At the forthcoming Active Advantage 2023 conference, open to institutional and wholesale investors, joint hosts Orbis, MFS and Baillie Gifford will present on the long-term value of an active approach for investment portfolios. It will examine local and global research into the critical factors underpinning good investing.
In preparation for the event, I spoke to Rosemary Shannon, Client Service Director, Baillie Gifford; Marian Poirier, Senior Managing Director, Head of Australia and New Zealand, MFS Investment Management; and Jason Ciccolallo, Managing Director, Orbis Australia.
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GH: Rosemary, you’re in Edinburgh now where it’s cold and early so let's start with you. We've seen major changes in markets in the last 12 months. Do you feel the favorable investment conditions of low inflation, falling rates, globalisation and cheap energy are in the past and what does this mean for the future of asset allocation?
RS: The past 12-18 months have been uncomfortable, and we have seen significant volatility driven by the war in Ukraine, rising inflation and rates. This has been challenging for performance. The continual review of our portfolio holdings allows us to check the investment thesis and its resilience through such an environment. However, we’re focused more on the long-term, transformational shifts in society rather than the macroeconomic conditions of the last 18 months or so. It’s too easy to become myopic and miss the big but slow-moving changes.
We think we're seeing the biggest long-term shifts since the Industrial Revolution, due mainly to advances in technology. And that really provides a fantastic opportunity for long-term active investors. There's never been a better time to hunt out, in our case, growth companies. Our eyes are tuned into the transition to clean energy, the future of sustainable agriculture, the electrification of transport, breakthroughs in biology. For example, we're looking ahead to cures for cancers and other diseases.
GH: Marian, coming to you, what is the impact on asset allocation of the market changes we’ve seen recently?
MP: We also focus long term but on overall asset allocation, cash now has a return, fixed interest has a return, so there are more tools in the toolkit. The changes you highlighted, inflation and higher rates, are 100% of concern to us. Higher volatility, scarcer access to capital and higher rates will likely lead to decreasing profit margins for some companies. I agree with Rosemary that active management or stock selection will be key to differentiate between winners and losers in a more difficult environment.
GH: Jason, has your thinking changed over the last 12 months?
JC: We think there have been decades of undisciplined capital allocation, with decisions which resulted in huge valuations for certain companies which led to big valuation dispersions. At the margins of the different asset classes, there have been some changes … for example, ‘bond-like equities’ such as Nestle and Coca-Cola became popular when rates were zero, however, as rates have risen, those same stocks have more competition today from the asset they were trying to replace: actual bonds.
Where we think there have been much deeper shifts is below the surface of each market. There’s a much bigger difference – a lot more value to be found - between European and Asian bank stocks, and US tech stocks, for example, than there is between Nestle, and corporate bonds.
GH: Many people who read this are retail investors learning about investing. What is the most important lesson they can learn from professional investors?
JC: To focus on the correct time horizon for their investments and not react to short-term market sentiments. We are long-term, contrarian value managers so there are a lot of the ‘Buffettisms’ that are hard to go past, and one often quoted is “be greedy when others are fearful and fearful when others are greedy”. It has served investors well by staying away from things that look inflated. It was only three years ago, on the precipice of COVID, when everyone thought the world was ending and that was a chance to avoid the perils of running with the crowd. The crowd also jumped into the glitz and glamour of crypto and meme stocks and SPACs and NFT's. I mean, those things were so hot then but now you go back and wonder, what were those people thinking?
GH: Yes, what was that all about?
JC: The advice not to run with the crowd applies all the time, at market lows or highs. There will always be times when investors have given up and are running away and believe the world's going to end in a particular market or sub sector. It sounds simple but investing is hard to execute in practice because you need to control your emotions, especially as a contrarian investor.
MP: Two points I would make here. First, nobody has an information advantage anymore, everyone has access to the same information. But you do have a time advantage if you can cut through the short-term noise. The second critical thing is resilience, which requires investors to do the homework, do the research, know what they're investing in. This also applies for clients. Do the research into managers and don't just go with last year's best performers, and then stick with them through the cycle.
GH: That's the challenge for clients, retail or wholesale. They have to tough it out because fund managers may go years where their numbers are not great. What are conversations with clients like in those times?
MP: I always go back to the time period we are looking at. We should be measured through the cycle, not say a three-year period. It doesn't mean ‘set-and-forget’ and not monitoring what the managers are doing. Everyone needs signposts along the way. One of the best questions we get asked prior to an appointment is, “When are you likely to underperform?” Ideally, clients will remember when you come to that underperforming period. Another good question is, “What happened? We didn’t expect you to outperform in this period.” Again, it's about knowing your manager, understanding what they do and when they're likely to perform and when they're not. And it makes for easier conversations.
GH: Jason, the three firms here are running joint seminars in Sydney and Melbourne making the case for active investing. Can you elaborate on why you think conditions are especially good at the moment?
JC: If someone had invested passively for the last decade in the broad US market, they would have returned around 11% per annum real after inflation. It was a time when people could invest in almost anything and make money. But the world has changed, as you said up front, with inflation, rising interest rates, geopolitical tensions, all those things are at play. What was the winning bid for the last decade isn't going to be the winning bid for the future.
The case is stronger than ever to use skilled managers to navigate this turbulent environment. That’s why we three managers have come together for this active message. We are differentiated in our style but unified in the way we approach investing, which is to be active and invest from a long-term perspective for our clients.
GH: That need to focus on the long term is the biggest single challenge for retail investors because the media bombards everyone with scary headlines. We’ve all seen redemptions rise when markets fall and applications increase when markets rise and it's frustrating.
Rosemary, can you identify something in your investment process that you think has delivered consistently good results?
RS: Our process has remained consistent through time and it's important not to change just because the short-term environment is different. But the inputs into that process are critical and one key input for us is the information that often comes from academia. In order to identify outlier companies, we need to understand the big changes I was talking about earlier and speaking to academics who share that long-term time horizon helps us to understand what's happening. They have access to cutting-edge knowledge about technological advances and long-term social and environmental shifts that could affect investments.
For example, we have a longstanding relationship with Hendrik Bessembinder. He’s the author of the famous study which shows all the wealth creation in the US market comes from just 4% of listed companies. We commissioned him to look at global equity markets and the 4% quoted for the US is even more concentrated globally. Only 1.3% of companies are really delivering the return and he helped us to identify them. That’s one example but we have 30 or so leading academics around the world. We do work in Edinburgh with the Genomics Institute and the Low Carbon School. We have a relationship with a farm in northern Scotland which is testing various elements of sustainable farming. It’s hugely varied, from the ethics of AI to genome research to sustainable farming.
GH: Jason, what part of your investment process consistently delivers?
JC: Contrarianism. It allows us to produce good returns because we focus on the mistakes other investors make. Many investors panic when things go badly and get excited when things go well, and there is a dispersion in behavior. We look at the stocks that are out of favor, and some people think that's brave because it goes against the crowd, but we research the long-term value of the company and we’re assisted because investors are increasingly short term. We don’t forecast the overall market as we don’t think anyone can do it. Our managers need to be independently minded and have the courage of their convictions, but the research is intensely peer reviewed as if it’s a PhD thesis to make sure we haven't missed something.
GH: Rosemary, back on Hendrik Bessembinder, whose research we have featured a few times in Firstlinks, if only 1.3% of global companies deliver all the outperformance, how do you find them?
RS: That’s the challenge. Hendrik has looked at company’s outcomes decade by decade to find the patterns over long-time horizons. The evidence suggests that returns follow fundamentals. There are four standout factors with statistical significance: strong cash accumulation, rapid organic asset growth, higher R&D spend and larger drawdowns in the prior period. You need active managers who are looking for these key characteristics and traits, often in outlier companies. So you should be expecting price volatility in that subset of companies.
GH: If I could clarify, as you saying that the best performers have a large prior period share price fall?
RS: Yes, from peak to trough of maybe 50% or more in the prior decade, but they subsequently perform exceptionally well. So patience and deep research can pay off if those other traits have been identified, which is where active management comes in again. Amazon, for example, is among this small cohort. It’s not a tech company as some people might label it, it is a tech-enabled retail company.
GH: Can I ask each of you to identify one company in your portfolios that best meets your investment and that you’re likely to hold for a long time like a decade.
MP: I'll give you a sector and a specific stock. US railroads don't sound hyper-exciting and hyper-techie, but they have long-term potential growth fueled by pricing power. There’s a strong ESG angle as rail is still the most energy efficient way to transport goods across North America. And on a stock, Schneider Electric, a European-based multinational is focusing on digital automation and energy efficiency in homes and offices, again with pricing power and long run growth. They help with the efficiency automation process, for example, most buildings leave too many lights on at night.
JC: Although we think long term, we probably don't plan to hold anything for a decade because we want to buy things at a significant discount to their intrinsic value until the market recognises the potential and we’re happy to bank that profit and move on. One example is XPO, a US logistics and trucking company which has changed a lot in the last decade. We don't know how much longer we'll hold it but today it offers a wide discount to our estimate of intrinsic value.
RS: Unlike Jason, we’re intending to hold many companies for 10 years or longer based on our average holding period in the past. So we could pick almost any company in our portfolios, but I’ll highlight a few. Moderna brings transformational change to our healthcare systems and how we treat disease and maybe prevent disease going forward. I mentioned Amazon already. Plus Mercado Libre which is the largest ecommerce platform in Latin America and a sort of emerging fintech provider. Maybe we hold that for 20 years. Companies such as Orsted which transitioned from oil and gas to become the largest offshore wind producer globally. And more unusual is John Deere, which is the world's largest agricultural equipment manufacturer, rapidly improving the sustainability of farming.
GH: What happens if one of those companies goes on a good run with an excellent gain. There must be a temptation to sell.
RS: We don’t have price targets because the environment and the markets are changing constantly, and an opportunity might be opening up to them. We bought Amazon before the iPhone existed and now you can buy anything on Amazon Prime using your iPhone. It was a bookseller and now it has a cloud business and a streaming business. So investors need to constantly review and understand the upside potential. Just because something has made five-fold increase to date doesn't mean it can't make another five-fold from here.
GH: Can we talk about the other side of investing, coping with setbacks.
MP: A few things come to mind for us. Our team always focuses on the downside risk and we ask a lot of questions around what can go wrong. If an investment doesn’t work, we recheck the long-term thesis, and if it’s no longer intact, we look at the valuation and work out our exit strategy. What has not changed is the strong management support when things go wrong. A lot of investments can take years to play out and if performance isn't delivering in the short term, portfolio managers need management support, as long as the thesis remains sound.
RS: If I can jump in, we're focusing more on the upside and the ‘blue sky’ potential, but I think that illustrates that we're a group of three managers who have deep respect for each other's processes but we're different. We’re often seen all together in one institutional client’s portfolio at the same time. It's complimentary as success does not come in a straight line, especially when you're investing in transformational growth companies. And so really, that's why that patience is required. Finding a few small but big winners will deliver outsized returns but it’s over a prolonged period of time.
GH: Jason, the process around setbacks?
JC: It’s inevitable with our style that we’ll hold stocks that go against us. For example with XPO, we may retest the thesis by getting a fresh set of eyes on it, or bringing it back to what we call the Review Policy Group to check if anything is fundamentally broken with the company, or if it's an even better buying opportunity. The portfolio managers do reviews every day using portfolio management risk tools.
GH: You must have some tough conversations with clients who ask why you’re holding some of this stuff?
JC: We often say some of our best stocks are the ones we even hate because they make us feel uncomfortable. But it generates great conversations with our clients because they read all the negative comments in the press. It's our job to explain what normalised earnings will look like for that company and why risk/reward will pay off.
GH: Marian, can we come back to non-traditional research sources. We hear about quirky things like placing cameras in supermarket car parks to see how busy they are. What does MFS do?
MP: It’s not leading-edge use of tech, but we’re doing a lot more collaboration between the equity and fixed income teams. It allows us to look at companies from different angles, and it paid off in COVID when we needed to have greater focus on company cash burn and work out which companies would survive or win in a major downturn. More recently, as market fragility increases and as capital becomes harder to access, it is important to identify those companies with stronger balance sheets who can undertake capex. It will help to identify survivors and winners.
GH: Are the fixed interest fund managers feeling better now that they do not need to justify negative interest rates? That must have been a tough sell.
MP: There's definitely a better buzz around fixed interest and we have some of the team are coming to Australia soon.
JC: On the non-traditional resources side, we hire some unusual people from different backgrounds. For example, we've developed an AI-based screening system that looks over our stock selection history going back 33 years and identifies patterns in the past and possible opportunities today. We use decision analytics to look at investor behaviour and biases displayed in particular stocks. We've used traffic data to assess how quickly distressed businesses were recovering post COVID, and we look at demographic analysis for the context in which companies operate.
RS: I know everyone talks about culture of the people and the organisation but it starts with the types of people we hire. When hiring graduates, for example, we look for curiosity and cognitive diversity, and that might be an historian, an astrophysicist or a musician, a ballet dancer or a geographer as much as the traditional economics or accountancy graduates. That kind of diversity of thought often does take us down different roads.
I’ll make a final comment that the reason we are running the Active Advantage seminars is the respect we have for each other and complementary styles which work well in a client portfolio. We're trying to have a collaborative and collegiate discussion on issues we feel are becoming lost in the short-term noise.
The Active Advantage 2023 conference - jointly hosted by Orbis, MFS and Baillie Gifford - is open to Wholesale Investors only. Orbis and MFS are sponsors of Firstlinks. This article is general information and does not consider the circumstances of any individual. Investors should seek financial advice before considering investments mentioned in this article.