One could find many reasons for not owning US equities: why bother investing in an economy which will only grow at around 3 per cent in 2007 while emerging economies could grow by 6 per cent and Japan may even reach 3 per cent? Why spend time researching equities which have underperformed all others over the past few years and are still trading at a 2006 price to earnings ratio of 15? Why invest in an area where the value of assets will shrink because of a long-term declining trend of its currency against mine? Why invest in an area where even my “objective” quantitative allocation model tells me I should have 20 per cent of my equities allocation in Asia ex Japan and emerging markets?
One could also find many counter-arguments in favour of increasing exposure to US equities:
- The US still accounts for 20 per cent to 30 per cent of the world’s gross domestic product and 50 per cent of the world’s market capitalisation.
- With an investment universe of roughly 7000 companies, the depth and liquidity of the US markets is still arguably unsurpassed.
- The relative valuation of US equities versus European equities has shrunk over the past few years due to improving corporate financial results and a lagging equity market. The FTSE100 has returned 29 per cent over the past two years while the S&P500 has only gained 12 per cent in local currency.
- Quantitative models by structure have to use historical figures and are often distorted by the duration covered, as they tend to place increased emphasis on the most recent periods. All three-year quantitative models now point towards a strong allocation in Asian companies while in 1998 a quant model recommending such a strategy would have been rejected.
Global brand names
The coffee you are currently drinking could perhaps provide you with the answer. Did your skinny latte come from a shop whose name starts with an ‘S’? Or maybe the solution lies in the music you were listening to on your thirty minute commute. Did your favourite song come from white trendy earplugs connected to a brand new device whose name starts with an ‘I’?
These household names, which come easily to mind as examples of great investment stories were not so easy to find even three years ago when Apple, for example, was still in recovery mode. There are not many fund managers around, who can honestly say that they have been invested in Apple for the past three years, but those who have, would have earned an impressive annualised return of 85 per cent. On the other hand those who invested in the S&P500 index only earned an annualised 11.5 per cent in dollars.
There is no point arguing that it is difficult to find good businesses at the right price and that building a “good” portfolio can be tricky. Many research papers and well respected books, such as A Random Walk Down Wall Street, by Burton Malkiel, have demonstrated that it is generally not worth investing in an actively managed fund, as the number of funds outperforming broad benchmarks is low in the long term.
These reports have not, however, demonstrated that it is impossible to find good long-term outperforming fund managers, they have just pointed to the difficulties that investors have had in finding them. Furthermore, one could argue that investing in an index fund in a choppy market would not be wise. On analysing the actively managed US equities funds held in the Standard & Poor’s fund database over a 10-year period to the end of May 2006 the best performing US equities fund distributed in France offered a return of 465 per cent. The poorest performer of the 70 funds existing 10 years ago had lost 30 per cent while the median fund had gained around 90 per cent. So, how do you find good active managers?
It is possible to identify successful managers through detailed research into their environment, their investment ethos and support teams and not by focusing on quantitative analysis alone. We have identified over time and after many hours spent with fund managers, analysts, traders, CIOs and strategists, that successful managers often share common characteristics. These traits do not necessarily refer to their approach to value or growth but to their investment culture, investment process and organisation. While the existence of these characteristics does not guarantee strong investment returns, their presence is common among funds which have outperformed the market over the long term.
Team players
Efficient investment teams are often composed of a small number of dedicated analysts/fund managers and managed by a few experienced leaders. A small team is able to remain flexible, take decisions quickly and act accordingly, as long as it provides enough resources to research companies. Without raising the debate relating to the merits of third party versus internal research, it seems that the best performing teams tend to conduct most of their research themselves, only relying on external research to confirm their findings. This, they believe helps them to take full responsibility for their investments. The best performing teams are often further incentivised by the investment of their own capital in their funds, or by receiving a variable compensation index linked to the long-term value offered to their shareholders.
Experience v Enthusiasm
While junior analysts often bring fresh ideas to the research process of funds with their modern approach to financial analysis, more senior fund managers are generally reliable because of the experience that they have gathered on the equity markets. This is providing that they remain open to criticism and new environments. The most successful teams are therefore composed of employees with a mix of experience and educational backgrounds. For example, who could better assess the technical innovation brought by a new chip as well as its business prospects than an IT analyst with previous experience as an IT developer/consultant?
A team that is not too large will find it easier to develop their own investment philosophy and process rather than doing what is required by their sales teams in order to impress their clients. “Do what you are good at” and “stick to your process” are mottos that we have heard many times but which have proved to be effective when applied. A philosophy shared and applied by all the members of the team, becomes a powerful tool as it fuels the investment process and protects it from short-term issues. This team strength was illustrated when I first met with Jeffrey Van Harte’s team, from Delaware Investments, who manage the newly launched Natexis US Focus Growth fund. One after the other, each of the analysts, both junior and senior conveyed exactly the same message on the characteristics of stocks they were considering. They were also consistent in the way that they looked at balance sheets and the manner in which they evaluated businesses. At the end of 2005, this team, who has been managing money with the same proven philosophy for more than 15 years – investing in mid to large growth companies at a time when they were out of favour – was offering an annualised 500 basis points of outperformance over the broad US equity markets, returning around 14 per cent in dollar terms. This fund is invested in 25 to 30 businesses owned for the long term, while some other successful funds are invested in 50 to 55 companies with a high turnover. This fact demonstrates that there are many ways to properly manage a fund as long as their investment teams truly respect and apply their process once it is defined. Change to the investment process is often the root of its failure. For example, where there is a sharp increase in a fund’s assets under management, the performance of the manager could be adversely affected if he is forced to increase the number of stocks in his portfolio to a level which is greater than his optimal level. Alternatively, his return could suffer where stocks have been sold out of a portfolio because of the sales team’s consideration for the concerns of their clients. Various articles have been written on the optimal number of stocks in a portfolio, the need to focus on low price/earnings stocks. All of these reviews are informative but none of them have ever identified the key metric or trick leading to consistent outperformance. There are indeed many ways of offering good returns.
What has, however, proven to be key for success is to have the investment management team concentrate on the performance of its funds, rather than solving operational issues. Having a dedicated trading team fulfilling its needs; being able to ask a well resourced team to run risk metrics analysis on its fund to complement its portfolio construction work; having a team of product specialists preventing clients from distracting the fund managers, are among many solutions an investment company can utilise to enable its fund managers to spend most of their time managing money. Metropolitan West Capital Management, a US investment manager which is the sub-adviser for Natexis US Opportunities fund (a US equities fund launched at the end of December 2005) provides a perfect example of this ethos. Set up on “silos” by Howard Gleicher, the company’s CEO and CIO since its creation in 1997, the firm enables a team of eight analysts and fund managers to do their job by providing them with full resources and by having a back-up team of so-called portfolio managers who gravitate around the investment team and convey the portfolio decisions to clients or prospects without influencing the stock selection or portfolio construction. Once again, the 10-year 14.2 per cent annualised performance of its composite and strong outperformance over the S&P500 with dividends reinvested demonstrates the success of such a strategy. Metropolitan West Capital Management and Delaware Investments use two different philosophies, two portfolio construction processes but both have generated excellent returns over a 10-year timeframe confirming our assessment that there are many good investment processes.
Timing
Investing in US equities via actively managed funds could particularly be rewarding at a time when market expectations are low, as this will allow good fund managers to express their talents and really demonstrate their capabilities. These final words would seem naive but 5 per cent of outperformance over a benchmark returning 5 per cent (what the S&P500 returned in 2005 in dollars) is really different at the end of the year from a 5 per cent out performance over a benchmark returning 26 per cent (what the S&P500 has returned in 2003). Some investors would argue that a long-term declining trend on the dollar could adversely affect their investments in US equities; we strongly believe that the investors should separate their tactical asset allocation and manager selection decisions from their currency management strategy.
IN ASSOCIATION WITH NATEXIS ASSET MANAGEMENT. Natexis Asset Management is the asset management subsidiary of the Banque Populaire Group. Managing assets worth €107.1bn, Natexis Asset Management is a leading player in the French market. It has recently launched a branch in the United Kingdom, Natexis Asset management UK, to serve the interests of institutional and corporate customers.
