Global equities: themes digest

In undertaking its recent Global Equity Sector Review, Lonsec held over 60 ‘one-on-one’ meetings with fund managers. Most meetings were held onsite, in the global offices of the investment teams and were supplemented by a video-conference programme.  This paper aims to capture the broad themes and observations that emerged as a result of this review process.

Great minds think alike
Lonsec observed that the average fundamental manager, where data was supplied, managed its portfolio with an ‘active share’ ratio in excess of 60%. ‘Active share’ measures a portfolio’s divergence from the benchmark (in terms of stock holding names and weights) and pleasingly indicates that the average fundamental manager was definitely active in its portfolio management approach.

By contrast, due to the typical larger number of holdings and quantitative benchmark relative risk management, Lonsec notes that the average quantitative manager was less active overall as judged by the active share ratios being typically less than 60%.

Diving deeper into the portfolios, Lonsec reviewed the ‘Top 10’ holdings, as at June 2010, of the 26 fundamental products researched. An extract of the findings is detailed in the table below. The ‘Top 10’ stocks are considered to be a fundamental manager’s highest conviction positions and held the largest absolute/active weights. 

Stock No. of Top 10s (n = 26)
Roche 7
Philip Morris International & Nestle 6
Pfizer & Vodafone 5
Apple, Google, Hewlett Packard, Johnson & Johnson and Wells Fargo 4

 

Roche (a Swiss pharmaceutical company) was the stock which engendered the most consistent high conviction levels. This stock featured in the ‘Top 10’ of seven of the 26 portfolios analysed (i.e. 27% of all portfolios). Moreover, given that Roche appears to be such a well regarded stock it is quite likely that it would also make an appearance in many other portfolios outside of the ‘Top 10’.

The degree of ‘commonality’ across ‘Top 10’ holdings is a curious and surprising outcome. Notionally, there is the potential for 260 stocks to occupy the highest conviction positions (26 x 10). However, an outcome of Lonsec’s analysis was the identification of there being only 172 different stocks across the ‘Top 10’ of the 26 portfolios. The MSCI World Index is constituted by over 1,500 stocks.

The funds management industry’s process-driven stock assessments, with similar modelling and assumption methodologies, may be a significant driver of this outcome. However, there is also the possibility that an undeterminable degree of ‘herding’ (e.g. safety in numbers) may also be a cause, if not a conscious one.

Investment teams stabilise
In last year’s report Lonsec noted that managers had mirrored the companies they invested in and sought to control costs with consequences for their investment teams. Investment teams were, on the whole, relatively stable. Managers highlighted that cost management-induced and performance-related turnover had largely played itself out. Voluntary turnover has been witnessed across some managers, but the overall trend has been muted. It is likely that this will be tested if the halcyon bull market days of 2006-07 return.

Further, in response to the changing global growth dynamics, managers have been flagging their intention to ‘beef up’ their Asian coverage—either through relocations from European or US offices, or through new regional appointments. This will be an interesting dynamic to watch, particularly as investment banks are also seeking to increase their presence in emerging markets, such as the Asia region, to capture their share of the advisory and transaction fees on offer and compete with buy-side firms for talent.

Location and perspective
One of the themes from the previous year’s sector review was the subtle difference in investment views, depending on where a manager was located. To refresh, US-based managers were, by and large, more constructive on the US and global economies than their counterparts operating from London and Edinburgh.

This year, however, most managers (regardless of location) tended to be mildly positive on the outlook for global markets. Notwithstanding, the Edinburgh-based Scots again stood out for their generally cautious tone. Interestingly, UK-based managers observed that the local population was relatively optimistic and appeared to be largely ‘deaf’ to the impending fiscal austerity that loomed in the UK over the near term.

Asia still sparkling
Managers were mostly constructive on the Emerging Asia region, believing that these markets as a whole exhibit favourable demographics and governments have learned valuable lessons from the 1997 Asian Financial Crisis. Many see the main opportunity to be the rise of the middle class and increased consumption through the step-up in per capita income. This is believed to touch many sectors, ranging from Financials (the belief being that the population is ‘under-banked’ and still reliant on a ‘cash’ economy which should benefit institutions like Standard Chartered) and Consumer Discretionary (e.g. increased consumption of luxury goods such as Louis Vuitton handbags).

An interesting anecdote Lonsec was told concerns Louis Vuitton: the luxury brand’s Hong Kong-based store apparently has the greatest amount of floor space globally of its outlets and has a limit on the number of handbags people can purchase. The main clientele is understood to be tourists from Mainland China who can arbitrage the tax differential (these products sell at a cheaper rate in Hong Kong than on the Mainland) and on-sell the bags once home for a profit. Money never sleeps!

Increased optimism reflected in portfolios
The increase in manager optimism generally translated into increased risk appetite. This was most notable in the Industrials sector, where most managers increased their absolute exposure to this sector. Industrials is an umbrella sector which encompasses a wide range of diverse industries, albeit it is considered to be cyclical and economically sensitive.

Lonsec also observed a notable rotation towards US stocks, with most of this being funded from Continental Europe and the UK. Most managers believed that the threat of a ‘double dip’ recession in the US, which had largely dominated markets during 2010, had largely subsided through successive fiscal and monetary policy stimulatory programmes.

Portfolios Stabilise
Lonsec observed that across the ‘average’ fundamental manager, from the period between December 2008 and June 2010, the stock turnover in portfolios increased through the first half of 2009 (with some overrunning the expected ceiling level), and peaked in the June 2009 quarter. However, since then there has been a notable decline in average stock turnover. Managers attributed this phenomenon to the general decline in market volatility across equity markets. Although, slightly contradictory, there were some managers which also noted that stocks were ‘highly correlated’ during this period, which hampered their ability to outperform their benchmark. Managers also highlighted that they believed that corporate earnings ‘visibility’ had improved, thereby instilling greater confidence.

Correspondingly, the number of stocks in portfolios experienced a similar upward trend from December 2008 through to June 2010. Broadly, stock holdings were seen to have risen throughout 2009 and largely stabilised in H1-2010. Managers attributed this rise to risk management and the spreading of ‘risky’ bets. To a large extent, Lonsec is sympathetic to this argument (increase stock numbers due to rise in volatility and uncertainty); however, this is also arguably reflective of a broad loss of conviction and increased wariness following a difficult few years.

Emerging Markets – more than one way to ‘play’ the story
While most products are managed against a MSCI World index variant (developed world-only benchmarks), product mandates typically allow managers to invest outside their benchmark and buy Emerging Market stocks, subject to threshold limits. Further, while managers may disagree on the ‘cheapness’ or ‘richness’ of Emerging Markets stocks in general, as noted earlier, most do not dispute the long-term trends that are favourable for these investments.

That said, managers generally fell into two camps: (1) those that ‘played’ emerging markets directly and (2) those that were more indirect. For example, Nestle—a developed market consumer staple stock—proved popular, with a general thesis being one of incremental growth being sourced from Emerging Markets. Tobacco stocks (such as Phillip Morris International) were also popular for a similar reason.

Managers had a degree of direct Emerging Market exposure at the time of review. Further, while Lonsec is sympathetic to the argument of accessing (historically volatile) Emerging Markets growth through developed markets companies, Lonsec has observed that the tendency of managers to emphasise this aspect of their rationale for holding a stock has increased, as the popularity of Emerging Markets has increased. Moreover, while a developed market stock may have incremental growth from emerging markets; this does not represent a ‘pure’ exposure.

Lonsec highlights the examples of BHP and Rio Tinto in Australia, arguably two domestic stocks that stand to benefit greatly from continued Emerging Markets growth, but whose market values were severely negatively impacted when the Australian Government proposed the idea of a new domestic tax. Arguably, Australia itself is starting to resemble an Emerging Market dependent company.

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