’ ability to survive their own cycle, as performance pressures drive business longevity issues.
  • There is a meaningful opportunity cost, where value managers would automatically forego the racier opportunities found in sectors such as Technology.

Typically the value manager will have less racey, cheaper, lower quality and more cyclical shares than their Quality counterparts. However, they will also be the ones delivering for investors when reality sets in. Just be prepared to be disappointed much of the time to earn this benefit.

Approach #3: Growth Investing

Growth investing is the last of our examples, and the hardest to execute in our view. This is because unlike the Quality funds (who can see what type of business they are buying), or the Value manager (who can see what price they are paying), the genuine growth manager can often see neither.

Using the example of Amazon to illustrate, the business could be termed ‘excessively expensive’ for much of its 20-odd year history as a listed share. This would not make the grade for the value investor, and unlikely for the Quality investor. The Growth investor however does not rely on the status quo perceptions of business models to make their decisions. Rather, they set out to identify the small subset of shares which will be driving new business models, disrupting incumbents and generally outperforming expectations over the medium and longer term. As Baillie Gifford highlights in the diagram below (their Long Term Global Growth is Tier 1 rated), a tiny fraction of the world’s companies drive the bulk of capital accumulation. They reference the Bessembinder study , where just 0.4% of all US listed companies (90 companies) since 1926 created around half of all stock market wealth.

Growth investors need to be optimists, and it is easy to get caught in a trap where “share prices going up = growth”. This is a common trap we see, catching out many so-called Growth investors, who are mostly easily satisfied with short term share price movements rather than strong company fundamentals.

The most significant trait of a good Growth investor is low turnover of share positions, where they make investments and rarely change them. Baillie Gifford was one of the few managers to buy Amazon early and hold on (they hold it to this day). There are some pitfalls to growth investing though:

  • The opportunity set is very limited. World beaters are just not that easy to come by. This means that the research process needs to be extremely detailed and selection risk is very high.
  • The failure rate is high, which is to be expected given the early stage many of the businesses are at.

While each of these three examples show how different mindsets can help separate the winners from the losers, each has its own set of pitfalls which will be accentuated dependent on the market cycle. For instance, currently the market cycle has favoured Quality and Growth (low interest rates and expanding economies = low risk aversion and cheap capital funding), whereas the lower quality Value biased shares have lagged. Throughout history these cycles have driven quite big performance differences between the management approaches, individually a bumpy ride for investors.

Combining these in a sensible manner can provide the best of both worlds: long term value-add by siding with the winners, and a more consistent journey. The net result is a diversified portfolio of cheap, high quality and high growth opportunities, and ideally a low allocation to the global losers who in aggregate reduce investor wealth.

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