“While passive investing is cheaper on the surface, we think investors are taking on more risks than they know,” said Mark Phelps, AB’s Chief Investment Officer—Concentrated Global Growth.

“Concentrated investing has actually provided a better risk/return profile than traditional or passive strategies. Surprisingly for many people, not only can it provide better excess and risk-adjust returns, it can reduce downside risk, too.”

While it’s true to a point that adding more stocks to an equity portfolio helps to reduce volatility, the benefit declines when the number of stocks passes 20 or 30, as it becomes harder for investment managers to reduce tracking error (a measure of how closely a portfolio follows its benchmark).

“This leaves a strong case to be made for quality of stocks, not quantity, in portfolio construction,” said the London-based Phelps. “By using research to focus on fewer but higher-quality stocks, concentrated investing has the potential to produce substantial alpha through security selection.”

Phelps noted that, historically, concentrated managers have been very successful.

“The median concentrated manager has delivered 3.32% alpha over the last five years and 3.76% over 10 years. Traditional managers have also produced alpha, though lower than those of concentrated managers (1.76% over five years and 1.87% over 10 years).

“Passive managers have posted slightly positive (3 basis points) excess returns over both time periods. Clearly, there is sometimes power in fewer stock holdings.”

One aspect of concentrated investing’s outperformance has been its upside/downside capture, or the percentage of up and down markets “captured” by an investment.

“Concentrated managers have delivered solid upside capture during the past 15 years, although less than that of traditional strategies,” said Phelps. “But their downside capture of 88.9% is lower than that of traditional managers (96.1%) and passive managers (99.9%).”
While attractive in its own right, concentrated investing can also be effective as a complement to passive investing.

“Over the 15 years ending December 31, 2015, a blend of 50% concentrated equities and 50% passive equities produced a higher annualized net-of-fee return than a passive-only strategy with slightly lower risk. The blended strategy was also better in terms of downside protection.

“These figures show the potential benefits to investors in today’s markets of sticking with a concentrated approach over the long term, and combining a concentrated approach with a passive strategy.”

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However, Mark Phelps, AB’s Chief Investment Officer—Concentrated Global Growth, says that pricing power can help investors identify companies that are capable of delivering sustainable growth in this environment.

“In a low growth world, pricing power can unlock higher profits. But with inflation stuck at very low levels—0.5% in the US and about 1.0% in the euro area—it’s not easy for companies to raise prices, says Phelps.

Pricing power is about more than the simple ability to raise prices, however. According to Phelps, in order to find companies with pricing power, investors need to understand the three keys to pricing power: innovation, competition and cost dynamics.

“Innovation is a great enabler of higher prices,” says Phelps. “Technology companies that create products or services that never existed before can command higher prices. The same can be said for drug makers who develop new treatments.”

Pricing power is often a function of the competitive environment. “Take the supermarket industry in the UK, where discount supermarkets such as Aldi and Lidl have cut prices so low that they are creating big problems for giant rivals like Tesco and Sainsbury.

“The premium brand supermarkets today can’t use their usual tactic of regularly raising prices slightly in a world without meaningful inflation. This same logic can be applied to other industries where low-cost providers have taken market share, from airlines to finance.”

In a low-inflation world, cost dynamics are crucial. “Consider a company like Ecolab, which makes cleaning chemicals derived from oil-based products. With oil prices at extreme lows, Ecolab’s input prices have dropped dramatically. So even without raising prices, profitability can increase.”

Pricing power is always an important component in the fundamental analysis of a company’s business model and earnings prospects.

“Today, with big challenges facing top-line growth across an array of industries, we believe that it is essential to understand pricing power to develop high conviction in specific stocks,” says Phelps.

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