State of the Nation
US SPECIAL
Donald Trump rose to power on a glorious wave of market performance. As he clinched his victory in 2016, the now-famous ‘Trump Rally’ lifted all boats, as FAANG stocks powered the S&P 500 to all-time highs – and the market hasn’t looked back since. However, at the time of writing, the US market is on the cusp of monumental change. Following a year of trade spats with China, 2020 raised the political stakes even further with the US’ assassination of Qasem Soleimani, commander of Iran’s elite Quds Force. The market impact was initially muted, but the longer-term implications remain to be seen. As if that wasn’t enough, US domestic politics have been heating up as well, peaking with impeachment proceedings against Trump just as the 2020 presidential election campaign kicked into full swing. So how are investors reacting to the tumult? In this supplement, we hear from fund buyers about the strategies they are backing in the US market regardless of the noise. We also take a close look at the most prominent sectors to see how outperforming portfolio managers are positioned. In addition, we have explored alternative ways to gain exposure to the market. This includes a look at innovative thinking around passives, what long/short equity investors are aiming for and how our EM Insider views the emerging world in the shadow of the US dollar.
Chris Sloley Editor, Citywire Selector
CHAPTER 1
The US stock market proved to be a strong bet last year but geopolitical headwinds are intensifying. As the storms gather we ask four leading selectors for their outlook on the country and which funds they are using or watching to express these views
Francisco Julve
A&G Spain
Our central scenario for 2020 involves a slight acceleration of global economic growth, with the US managing to stabilise its growth at 2%. This implies a low risk of recession and, therefore, the longest expansion in history is likely to continue. This positive, but cautious view of the US market is underpinned by supportive monetary policy and the prospect of an extended cycle. In the equity space, valuations still appear reasonable in general, but in a year where volatility and divergences may appear, it is important not to be invested in the wrong side of the market. The presidential election will have a big influence on markets since all the candidates will try to please Wall Street. In the current low rate environment M&A activity is likely to continue, so there might also be selective opportunities in small caps. We are positive on companies that can take advantage of new trends, such as technology, innovation, healthcare and consumption. We have one eye on reasonable valuations and will emphasise exposure to resilient, low volatility, large-cap companies with good fundamentals whose size, quality and low-volatility profile should help them outperform in the short run. In the fixed income space, our approach is cautious, selective and flexible in order to navigate this late-cycle and low-yield environment with a strong focus on volatility and risk. Monetary policies are likely to remain stable which could keep spreads at current levels for credit. This means existing yields, especially for those who like US dollar exposure, are attractive. In treasuries, the range of 2% could be a good entry point for the 10-year bonds which should give a reasonable yield in addition to great downside protection, while inflation is absent and the Fed is on hold.
Thomas Romig
Assenagon Germany
We are generally positive on the outlook for the US this year given the Federal Reserve’s continued willingness to support financial markets, as well as moderate valuations and tentative signs of a turn in the business cycle. However, gauging the impact the upcoming presidential election is likely to have on the market is turning out to be a more complex task than predicted. Both Democratic and Republican agendas feature a mix of supposedly bullish and bearish pieces of legislation. President Trump’s aggressive push for further deregulation has actually improved the ease of doing business, but economic growth has still suffered from his continued protectionist tendencies. Considering the US’ current relationship with its trade partners as well as recent rhetoric from President Trump’s economic team, we do not expect these trends to break in the immediate future. Democrats promote a mixed bag as well: tightened regulation of the financial sector and increased taxes for the wealthiest parts of society on the one hand, and increasingly subsidised education and significant infrastructure programmes on the other. So there are elements we are less positive on – especially due to the uncertainty of the presidential election – but in essence we are still positive. Therefore, we prefer staying constructively positioned and continue to prefer equities and high yield bonds over treasuries. While also appealing on an absolute basis, the sky-high relative valuation gap between equities and treasuries is a centrepiece of our bullish positioning. Selected high yield investments can also serve as a stable source of income. In light of increased uncertainty, we are also deploying some smart hedging solutions as well as a variety of uncorrelated absolute return strategies. Moreover, we believe that flexibly-managed asset allocation will be an important factor for success.
Pierre Bismuth
Myria AM France
We have decided to stay invested in US equities in 2020 – via US equity or global equity funds – as this is the world’s leading market. Like lots of investors, we think this year will be a double-edged one, as the presidential election can be very supportive for risky assets but can also bring volatility. For the first part of the year, our central scenario is that growth stocks, specifically technology ones, should beat market expectations, and the US is the main market in this respect. On the bond side we favour duration as the central banks have told markets that rates are not going to go up any time soon. In addition, we think investing in the US dollar offers a lot of protection, even if your base currency is the euro, so we also like the high-yield segment of the US market, because of the absolute level of the yield to maturity. Asset managers we like include long-term favourites such as Seilern, for its World Growth and America funds. We also rate Edgewood’s L Select US Select Growth fund, and the Ossiam Shiller Barclays Cape US Sector Value fund. Our head of fund selection also advocates new picks such as the Polen Focus US Growth fund, the Polar Capital Global Technology fund, which is mainly invested in US equities, and the CQS New City Global fund, which is also loaded with US stocks. On the bond side, our long-term preferences go to the Sky Harbor GF US Short Duration High Yield fund in USD and the Lord Abbett High Yield fund, also in USD.
Nick Wood
Quilter Cheviot UK
Our lead pick within the US today is Vulcan Value Equity. The fund is managed by CT Fitzpatrick and team out of Birmingham, Alabama. The team runs a fairly concentrated portfolio of typically 25-40 stocks, and tends to reduce the number of holdings when it believes it has the greatest opportunity. Having had a relatively weak 2017 and 2018 versus the S&P 500 – primarily due to the fund’s value bias – 2019 was been very strong. The fund returned around 39% versus 26% for the S&P 500 (in sterling terms), even though this was another poor year for value. The team focuses on companies trading at below intrinsic value, but where the company is stable or growing, something which generally means avoiding deep value names. It also tends to avoid direct commodity exposure or banks. Today, technology companies account for around a third of the fund, including Skyworks Solutions, Qorvo and Nvidia. The portfolio also have significant exposure to more classic value sectors, with financials and healthcare significant weights, albeit avoiding banks specifically. In the last couple of years, the fund has taken the opportunity to invest on weakness in a number of the FANG stocks more traditionally owned by growth managers. This gives the strategy a more balanced look from a style perspective, but the acid test came in recent months when the fund performed well in the value rally. So why back the fund today given the strong performance last year? We like the combination of a value discipline but focusing on growing companies. The team also tracks the overall portfolio discount, and today that stands at a very healthy level versus long-term history and remains attractive. Historically, the fund has also protected capital well in a falling market, but of course history isn’t necessarily a guide to the future.
The travails of Donald Trump’s presidency appear all-absorbing for US market watchers but there are plenty of other important factors that are likely to define investment opportunities over the next 12 months. Chris Sloley talks to leading investors about the hurdles ahead
‘As the presidential election looms in the US, disruption in both domestic and foreign policy is on the cards whether Trump stays in or the Democrats take over. Even if the lull in the trade war with China holds, other issues like tax and competition law reforms will likely emerge, affecting US equity markets.’ And with that, Norman Villamin, CIO for private banking at UBP, has succinctly outlined the challenges that face those eyeing the US market in the year ahead. The focal point will ultimately be November’s election, to say nothing of the impeachment proceedings that are rumbling on at the time of writing. However, there are several hurdles beyond politics that the fund management world needs to watch for.
One example is the health of the US economy. Ariel Bezalel, head of strategy for fixed income at Jupiter Asset Management, is among those looking closely at whether the situation could become more challenging despite recent growth. ‘The country is on course for an imminent earnings recession: Q4 earnings, together with Q3, are forecast to be negative. According to a recent survey, half of the CFOs in the country are expecting a recession by the November 2020 presidential election, which is likely to have a significant impact on investment spending.’ Bezalel adds that credit markets are also showing signs of stress, as recession concerns have reduced demand for debt further down the quality spectrum, especially within high yield. ‘This fragile dynamic is particularly worrying considering corporate debt is at an all-time high at around half of national GDP, with trillions of dollars having been funnelled into unproductive share buybacks. The tech sector seems particularly vulnerable within this context, as well as to political risk given bipartisan support for breaking up the major tech companies.’ His concerns are echoed by Christine Todd, US head of fixed income at Amundi, who believes those investing in the US bond market need to consider their risk appetite, particularly in light of the Federal Reserve reversing its previous tightening cycle to remain much more accommodative. ‘A macro environment marked by stabilising growth, loose financial conditions, and an accommodative Fed should be positive for risk assets in general. We see greater potential for spread tightening in securitised credit than in corporate bonds, but we expect both sectors to generate an important carry advantage over treasuries, which are likely to nudge slightly higher. ‘US corporations have elevated levels of leverage, which are affordable with low interest rates and spreads at multi-year tight levels. Watch for stress in the event of higher rates. High yield bonds are attractive on an idiosyncratic basis, especially given technical conditions in the lower quality bank loan segment,’ she says. A large amount of the debate in 2019 centred on the relationship between the White House and the Fed, which dropped plans for aggressive rate hikes and instead enacted a third rate cut at the end of October and has given no signs of changing tack in 2020. While some investors dispute this, such as Lombard Odier’s chief economist Samy Chaar, there is a feeling that the Fed’s course is now interwoven with the ongoing trade dispute between the US and China. If this were to change, Jerome Powell’s hand may be forced, says Chaar. ‘What if, this time round, the US and China manage to reach a trade agreement that is both convincing and durable? This factor is clearly the pivotal element to our 2020 scenario – and the upside “risk” to our base case. Capital spending and trade flows would pick up markedly, and growth rates across the globe revert back towards their longer-term trend. Which would of course make the Fed much less liable to ease policy further,’ Chaar says. TRADE WAR TALKS: WHERE NEXT? The ongoing trade dispute has dominated discussions throughout 2019 with the tit-for-tat tariffs providing short, sharp shocks for the market. Donald Trump signalled plans to sign a comprehensive deal, which would come into effect in mid-January, which produced a major stock market bounce, but whether it has significant long-term implications remains to be seen. Xiadong Bao, a fund manager at Edmond de Rothschild, is among those who believe there are deeper challenges that need to be addressed. Speaking before the December meeting between the US and China, the global equity manager, who specialises on China, believes a lot remains to be seen with regard to the current customs duties already in place. ‘Nevertheless, the confrontation persists. On the technological front, let’s not forget that Huawei’s CFO has still not regained her freedom, while China intends to ban foreign software from its administration. In addition, the technology giants are continuing to relocate their production outside China. ‘The confrontation between the two great powers is unlikely to stop geopolitically and ideologically, as there is US support for the Hong Kong demonstrators, as well as presidential elections in Taiwan, which is a valuable ally of Washington. The US has also raised human rights concerns over activity in the Xinjiang Uighur autonomous region.’
But, what about Trump? It is hard to speak definitively as the impeachment case is ongoing and the situation may have changed by the time of publication. However, the next quarter will define the field as far as which Democratic candidate will be vying for the top job. If Trump survives the case, commentators believe he will retain his seat. Stuart Cox, a global fund manager at Jupiter, says: ‘While it appears likely that Trump will be re-elected in 2020, the election outcome could prove to be closer than currently expected. However, regardless of the result, I will strive to exploit opportunities and manage risks as they arise, and I believe strong fundamentals are likely to win the day.’ The consensus appears to be leaning towards one of expected volatility – something JP Morgan attempted to get ahead of with the launch of the Trump tweet-focused Volfefe index in September. So, what will fund managers be doing? Cox believes there are secular calls to be made. ‘I’ll continue to seek out some of North America’s highest-quality businesses, which are backed by strong, stock-specific investment cases. Through a combination of fundamental research and company engagement, I strive to be at the forefront of these evolving investment opportunities.’ RED, WHITE AND GREEN? One trend that could become more prominent for those investing in the US is ESG. The market has been criticised for being slower on the uptake than European counterparts but there are many factors working in its favour. With the overall size and scope of the US market, broker coverage is not an issue, while it is understood company disclosure has also improved markedly. Simon Clements, manager of the Liontrust GF Sustainable Future Global Growth fund, believes the US market, especially with Silicon Valley as a driver of innovation, can continue to entice stock pickers. ‘These companies tend to be very good from an environmental and social perspective, as it is something that is understood in that part of the US. Whereas five years ago, very few US companies would produce sustainability or CSR reports, these days they are commonplace. These types of reports are a great way to dig and understand how a business thinks about its environmental, social and governance impacts, and the steps they take to mitigate these.’
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iM Dolan McEniry plan to snap up bond bargains in 2020 market storms
DANIEL DOLAN Dolan McEniry Fund Manager iM Dolan McEniry US Corporate UCITS Fund
ROGER MCENIRY Dolan McEniry Fund Manager iM Dolan McEniry US Corporate UCITS Fund
Daniel Dolan and Roger McEniry, managers of the iM Dolan McEniry US Corporate UCITS Fund, believe the opportunities in 2020 may lie in a ‘big market trauma’ or negative development in the credit markets. In any event and in any market, they plan to continue to employ their no-nonsense strategy of buying what they believe to be safe but unloved corporate bonds. Dolan McEniry Capital Management has carefully followed its value investing approach to fixed income over the course of its 22-year history. Their careful in-house credit analysis with its free cash flow focus has been a winning formula for corporate bond investing and has meant that none of Dolan McEniry’s funds or separately managed accounts have ever borne the brunt of a corporate bond default. The pair do not make any predictions on the economy or interest rates. They instead focus ‘on credit, what the risk is, and what the relative price of that risk is’, and are always attuned to looking for opportunities when markets are difficult, McEniry said. ‘The opportunities in 2020 may be big market trauma and turbulence,’ he said. ‘We love it when stuff hits the fan – when investors get nervous. The prices of bonds we own may be down in the interim on a mark to market basis, but we believe there will be buying opportunities.’ As ‘micro-fundamental-driven investors’, the managers work company by company rather than looking at sectors. ‘We don’t evaluate sectors. Sectors don’t pay you back – individual companies pay you back,’ McEniry said. But he admitted it is difficult to find ‘compelling value’ as spreads are tight. ‘We have more in investment grade bonds than high yield bonds at the moment as we do not believe we are getting paid for the risk in high yield,’ McEniry said. Spreads have tightened rapidly over the past year, according to McEniry, who said last Christmas ‘spreads were wide, there were opportunities everywhere, and we were clear in expressing our opinion that it was the time to invest’. However, McEniry said, the ‘pendulum has swung back, and it has done so rather violently and in short order’ and the opportunity set moving into 2020 ‘is not as compelling’. Whatever moves the market makes next, Dolan and McEniry are focused on their investment strategy and steadfast in ignoring the market noise. ‘If you recall a year ago, many of the pundits were saying there was going to be a recession, that it was the end of the cycle. There was talk of a credit bubble and of downgrades – and they were wrong,’ Dolan said. ‘That is another point in our strategy – we are contrarian and cynical. We do not rely on what others have to say.’
Dolan McEniry has a unique investment process that is done in-house. ‘We are value managers in the corporate bond space, so what we strive to do is buy safe credit based on our own research,’ Dolan said. ‘We want to buy bonds at as wide a spread as possible, so we start from there. We are credit analysts. That is the DNA of our firm.’ There are two key elements to Dolan McEniry’s bond assessment process: they look for companies that both generate large amounts of free cashflow in relation to indebtedness and trade at relatively attractive prices. The balance of risk and return must be compelling. ‘The stronger the cashflow a company produces, the wider the margin of safety we’ll have to work with in trying times,’ Dolan said. In order to uncover companies like this, the managers rely on their own research for investment ideas, Dolan said. ‘That means we rarely read third-party research,’ he said. ‘If it comes into our office via snail mail or email, we usually delete it or throw it away. We do not pay attention to ratings agencies except to comply with investment policy statements.’ He said financial statements are central to the firm’s process, as are the 10-year historical spreadsheets they create in which ‘each line item is important to us.’ Dolan McEniry then focuses on the capital allocation choices made by management teams of potential investments. ‘We don’t often speak to management teams or go to investor days or listen to investor calls. We read financial statements,’ he said. ‘Why would we care about what someone else thinks? Management teams cannot tell you anything more than they can tell anyone else. ‘Who knows what the future will bring, so we carefully watch how management allocates capital. How efficiently do they manage working capital? How do they make their capital expenditures? What are their dividend policy and share repurchase decisions? These are the things we care about.’ With research so central to the investment process, the firm believes it critical to invest where they feel they understand the underlying businesses. They are drawn to consumer staples, services, low technology, retail, distribution, and manufacturing, among others. Basic and easily understood businesses with strong brand names and market positions are particularly attractive to the bond investors at Dolan McEniry. The firm tends to invest in high cash flow return on investment businesses without huge capital requirements. It’s also notable what the firm avoids, and Dolan said in order to stay within their ‘circle of competence’ Dolan McEniry does not invest in bonds issued by banks, insurance companies, or broker dealers. ‘We don’t buy financials because it’s not in our skill set to confidently or competently assess the free cash flow of those companies or how that free cash flow gets allocated. We have a similar posture with utilities and most energy companies. We leave those industries to others and stick with what we feel we know. This has been very helpful to us in past market downturns. ‘When we make a credit decision, we have two fundamental considerations,’ Dolan said. ‘We want to make sure we collect our interest payments twice a year and get our money back when the contract matures.’ The managers made their unique investment style available to investors outside of the US with the launch of the iM Dolan McEniry US Corporate UCITS Fund in 2017, which utilizes Dolan McEniry’s flagship Core Plus strategy. The fund holds the bonds of between 35 and 40 issuers in roughly equal weighting. ‘We are buy-and-hold bond investors,’ McEniry said. ‘We don’t pay any attention to what others do. Our strategy and process have been effective for a long time – for 22 years. ‘It’s not rocket science. We buy companies we understand and which generate a lot of cash. And we’re not just looking for safety, but also for bonds that are a little unloved or cheap or out of favor – one of those things – so we can put ourselves in position to outperform our benchmarks and our peers.’ McEniry said. The iM Dolan McEniry US Corporate UCITS Fund returned 11.68% in 2019, versus 10.41% from its stated benchmark, the Bloomberg Barclays US Intermediate Credit index. Since inception the fund has returned 4.56% against a return of 4.39% by the index1. If that potential market trauma or negative development in the US credit markets presents itself anytime soon, Dolan McEniry believes it will be ready.
1. Past Performance is not indicative of future results. NAVs and performance information for the iM Dolan McEniry US Corporate UCITS Fund are reflective of management fees and transaction costs and include the reinvestment of all income.
CHAPTER 2
US fixed income managers are still reaping the benefits of a relatively strong economy but there are some big unknowns on the horizon and leading players are positioning accordingly. Rob Griffin reports
US fixed income has performed quite well over the past year, says Steven Lear, manager of the JPM US Bond fund. ‘Market sentiment benefited from a dramatic shift in monetary policy when the Federal Reserve changed course by ending its balance sheet reduction programme and started cutting rates,’ he says. Lear says going longer in high-quality US duration proved to be a good move during 2019, as did his belief that strong US labour market fundamentals would underpin the US consumer, and related securitised holdings. ‘We have been, and remain, cautious on credit risk, although we acknowledge we were early with this call,’ he says. ‘Gains across investment grade and high yield credit since the beginning of 2019 have been more significant than we envisaged.’ Lear is growing more cautious on risk and is preparing for an environment that is closer to the end of cycle. ‘We are moving up in quality across portfolios – favouring higher-rated bonds within a given sector, and reallocating across sectors to those with lesser credit exposure,’ he says. In addition, he has reduced high-yield holdings to the low end of his historical allocation, replaced a portion of investment grade corporate credit with government-guaranteed US agency mortgages, and shifted remaining credit holdings higher. TRADE WAR WORRY Lear sees the trade war and the general uncertainty it brings as the biggest risk to US and global markets, noting that the conflict has grown increasingly unpredictable since President Trump escalated tariffs in May last year. ‘Our concern is that prolonged disagreement will hit economic growth, with widespread uncertainty leading to a noticeable pullback in business investment,’ he says. Although much depends on trade, he believes conditions look reasonable for US fixed income going into 2020. Similarly, US treasuries ought to perform well in a flight-to-quality scenario, should the trade war drag on. ‘Inflation remains low and stable, and, in a world devoid of yield, we see favourable technical dynamics for US fixed income as a whole,’ he adds. ‘Investors searching for income can still find attractive, positive-yielding securities across a wide, investable US market.’
NO SECRET SAUCE There are always problems to tackle, says Thomas Farina, manager of the DWS Invest ESG Corporate Bonds fund. ‘Over the last 10 years we’ve had lots of unpredictability to contend with but always found a way to manage it,’ he says. He doesn’t expect the coming year to be any different. ‘You can have a view on who is going to win the US presidency, whether there will be a repeal of Brexit, and if there’s going to be a trade deal, but it’s more important to take a measured approach,’ he says. Looking at the fundamentals and carrying on with bottom-up investing is where his focus will be over the coming months. ‘We continue to invest in USD investment grade issuers which are prudently managed, have business resilience, good market shares and are well positioned for uncertainty,’ he says. ‘There’s no secret sauce. We’re doing fundamental work and making reasonable bets.’ INVESTMENT GRADE STILL ON TRACK Farina says US banks have enjoyed credit rating upgrades and expects that to continue. ‘Spread levels and valuations have improved, and we’ve seen some very good performance from US banks in comparison to the market and versus their European peers,’ he says. Inflows into the broad US fixed income area have also been surprising. ‘These inflows were much stronger than anyone anticipated at the beginning of the year. There has also been exuberance about the potential of a trade deal between the US and China. The market is looking at this very positively, whereas I had expected more caution.’ From an economic perspective, Farina highlights that the US is growing at 2% and Europe at 1%, so he doesn’t see a recession on the horizon. As a result, he expects investment grade credit to continue performing well. However, once you start factoring in the potential outcomes of the US election it becomes increasingly difficult to predict how things are likely to look in a year’s time. ‘2019 was a year of two halves – the first very strong and the second characterised by sell-offs and rallies – so I’d expect something similar to H2 in 2020,’ he says. ‘We’re probably going to see a bit more volatility during the first three quarters.’ WATCHING FOR BLACK SWANS Gerard Fitzpatrick, head of fixed income and senior portfolio manager on the Russell Investments Global Bond fund, agrees there is a continued focus on the outcome of US/China trade talks, with the expectation that a lite-trade deal is done as the US election approaches. In general, he says the outlook for US credit over the next year looks robust enough to maintain an overweight, although it always pays to be cautious. ‘It’s important to be vigilant for any negative developments coming from the Fed, contagion risk causing challenges for US credit and any possible “black swans”, which could force the US economy into a recession earlier than anticipated,’ he says. As far as portfolio positioning is concerned, Fitzpatrick believes longer-term bonds will generate higher returns than comparable shorter-term bonds or cash. ‘We have a strategic preference for such positioning for both return and risk reasons,’ he says.
He believes bonds with credit risk will generate higher returns than comparable high-quality government securities over a market cycle. ‘Our tactical process also keeps us overweighting credit, given the interaction by a supportive cycle with valuations that are not too expensive,’ he adds. ALL EYES ON THE ELECTION Looking ahead, Andrew McCaffery, global CIO of Fidelity International, says the upcoming election campaign is crucial to markets. ‘The big risk for investors in 2020 is that Elizabeth Warren gets the Democratic nomination and markets retreat as liquidity conditions begin to deteriorate,’ he says. ‘Private capital, too, is likely to be a target for Warren, given her focus on corporate taxes.’ He believes the US is approaching a moment of reckoning: either the cycle turns or it rolls on until the US election at the back end of 2020. ‘Corporate concerns about borrowing will only increase if the Democrats appear likely to win the US election and central banks may have little left in the tank to combat these late-cycle dynamics,’ McCaffery says.
Inflows into the broad US fixed income area have also been surprising. ‘These inflows were much stronger than anyone anticipated at the beginning of the year. There has also been exuberance about the potential of a trade deal between the US and China. The market is looking at this very positively, whereas I had expected more caution.’ From an economic perspective, Farina highlights that the US is growing at 2% and Europe at 1%, so he doesn’t see a recession on the horizon. As a result, he expects investment grade credit to continue performing well. However, once you start factoring in the potential outcomes of the US election it becomes increasingly difficult to predict how things are likely to look in a year’s time. ‘2019 was a year of two halves – the first very strong and the second characterised by sell-offs and rallies – so I’d expect something similar to H2 in 2020,’ he says. ‘We’re probably going to see a bit more volatility during the first three quarters.’ WATCHING FOR BLACK SWANS Gerard Fitzpatrick, head of fixed income and senior portfolio manager on the Russell Investments Global Bond fund, agrees there is a continued focus on the outcome of US/China trade talks, with the expectation that a lite-trade deal is done as the US election approaches. In general, he says the outlook for US credit over the next year looks robust enough to maintain an overweight, although it always pays to be cautious. ‘It’s important to be vigilant for any negative developments coming from the Fed, contagion risk causing challenges for US credit and any possible “black swans”, which could force the US economy into a recession earlier than anticipated,’ he says. As far as portfolio positioning is concerned, Fitzpatrick believes longer-term bonds will generate higher returns than comparable shorter-term bonds or cash. ‘We have a strategic preference for such positioning for both return and risk reasons,’ he says.
Quality value hunter Krawez bets on media and healthcare for tough 2020
BRIAN KRAWEZ Scharf Investments President & Fund Manager iM Scharf US Quality Value UCITS Fund
Brian Krawez manages the iM Scharf US Quality Value UCITS Fund which is typically made up of 25 to 35 stocks that fulfill two criteria: a history of predictable earnings and a good favorability ratio. The favorability ratio is a proprietary metric that compares a stock’s potential upside to its potential downside based on historical valuations. The fund is currently backing healthcare and media as quality value plays that Krawez believes will stand out in what could be a tough 2020. Value managers have had a difficult decade as low interest rates and quantitative easing have buoyed growth stocks and fueled this decade’s strong bull market run. There was a glimmer of hope for out-of-favor value stocks in September as markets rotated out of growth, but Krawez believes next year ‘is going to be tougher for everyone.’ ‘A decade of double-digit market returns has lifted stock valuations and consequently reduced the number of attractive opportunities. Despite this, our portfolio is invested in a number of areas that we believe the market is overlooking and that could do well going forward,’ he said. Healthcare is one sector Krawez has confidence in for next year, ‘particularly in pharmaceuticals’ as fears over more stringent drug regulation have weighed on stock prices. Krawez said the drug companies in his portfolio ‘generate great cashflow’ and have ‘interesting drugs in the pipeline.’ ‘They are trading at valuations that offer strong favorability, so it is an area that we believe could attract investors’ attention if returns get more challenging,’ he said. ‘Investors often return to these stocks for their stability and safety of both cashflow and dividend. They may not be as exciting as growth stocks, but there are many attractively priced pharmaceutical companies which pay decent dividends and are expected to grow earnings.’ Krawez is also on the lookout for opportunities in media and pointed out Comcast, which is currently trading at 13 times earnings. This compares favorably to its historical median high P/E of roughly 17. He said the company has come under pressure as investors are worried about its diminishing cable TV business as more people unsubscribe in favor of online, on-demand services. ‘Investors are concerned about households getting rid of cable; however, the reality is that Comcast makes most of its money on broadband internet services,’ Krawez said. ‘Broadband is an essential service which means households are less likely to cancel it. This leads to higher earnings predictability for Comcast. The company has a Value Line earnings predictability score of 100, which is based upon the stability of year-to-year earnings. Combine this with the stock’s strong favorability ratio, and you have the two things that we look for in an investment.’ Whether September’s rotation into stocks like Comcast is a permanent shift or another false dawn for value is ‘difficult to predict,’ Krawez said. The differential between growth and value stock valuations is ‘very wide’ and that would suggest a rotation could be coming, but he noted that valuations in the 1990s got much wider and there are no guarantees they will not stretch further this time around. Rather than try to time the next big rotation, Krawez will continue to seek out high quality stocks trading at a discount and aim to avoid the value traps that plague many value managers. He said that managers have had to contend not only with value being resolutely out of favor and the underperformance that comes along with it, but also with technological disruption that has made seemingly cheap stocks value traps. Krawez said that value strategies normally rely on a ‘reversion to the mean’ premise that assumes if a stock falls out of favor, it will regain its value over time.
However, technology has upset this strategy by creating a small number of “winner-take-all’ companies. As first adopters of new technologies, these companies outpace others in terms of growth and ultimately share of the market. He added that Amazon is a prime example of one of these companies. It moved from online retail to film and television production, cloud computing, and fresh groceries, and continues to pose new threats to other industries such as payments and small business lending. He does not believe that the situation where a handful of companies dominate the market can continue. ‘My view is that, historically, when you have a winner-take-all situation, something changes, and a lot of the time it is the market and sometimes it is regulation,’ he said. ‘We are seeing both now. In the US, we have talks of regulating various technology companies, and we have smaller companies adopting technologies that will help them compete with larger players. I believe it will soon be less winner-take-all, and in the future, the benefit of growth will accrue to more market participants.’ While companies fight to play catch up with early adopters that have gobbled up growth, Krawez continues to avoid value traps by looking for ‘quality value’ companies with a history of stable, predictable earnings rather than pure value companies. ‘Earnings predictability helps to ensure that we don’t wake up one day and realize our earnings estimates are cut in half,’ he said. He looks for companies that are cheap relative to their sector rather than cheap in absolute terms. This strategy has been difficult as of late as Krawez said there have ‘not been a lot of quality value opportunities over the last four or five years.’ ‘It has been harder because the cheap companies have more structural problems than we prefer to take on, or we have to pay up for the companies that are better quality – neither of which we like to do,’ he said. The focus on quality value is an integral part of the iM Scharf US Quality Value UCITS Fund run by Scharf Investments, and it has generated value for investors over the long-term. While Scharf’s Large Cap Equity strategy, which dictates the fund’s strategy, has underperformed the S&P 500 in recent years as value has remained out of favor, it has returned 11.4% net of fees since its inception of 12/31/1990 versus 10.4% for the index through the end of 2019. Krawez said he used to be a ‘deep value’ manager until he realized ‘there were some flaws looking at absolute valuations.’ Instead, he said it was more profitable to look at the past trading history of a company to work out which companies are ‘cheap relative to history.’ ‘Our strategy gives us the flexibility to buy better quality companies that are trading at attractive valuations,’ he said. He flagged Booking Holdings as an example of the type of stock that would fit Scharf’s ‘quality value’ criteria. With an earnings predictability score of 100 and a history of strong earnings growth, it is ‘still reasonably priced’ relative to its history. At an estimated 18 times earnings, the stock has 43% upside to its median high P/E and just 13% downside to its median low, offering a very attractive favorability ratio. Krawez said his portfolio allows him to deliver growth to investors, while also aiming to protect on the downside. By buying stocks with a history of consistent earnings that are trading at the lower end of their historical valuation ranges, Scharf’s portfolios have historically outperformed during market downturns. ‘With value, people think there is no real growth, however the companies in our portfolio are projected to grow earnings by 10% this year on average compared to just zero to 2% for the S&P 500. While we believe 2020 may be more challenging than recent years for many investors, we are confident in our current portfolio and believe it is positioned to deliver strong relative returns over the long-term.’
This material includes forward looking statements based on Scharf Investments’ experience and expectations about the securities markets and the methods by which Scharf Investments expects to invest in those markets. Those statements are sometimes indicated by words such as “expects,” “believes,” “seeks,” “may,” “intends,” “attempts,” “will,” and similar expressions. The forward looking statements are not guarantees of future performance and are subject to many risks, uncertainties and assumptions that are difficult to predict. Therefore actual investment returns could differ materially and adversely from those expressed or implied in any forward looking statements. The securities identified and described do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that investment in the securiites identified was or would be profitable. Returns include the reinvestment of income. Past performance is no guarantee of future results.
The Fed is set to be supportive for US credit but there’s more geopolitical turbulence ahead. We talk to TwentyFour AM’s David Norris who recommends weatherproofing portfolios via careful diversification
Building diversity into portfolios is the way to prepare for the many challenges facing the US credit market in 2020, says TwentyFour Asset Management’s US credit chief David Norris. Norris advocates a well-balanced portfolio with shorter duration and higher credit quality, in order to maximise the chance of a good level of income while protecting capital. He says higher-quality US high yield should provide stable returns given the US growth outlook and a supportive Fed. That said, there are several geopolitical clouds on the horizon this year, starting with the ongoing US/China trade tensions as the superpowers move into phase two negotiations. Beyond that, the upcoming presidential election promises increased volatility towards the back end of the year, Norris says. ‘These challenges, however, will be negated by a very accommodative Fed should the environment warrant it.’ Central bank policy contributed strongly to 2019, he adds, as the Fed’s more dovish stance in January 2019 was one of the biggest drivers of growth in US credit last year. ‘The Fed’s three rate cuts over the course of the year provided the stimulus and confidence for investors to drive spreads and yields to historically low levels.
‘However, with the memory of Q4 2018 firmly in the back of investors’ minds, the performance was predominately in the higher end of fixed income, as seen by the outperformance of BBB and BB spreads vs CCC-rated credits,’ he adds. Overall, Norris expects a healthy first quarter. This takes in the new issue market, which was very strong in 2019 as issuers capitalised on the low rate environment to improve balance sheets. ‘As such, approximately 70% of US high yield new issuance in 2019 was refinance-driven. We expect that trend to continue into 2020. ‘Given that we are beginning the year at lower outright yield levels and tighter spreads compared with the same time last year, 2020 will require a strong focus on reducing volatility through effective risk management.’ The biggest change this year is the expectation that the Fed is unlikely to spring any nasty surprises, Norris says.
CATCHING FALLEN ANGELS One trend that stood out in US credit last year was fallen angels, as 11 investment grade US corporate issuers dropped into high yield territory, accounting for $16 billion (€14.4 billion) of notional debt. Avoiding the names at risk of dropping into high yield should be a priority for investors, particularly in the late credit cycle when valuations tend to be more stretched and corporate leverage is generally heightened, Norris says. That said, identifying credits that might benefit from a move in the opposite direction can be just as important for returns, he adds. In this regard, the manager points to Newell Brands, the maker of Sharpie pens, which was downgraded to BB by Standard & Poor’s on 1 November, in a move that forced it out of the BAML US IG index and into the BAML US High Yield one. ‘With Newell currently targeting a net debt/Ebitda ratio of 4x by year-end 2019 and 3.5x by the end of 2020, the company could be a candidate to regain its IG status. Thanks to that 50bp spread widening, the yield-to-maturity on Newell’s 4.2% 2026 bonds is currently 3.62%, compared with 3.16% on the BBB index and a 3.79% yield-to-worst on the BB index. That represents attractive value with potential for upside should the company meet its leverage targets.’
Jessica Beard Deputy Editor
Convertibles manager Arnaud Brillois scrambled to reposition his portfolio following a powerful market rotation last year but the Lazard manager says he is now poised to recapture the upside, particularly in the US part of his fund. Jessica Beard reports
Talk of a sector rotation from growth to value last September missed the mark – the real shift was from high to low momentum, says leading convertible bonds manager Arnaud Brillois. The Lazard manager says the companies that led the way in the US market from the beginning of 2019 to August became the laggards in the second part of the year, while those that had done badly up until the summer went on to outperform. This rotation has some way to run as there are still sub-sectors that are correcting in terms of valuation, he adds, and convertible bonds have been caught up in the move. Brillois, who runs the Lazard Convertible Global fund, says the rotation was partly triggered by the high valuations of some sub-sectors, especially in technology.
‘The beginning was WeWork when investors suddenly realised the company was too overvalued. Many systematic investors then decided to revalue the company and the rotation started at the beginning of September.’ This move is evidenced by the performance of US convertible bonds, which had a fantastic run from January to August but then underperformed the S&P 500 by some way in the final part of the year. The sectors most affected by the switch included software, cyber security, online retail and biotechnology. ‘A lot of convertible bonds that were very equity-like saw their equity fall, so the convexity of a convertible bond has increased. Many of the companies affected in our portfolio have a very good balance sheet and had positive results in October but it was not enough to stop the rotation. We are in a situation where a part of the convertible bond market has strongly corrected, especially in the US which had a very high valuation.’ That said, the underlying equity has produced very strong results, so at some point, that part of the convertibles market should deliver strong returns, Brillois says. Looking at past performance, his fund has returned 33.4% in USD terms over three years to the end of November versus 10.7% from the average manager in the sector. RIGHT AND WRONG ON TACTICS Brillois says the 6-9 September rotation was the most powerful since 2001, and the strength of this latest one prompted a series of tactical moves. ‘We decided to sell a few names that were not protected and had high valuations, but we thought most of the companies we had in the portfolio would rebound when results were published so we kept them. We were both right and wrong – more than 80% of the companies that we have in the portfolio beat their estimates but it was not enough to stop the rotation.’ At this stage the manager decided to de-risk and sell some of his US holdings with the intention of starting to buy them back at the end of December. This meant offloading names from the tech sector, which up until this point had represented the portfolio’s largest sector holding for more than three years. However, the rotation pushed consumer discretionary into the top spot. ‘We are still waiting on some sectors but we are starting to invest a small amount on the names that have been destroyed during the last quarter. ‘This means that the US is now a very strong part of the fund, not only in terms of its primary market, but in the fact that a large part that was overvalued is now fairly valued or perhaps even undervalued.’ Brillois adds that there is a lot of cash in the portfolio at the moment, as he is poised to buy back the companies he sold tactically. ‘In 2020 we will be back in the US very strongly when the companies that have been attacked stabilise.’ The main challenge for convertible bond managers in the coming year will be market timing, as the equity market will rise but it will do so very quickly so investors will have to be ready to capture the upside, he says.
In the alphabet soup of US bonds, those with too many of the wrong CCCs on their plates could be going hungry in 2020, writes Chris Sloley
Much of what mattered in US high yield over the course of 2019 was focused on how you played the CCC area of the market, says Seth Meyer, who oversees four high yield focused funds at Janus Henderson Global Investors. The Denver-based investor says the bulk of outperformance across his funds was defined as much by what he didn’t hold as what he did. ‘If you look at our performance year-to-date, what has worked for us is taking better CCCs than the market gives you. ‘What I mean by that is finding those stories in the CCC bucket that are going through the fundamental, transformational stories of deleveraging or ESG improvement that is not yet reflected in their valuation.’ He adds: ‘Perhaps more importantly, this is in addition to avoiding the names that were hammered last year. I am talking about those that were down 40%, 60%, 70% or even as much as 90%. That is why we won last year – through really solid securities selection.’ HEAD-SCRATCHING TIME Meyer says the market was much more homogeneous a decade ago, as evidenced by around 25% of the main indices being CCC-rated debt in 2008. When looking at the current make-up, this number has fallen closer to 12%. Meyer believes this presents an interesting quandary for him and his counterparts. ‘Generally, when we have such an aggressive risk-on rally as we saw in 2019 with the index up 13% YTD, you would have the CCC part of the index leading the rally. When US HY has been greater than 5% in total return, CCC securities have always led the rally.
The main factors weighing on exposure have been US/China trade disputes, stalling growth and major central banks flipping from a tightening emphasis to a looser stance, he says. ‘All of these things led investors to be a little more cautious than would have been the historic norm in an environment which would have been risk on.’ WILL THE SONG REMAIN THE SAME? So, will these be the main factors for the year ahead? Meyer highlights that at the end of 2019 many bond buyers aggressively moved into CCC-rated debt, a shift which he views as 70-80% technical rather than being done for fundamental reasons. ‘Liquidity is thin through December, while dealers are not naturally long a lot of these high yield bonds. There isn’t a lot of trading taking place to drive valuations higher, either.’ ‘What changed the mindset is that investors became more confident that we wouldn’t see a recession in 2020, OPEC reached an agreement, and world GDP growth started to improve from a low base.’ ‘Ultimately, valuations were disconnected. We weren’t significantly underweight oil and gas all year. We were underweight but not by much but we are getting a little closer to benchmark right now.’
The US market is made up of multiple strands but some trends may be more instructive to follow than others. CIOs and Super Allocators reveal the themes they are watching most closely for a steer on the future
A multi-boutique with a purpose
JEAN MAUNOURY Deputy CEO & CIO iM Global Partner
Boutique asset managers are set to experience a rise in popularity in the coming years as the questions of active ownership and value for money have come to the forefront of investors’ minds. Unlike some of their large competitors, boutiques are able to focus all their efforts on one strategy while remaining nimble, which often leads to a high active share. In a world where management fees continue to feel the squeeze and the regulator is on a hunt for ‘closet trackers’, active managers are already being rewarded with investors’ cash. Their performance figures speak for themselves, according to iM Global Partner’s research boutique managers are able to outperform their larger counterparts. At the same time, boutiques also provide the feel-good factor for environmentally conscious investors, with a report from think tank New City Initiative (NCI) showing 90% of boutiques are incorporating environmental, social and governance (ESG) factors into their portfolios1. However, boutiques are facing various constrains, with increasing regulatory burdens and rising costs of running businesses threatening to push many out of the market. Jose Castellano, deputy CEO and Head of International Distribution at multi-boutique iM Global Partner, said: ‘The industry is going through a very complex situation. The vast majority of assets under management have not met their targets, but they have managed to charge high fees. ‘This has substantially changed the fiduciary responsibility for banks and assets managers. Now the main driver to put a fund or an asset management solution on the shelf is price, the right price, and performance.’ As a result, the industry is undergoing a major restructure and ‘growing very binary’, Castellano added. In simple terms, a division is emerging between firms offering low-cost beta and providers of alpha. ‘On the one side, you have very low-cost structures, including passives, which is an area that is growing tremendously. But it’s passives so the fees are very low, and they will become even lower,’ Castellano said. ‘And on the other side, you have a big opportunity for highly active, high-alpha producers. In this space, you really need very high quality. But it is not really that price-sensitive.’ INDEPENDENCE This is where multi-boutiques come in – businesses that buy into boutiques and provide them with marketing and regulatory support to allow them to focus on what they do best; managing money. This structure has been growing in popularity, but not all multi-boutiques are equal. Unlike some of its competitors, which often buy entire teams or businesses, Castellano is adamant about one thing: iM Global Partner acquires minority stakes in boutique partners. ‘Independence is a big factor for us when finding a Partner,’ Castellano said. ‘We believe that whenever they lose independence, it is the beginning of the end for a company, so we want them to remain independent. That’s why we only acquire a minority interest. You can’t buy a majority interest and call it independence.’ Since its launch in 2013, iM Global Partner has focused on acquiring stakes in best-in-class entrepreneurial investment firms on a long-term time horizon. To be considered, a firm typically has to be active, have outstanding track records and an ability to grow over the long term. Additionally, any new Partner must be complementary to the existing boutiques under the umbrella. ‘We are looking for Partners having gone through adverse market conditions, having unique investment philosophies and running high conviction portfolios’ said the firm’s deputy CEO and CIO, Jean Maunoury. So far, the multi-boutique has built up a strong portfolio in European equities, US and global equities and US Corporate bonds counting six Partners spanning value, growth and long/short equity and bonds propositions. However, the firm is now looking to strength this offering by partnering with managers in areas such as European and emerging market (EM) assets, as well as expanding further into fixed income. Maunoury added EMs are particularly interesting, both on the equity and bond side, as they ‘represent a good investment over the long term and it is an area where highly talented managers can deliver high alpha ’. ‘We are not making an investment decision for the coming three months – we are making one for the coming 10 years,’ he added. DEEP DIVE DUE DILIGENCE Since iM Global Partner partners with one asset manager in any given asset category and style, the selection and due diligence process is extremely rigorous. Maunoury said: ‘We don’t partner with multiple managers in every asset class and promote them according to performance. We stick with one for the long-term, so we need to ensure the ones we are investing in are really the best of the best. This forces us to do much deeper due diligence on managers.’
This means members of iM Global Partner across the board are involved in the selection process, bringing decades of experience in asset management and manager selection to the process: from the investment team to the Heads of US and International distribution and the founder and CEO Philippe Couvrecelle himself. The team combines its expertise to provide a 360-degree view of a firm based on both qualitative and systematic measures. Maunoury said: ‘We believe in independent thinking when it comes to looking at investment firms, and it is essential that the different angles we have of looking at potential Partners lead to the same conclusion. This is also true for idea generation, which comes from a combination of experience, systematic unique filtering and more and more from potential Partners directly contacting us.’ ‘We take a long time to make sure the manager, whose capital we acquire, is the right one. Once we invest, we have a long-term commitment to work with them side by side. That is why we call them Partners.’ CULTURAL FIT On the qualitative side, one of the key aspects in a potential Partner is the company culture, according to Head of Research Bo Huang. ‘We want them to have a long-term vision for growth, and to treat their employees with respect,’ she said. ‘For example, [our Partners] Polen Capital and Dolan McEniry have a very collaborative culture in place. The portfolio managers and analysts work very closely together, there is a real fertilisation of ideas across the chain, and they are not afraid to speak up and express their views.’ The due diligence process also involves looking at the stability of the team, interviewing present and past employees, identifying key decision-makers as well as support team, and scrutinising the company infrastructure. Once a company with the right cultural fit has been picked, it’s time to look at the investment process. ‘The firm must be able to demonstrate a disciplined, repeatable process that can perform strongly over the long-term. Of the existing Partners, all boast top percentile performance over the years,’ Huang said. ‘Even if sometimes their style is out of favour, we still have confidence that the manager will deliver high alpha across market cycles,’ she said. ‘Sometimes our Partners’ strategies are temporarily underperforming due to their benchmark agnostic approach for a period, but over the long term, they have always beaten their peers and benchmarks.’ ‘iM Global Partner does not see itself as a fund selector,’ she added. Rather, the firm is looking for long-term Partners that have the ambition and ability to grow and want iM Global Partner to accompany them on their journey’. Over the long -term, iM Global Partner believes this process will allow it to build a portfolio of ‘the best-of-the-best alpha producers’ across all key asset classes.
1. https://citywire.co.uk/wealth-manager/news/number-of-fund-boutiques-adopting-esg-doubles-in-five-years/a1195854
How iM Global Partner is building a best-in-class offering platform while maintaining independence and taking due diligence to new heights
JOSE CASTELLANO Deputy CEO & Head of International Distribution iM Global Partner
BO HUANG Head of Research iM Global Partner
Following a solid 2019 investors remain positive on the outlook for US equities but many are edging towards a more defensive posture. Rob Griffin gets the lowdown from top fund managers
Last year was certainly a good one for US equities, generating the best returns since 2013, says Derek Deutsch, co-manager of the ClearBridge Sustainability Leaders fund. ‘We attribute this to a more accommodative US Federal Reserve, reasonable economic growth, and healthy consumer spending,’ he says. ‘These factors overcame heightened geopolitical risks and anti-competitive trade policy.’ Technology investments have been among the most positive contributors to the fund, while holdings in renewable energy companies, such as SolarEdge Technologies, Ormat Technologies, NextEra Energy and Brookfield Renewable Partners, have also helped drive performance. However, biotechnology companies underperformed. Deutsch says this was due to a combination of competitive threats and negative sentiment towards the healthcare sector, generated in part by the forthcoming US presidential election. ‘We remain modestly overweight in the industrials, information technology and utilities sectors, which is a function of bottom-up fundamental research that integrates ESG considerations in guiding stock selection,’ he adds. He suggests consumers may hold the key to success. ‘If they can remain resilient, we believe the recent interest rate cuts by the Fed will begin to have an impact early in the new year, allowing the US economy to avoid recession and helping equities deliver positive returns,’ he says. UNDERPINNING A POSITIVE OUTLOOK Frank Caruso, manager of the AB American Growth fund, agrees the US market has performed well and says valuations – in terms of price/earnings ratios – are higher than Europe or most emerging markets. ‘This is perhaps unsurprising, as the US is home to the majority of the world’s high-quality growth companies that deserve a somewhat higher valuation,’ he says. ‘Current earnings are trailing market gains, so accommodative monetary policy appears to be driving US equity returns.’
He remains overweight healthcare and underweight technology. ‘Healthcare has performed better recently, largely reflecting strong underlying fundamentals and perhaps some softening of healthcare reform proposals on the presidential campaign trail,’ he says. However, he views the odds of dramatic reform, such as Medicare for All, as very low and uses swings in sentiment and prices to manage positions. Caruso says US economic growth is forecast to be higher than Europe, employment numbers are strong, and both the housing market and levels of consumer spending are solid. However, he notes some potential clouds. ‘In addition to uncertainty around trade wars, the 2020 presidential campaign and impeachment proceedings may sour investor sentiment and cloud the corporate capital expenditure planning horizon,’ he says. ‘Given this backdrop, markets could become more challenging.’ Of course, such a scenario may create opportunities for those willing to be liquidity providers in times of stress. ‘During the 2016 election year, value sectors like finance, industrials and commodities/energy did very well, so it will be interesting to see what this year brings,’ he says. RISKS AND REWARDS The problem is that market sentiment can be very fickle and notoriously hard to predict, says Brad Weafer, co-manager of the Marlborough US Multi-Cap Income fund. ‘We prefer to focus on the fundamentals of the concentrated group of high-quality companies we own,’ he says. He points out that, on average, companies in his portfolio grew earnings per share by 10%. ‘With overall earnings for the wider market barely growing, we are quite happy with that result,’ he says. ‘We saw strength in a number of our large technology holdings, including Microsoft, Mastercard, Equinix and Apple.’ Weafer says the global economy needs productivity enhancements to support growth in the coming years and decades, with population growth forecast to be lower, relative to history, and even negative in some regions. ‘The US technology industry is a global leader, and both the fund and US markets are overweight this space,’ he adds. The fund’s most disappointing holdings have been healthcare companies including Gilead, UnitedHealth and Johnson & Johnson. ‘Demographic trends support a robust outlook for healthcare demand, but drug pricing controls and healthcare policy have been a key topic of political debate, specifically from the Democratic Party presidential nominees,’ he says. Weafer believes the key issue facing US equity markets remains policy error, particularly the risk that the current trade dispute with China transmits into weakness for the US economy and harms corporate profits. ‘Given the complexity of the issues, it’s difficult to predict what the outcome of these negotiations will be,’ he says. ‘What we can see is the negative impact on business confidence.’ He also highlights declines in the Conference Board Measure of CEO Confidence. ‘To grow the economy and profits, businesses need to invest,’ he says. ‘As CEO confidence correlates with business investment, the decline in recent months is not encouraging.’ However, Weafer maintains that the outlook for his portfolio’s companies remains bright and he expects the businesses he owns to grow ahead of the rate of the broader market.
EMPHASISING QUALITY Ralph Bassett, head of North American equities at Aberdeen Standard, is cautiously optimistic that the economy will remain on a firm footing – even though he is retaining a high quality/defensive posture that should enable outperformance even if he’s wrong. ‘Focusing on quality franchises with pricing power, recurring revenues and strong management teams matters more than ever in preserving and growing our clients’ capital,’ says Bassett, who runs several funds including the Aberdeen Mid Cap US Equity. As we are now more than 10 years into a bull market, with a likelihood of more modest returns going forward, Basset says his strategy of protecting investors in down markets will become even more relevant in the years to come. While he’d welcome a more robust growth environment, Bassett continues to see minimal risk of a recession, given recent policy actions, low inflation expectations, and positive corporate profit growth. ‘The environment broadly remains supportive of positive sales/earnings growth. Growth is expected to accelerate as we move into 2020 and, given the reasonable valuations, that supports a positive view for US equities.’
CHAPTER 3
RISKS AND REWARDS The problem is that market sentiment can be very fickle and notoriously hard to predict, says Brad Weafer, co-manager of the Marlborough US Multi-Cap Income fund. ‘We prefer to focus on the fundamentals of the concentrated group of high-quality companies we own,’ he says. He points out that, on average, companies in his portfolio grew earnings per share by 10%. ‘With overall earnings for the wider market barely growing, we are quite happy with that result,’ he says. ‘We saw strength in a number of our large technology holdings, including Microsoft, Mastercard, Equinix and Apple.’ Weafer says the global economy needs productivity enhancements to support growth in the coming years and decades, with population growth forecast to be lower, relative to history, and even negative in some regions. ‘The US technology industry is a global leader, and both the fund and US markets are overweight this space,’ he adds. The fund’s most disappointing holdings have been healthcare companies including Gilead, UnitedHealth and Johnson & Johnson. ‘Demographic trends support a robust outlook for healthcare demand, but drug pricing controls and healthcare policy have been a key topic of political debate, specifically from the Democratic Party presidential nominees,’ he says. Weafer believes the key issue facing US equity markets remains policy error, particularly the risk that the current trade dispute with China transmits into weakness for the US economy and harms corporate profits. ‘Given the complexity of the issues, it’s difficult to predict what the outcome of these negotiations will be,’ he says. ‘What we can see is the negative impact on business confidence.’ He also highlights declines in the Conference Board Measure of CEO Confidence. ‘To grow the economy and profits, businesses need to invest,’ he says. ‘As CEO confidence correlates with business investment, the decline in recent months is not encouraging.’ However, Weafer maintains that the outlook for his portfolio’s companies remains bright and he expects the businesses he owns to grow ahead of the rate of the broader market.
A US long/short fund for the long term
JOHN BRENNAN Sirios Capital Management Fund manager Schroder GAIA Sirios US Equity UCITS Fund
How should investors best shield themselves from the ongoing challenges of the global economy?
This year is shaping up to be a challenging one for investors. While the global economy may have narrowly avoided a recession, thanks largely in part to central banks turning ultra-dovish, the US is likely to slow further while earnings growth is expected to remain tepid. Add in the ongoing US/China trade war, a potentially explosive 2020 US election, recent climbing volatility, and it’s easy to see how investors may struggle this year. Fortunately, there are defensive long/short managers that investors can use to shield themselves from some of these issues by exploiting increased performance dispersion and staying invested across the cycle. ‘I think right now, it makes sense to be invested both long and short,’ noted John Brennan, fund manager of the Schroder GAIA Sirios US Equity UCITS Fund. INVESTING THROUGH THE CYCLE With many beginning to doubt how much road the current bull market has to run, a long/short fund makes sense for those investors wanting to play offense and defence and invest across the cycle. ‘When we look back at this strategy, which goes back to 1999, we see that we’ve captured our fair share of upside, but mostly outperformed on the downside,’ Brennan explained. ‘We look to generate around 50% of the upside, but with around 20% of the downside. When you put that together, we tend to outperform over the cycle.’ Meanwhile, that outperformance is a result of careful portfolio construction and diligent bottom-up research that allows the team’s stock-picking skills to shine over time. ‘Everything is done on a bottom-up basis,’ Brennan said. ‘We have the same strategy across all the sectors we cover. We’re growth-orientated but value-sensitive.’ There is also a sector specialist that heads up all the research on each of the consumer, financials, healthcare, industrials/materials, and tech and communications teams, with each providing ideas for the fund. ‘We’re not trying to force the portfolio to be a certain way in terms of sectors, or even in terms of long or short. It’s really the idea generation – if they happen to find better ideas on the short side, we’ll skew that way, and vice versa. Overall, we want our net exposure to typically range from 25% to 75%.’ ‘If we’re getting too far outside those exposure boundaries, we may have to stop,’ he added. ‘We are currently at approximately 50% net exposure. That’s not a macro call – that’s just about where we are finding the best stock-by-stock ideas.’ BUILDING A ROBUST PORTFOLIO Although Brennan is hesitant to make any big macro calls, he still believes that a recession is not imminent and so has a decent-sized long book. ‘I would say that we’re actually mid-cycle rather than late. It’s late when you look at how long it’s taken, but in terms of housing and other areas, the country is underinvested, so that’s more mid-cycle,’ he explained. ‘It’s a bit of an odd cycle this time because of what happened in 2008 and 2009, and the extremely slow recovery that’s happened since. So, while our net exposure has been coming down recently, we’re still at around 50% overall.’ ‘From a sector point of view, healthcare is an area that we really like – particularly medical devices,’ he said. ‘The medtech sector has benefited in the US from ageing demographics and a focus on lowering the cost of healthcare. With over 17% of GDP spent on healthcare in the US, growing at a mid-single-digit rate, there are many companies with solid long-term growth prospects. ‘Tech and communications is one area where it is a bit more challenging to find good long recommendations because it’s seen such an increase in valuation over the last year or so. One area we do really like is 5G, with the deployments already starting to happen in the US, and also in some geographies like Asia. We think that’s a sector in the early stages of strong growth.’ Elsewhere, aerospace and defence remain solid secular growth stories, especially on the commercial aerospace and aftermarket side. Financials, as well as a range of consumer names, have done well in recent years and could continue to do well if inflation picks up in 2020. Meanwhile, the short side is mostly comprised of companies that are overvalued and are losing market share or their competitive advantage, which should see their value decline over time. PUTTING IT TOGETHER That bottom-up approach and strictly disciplined stock picking has certainly worked over time. Although the strategy has trailed the S&P 500 over the past three years as the US stock market has powered to all-time highs and experienced vintage years in 2017 and 2019, it’s handily outperformed the S&P 500 over the years. Between July 1999 and December 2019, the strategy has enjoyed a cumulative return of 361%, compared with the S&P’s return of 210%. It’s also managed to keep its upside capture of 49.5% with a downside capture of just 21.1%. All up, it has an annualised return of 7.7%, compared to roughly 5.7% for the S&P, but with a much lower volatility of 8.7% compared to 14.5% for the S&P. ‘When the market is ripping higher and there’s a flight to high beta and high risk, we’re definitely going to lag,’ Brennan admitted. ‘But outside of that, if we have a market where you have lower correlations and higher dispersion, as well as choppier overall performance with greater idiosyncratic risk, we should do well in those environments. And in down markets, the strategy is designed to provide downside protection to our clients that want to stay invested and not worry about moving tactically or making trading decisions themselves.’ ‘The strategy is an over-the-cycle strategy that is designed to provide upside capture and downside protection, leading to outperformance over the long term,’ he added. ‘With some of the market extended, buying and holding an index might not make sense. But for those wanting to stay invested, without having to worry too much about valuations, market timing or big downside moves, I think a long/short strategy is an option for generating attractive risk-adjusted returns.’
Source: Schroders and Sirios as at 31 December 2019. Sirios Capital Management, L.P. (“Sirios”) is an independent investment advisor registered in the United States under the Investment Advisers Act of 1940. Registration of an investment adviser does not imply any level of skill or training. Although Sirios provided some of the information contained herein at the request of CityWire, this article was prepared solely by CityWire. This article is not intended to advertise or market any services of Sirios or its affiliates. This article does not constitute an offer to anyone, or a solicitation by anyone, to subscribe for shares of Schroder GAIA Sirios US Equity Fund (the “Fund”). Nothing in this article should be construed as advice and is therefore not a recommendation to buy or sell shares. Subscriptions for shares of the Fund can only be made on the basis of its latest Key Investor Information Document and prospectus, together with the latest audited annual report (and subsequent unaudited semi-annual report, if published), copies of which can be obtained, free of charge, from Schroder Investment Management (Europe) S.A. An investment in the Fund entails risks, which are fully described in the prospectus. Past performance is not a reliable indicator of future results, prices of shares and the income from them may fall as well as rise and investors may not get the amount originally invested. Performance shown is as of 31 December 2019. Performance shown is for a Sirios advised private fund (the “Private Fund”) in USD from July 1999 to February 2013. From March 2013 onwards Schroder GAIA Sirios US Equity C Acc USD has been used. Performance is shown net of fees. Fees used to calculate the returns of the Private Fund are based on actual fund level fees and not any specific share class. Return is net of all expenses, management fees, and incentive fees or allocations. ‘S&P’ refers to S&P 500 Net Total Return Index. Index returns are provided for comparative purposes only. Indices are unmanaged, include the reinvestment of dividends and do not reflect transaction costs, management fees or any performance fees. Unlike indices, the Fund is actively managed and may include substantially fewer and different securities than those comprising each index. The S&P 500 Net Total Return Index is an unmanaged market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance. Performance includes results attributable to “new issues.” Performance for some periods would be different for those investors who are not eligible to participate in new issues. In addition, an investor’s actual performance may differ from the performance presented above due to timing of investment, capital contributions and capital withdrawals. Performance reflects the reinvestment of dividends and other earnings but does not reflect the effects of taxation, which will result in lower returns to taxable investors. Current year returns are preliminary, based on estimated annual incentive fee/allocation amounts and subject to subsequent revision and audit.
Jessica Beard talks to William Blair’s James Golan and David Ricci about their long-term bet on cloud-based computing and other strong trends in US technology
The semiconductor space is a key area to watch in US large-cap equities, as the three- to five-year profit pool looks appealing relative to the overall market, say William Blair managers James Golan and David Ricci. This industry has been one of the biggest drivers of performance for the co-managers on the William Blair Large Cap Growth fund. Semiconductor-related stocks made it back onto the managers’ radar early in 2019, as there has been an increase in the use of semiconductor content across a variety of products, such as in cloud-based computing, autonomous vehicles and in automobiles more widely. ‘That was very appealing to us and we increased our holdings within the space over the past few quarters and that’s been helpful in terms of performance,’ Golan says. In March, the pair began to intensify their research in the area and added some new names to the portfolio. The quality growth investors target companies in industries where profits are growing at least as fast but preferably faster than the overall US economy. In this context, the fund managers pay particular attention to the technology sector, with an emphasis on companies operating within the cloud-based industries. ‘Cloud-based computing – which is basically outsourcing corporate data centres to large platform companies such as Microsoft and Amazon – is probably worth about $100 billion (€90 billion) today but we think over the next three to four years that could grow to $300-400 billion.
‘So, we’re still very early in the process in terms of corporate America and corporations across the globe outsourcing their data centres to these cloud-based companies. This move allows companies to lower overall capital spending requirements and creates savings on the operating side as they outsource their workloads to these large platform companies,’ Golan says. It’s an area the team has looked into for several years but it still has a lot of potential and is a powerful growth sector, they say. OTHER EXCITING TECH TRENDS Cloud-based computing is a central theme in the portfolio but is not the only technology-linked trend to emerge, as the investment team targets long-term secular developments, co-manager Ricci adds. These include themes such as the shift from store-based to online-based retailing, from linear TV to streaming, and from traditional advertising and newsprint to digital advertising. Fintech is also driving long-term shifts, such as the move towards card and even person-to-person payment, he says. Overall, these trends are long term and are likely to underpin above-average industry growth. ‘We look at the profit pools within fintech, whether it is the shift towards networking, towards merging and acquiring or towards digital payment away from cash. The types of companies involved are the network ones like Mastercard, the PayPals of the world, the merchant-enquiring companies like Fidelity, these are all net beneficiaries of this long-term secular shift.’ Indeed, the tech sector has been the biggest area of outperformance for the large-cap fund which has returned 24% over three years to 2 January 2020, outperforming the Russell 1000 Growth TR USD index by 3%.
‘That was very appealing to us and we increased our holdings within the space over the past few quarters and that’s been helpful in terms of performance,’ Golan says. In March, the pair began to intensify their research in the area and added some new names to the portfolio. The quality growth investors target companies in industries where profits are growing at least as fast but preferably faster than the overall US economy. In this context, the fund managers pay particular attention to the technology sector, with an emphasis on companies operating within the cloud-based industries. ‘Cloud-based computing – which is basically outsourcing corporate data centres to large platform companies such as Microsoft and Amazon – is probably worth about $100 billion (€90 billion) today but we think over the next three to four years that could grow to $300-400 billion.
BNY Mellon’s John Bailer is rubbing his hands in readiness of big gains coming from the market’s rotation towards more cyclical sectors. He talks about over-hyped bond proxies, Warren Buffett and his big overweight in financials
John Bailer says being underweight defensive stocks has been one of the biggest performance drivers for his BNY Mellon US Equity Income fund over the last three years. He says most of his peers focus far too much on overvalued bond proxies, ignoring the wealth of opportunities available in more cyclical sectors, such as financials and energy. Bailer, who started his career as a US large-cap value analyst in 1999, says the market had several phases of extreme negativity towards certain sectors during the last two decades. He was surprised, for example, how long the negative mood lasted around financials following the Global Financial Crisis. Similarly, he says it took a long time for investors to get excited about the tech sector following the dotcom bubble.
Margaryta Kirakosian News Editor
‘A lot of financials destroyed the book and shareholder value in 2008, but it’s surprising that investors haven’t been willing to look past that at how companies are positioned now and how much cash they are returning to shareholders. ‘But just as people moved back towards technology, I think they are going to start gravitating back to financials. We’ve been fighting that war long enough, it’s time to start looking to the future,’ he says. LEADING THE CHARGE Bailer leads by example. Financials are his most bullish bet for 2020 and the biggest sector in his income fund, accounting for more than 30% of the portfolio. JPMorgan, for example, was the second-biggest holding in the $400 million (€358 million) strategy at 4.9% at the end of November 2019. ‘The firm spent $12 billion dollars on tech this year and that really differentiates it. JPMorgan is benefiting from these changes because it can create the best app for consumers or utilise blockchain technology to cut costs.’ Bailer adds that compared with other value sectors, financials benefit from attractive valuations and the absence of secular challenges, not least because they are aided by technology. ‘And it is not just us that believe that. Warren Buffett has above 40% of his holdings in financials and he has said several times in the past that these companies are going to survive the next 10 years.’ What about their regulatory environment? Bailer admits this became very difficult after the financial crisis but this in turn encouraged big banks in the US to make their best ever loans. FINANCIAL LANDMARK Bailer says the capital level of the banks hasn’t been this good since 1930, allowing them to return a lot of that capital to shareholders. ‘What I love about that as a dividend manager is that it’s not just management that is raising these dividends for you, or the board of directors who approve those dividends. ‘It is also the Federal Reserve, which is allowing these big banks to return a significant amount of cash to shareholders, through their stress-test process, in the form of buybacks and dividends,’ he says. One of the biggest bets Bailer expects to play out in 2020 is the sectoral rotation, with value gradually getting an upper hand over bond proxy names. His portfolio has as much cyclical weight as it can tolerate at the moment with big overweights in financials, materials and energy. ‘I would not expect that to go up anymore and we feel very comfortable with that overweight. I imagine we will continue with this positioning in 2020.’ he says.
Could there be another decade of growth?
DAMON FICKLIN Lead portfolio manager Amundi Funds Polen Capital Global Growth UCITS Fund
Polen Capital managers are still finding ways of delivering performance after a bullish decade
A decade into the bull run and Polen Capital portfolio managers are still finding growth opportunities in everything from technology to sports brands and believe that there is another decade of positive growth to come. The portfolio managers follow a time-tested investment process that they believe provides them with an advantage, which includes running concentrated portfolios of between 25 and 35 stocks of ‘best ideas’. Damon Ficklin, lead portfolio manager of the Amundi Funds Polen Capital Global Growth UCITS Fund, said they believe concentration is a big advantage as it allows them to reduce market risk. He looks for quality companies that have ‘sustainability, predictability, and dependability’ and, most importantly, the right earnings profile that includes ‘double-digit earnings growth’. This means that ‘in the worst of times, such as a recession when you could see a 30% decline in earnings across the market, our companies may slow down but are expected to still get a decent rate of return’. ‘That does provide some downside protection,’ Ficklin said. ‘We invest in equities, so they can go down. But the difference in earnings power is a big deal to us.’ The focus on earnings means his fund has no exposure to energy, materials or telecoms which he said struggle most in a ‘tough environment’. Tucker Walsh, lead portfolio manager of the Polen Capital US Small Company Growth UCITS Fund, said he looks for ‘high-quality growth companies that can compound value over a number of years’. ‘There are only a handful of businesses that can do that,’ he said. ‘We hold them for a long time to let them do their thing and compound value. That has been the formula of Polen Capital since 1989.’ Ficklin said it is not only about picking companies with high-earnings growth, but being able to choose the best growth companies across the growth spectrum. For example, this approach has helped the fund outperform the benchmark over one and three years, and in 2019, the fund returned 34.7% against 26.6% for the MSCI All Country World index. ‘Visualise a spectrum – on the far right is high growth like Adobe and Alibaba; you pay higher prices for higher growth and what looks like expensive price/earnings over 12 months becomes a reasonable price over a longer period when earnings growth is 20-25% a year,’ he said. ‘Then we have more modest growth companies like Nestle and Accenture. They provide the ballast to the portfolio.’ LOOKING AHEAD Walsh, who invests in companies with a market cap of between $500 million and $3 billion, said that despite nervousness about the end of the decade-long bull run, he believes there are ‘still a lot of great growth companies to invest in’. ‘There are companies that have repeatable growth rates,’ he said. ‘The growth rate doesn’t have to be high, just repeatable because of a competitive advantage the company may have or because it really does have a value-add relationship with its customer.’ However, he said that small-cap investing can have pitfalls as ‘a lot of small growth companies have a rapid growth rate and are losing money’. ‘We aim to avoid those because there is a very wide range of possible outcomes,’ he said. ‘There are companies out there with good growth prospects, but you have to be careful to stay in ones that are repeatable, reinvesting in their businesses, which creates that compounding effect we are looking for in small-cap growth companies. It requires less timing.’ Walsh’s largest sector weighting is to technology, which makes up around 35% of the portfolio and is an area where ‘we always find interesting prospects’, but, like Ficklin, he is avoiding cyclicals. ‘We are very excited about the prospects for technology, healthcare and consumer discretionary,’ he said. He added that the companies operating in these areas have the potential to deliver ‘compounding growth over time’ and have ‘unique products and services’. However, he said that in technology investing, there is currently a dearth of companies coming to market. ‘We are finding that not as many companies are going public in the tech sector in the small-cap category,’ he said. ‘But there are still enough really good ones out there, in our view, that do fit our criteria. We like tech and think it will always have a significant weighting.’ Ficklin is hunting for investments under the banner of ‘digitisation and personalisation’, although, as a bottom-up stockpicker, he does not follow a thematic investment strategy. ‘We have significant investments in Mastercard and Visa, and that growth has been clearly in motion for many years and will continue for many more years,’ he said. He said the shift from cash to card payments and now to digital payment systems means these companies are growing revenues in the high single digits. In the theme of digitisation, he is also looking at the move of advertising from offline to online and has invested in both Facebook and Alphabet. SUPPLY AND DEMAND Investments in Adidas and Nike play to both digitisation and personalisation, as both brands are selling more online and offering more personalised services to customers, such as personalised trainers. Ficklin said there are not many businesses that have a wholesale arm that supply goods, in these cases to sportswear retailers, but also run their own direct-to-consumer shops both on and offline. He said that these two sports brands do both and ‘dominate the global market’, and online sales are only growing – a trend he expects to ‘continue for some time’. Walsh is also looking at the digitisation theme. For 2020, he has pinpointed opportunities in IT services, which is an area ‘we are constantly looking to for great companies’ as he said there is an increasing need for companies needing ‘outsourced help with digitisation, the cloud and digital customer experience’. He is also looking at ‘discount and specialised retailers’ that are capitalising on a niche. Growth investors have had a remarkable and unprecedented run of good markets, but there is now talk that the cycle is at an end, and a rotation into value in September spooked investors and did little to quell fears that growth is no longer king. However, Ficklin said: ‘We do think [growth stocks] will be as strong over the next 10 years.’ ‘Historically, if you are looking at the growth-value cycle, that was driven by the interest rate environment and the ebb and flow of the economy,’ he said. He said a decade of ‘zero or very low interest rates’ has created a ‘bifurcation of companies that are actually growing and those that are not’ and created a situation where you have ‘long-term earnings growth as the driver of performance and not interest rates moving markets’. ‘We have been left with a simpler picture,’ he said. ‘And the environment is not different to 10 years ago; interest rates are still low, [central banks] tried to move them back to normal but realised the environment is not quite strong enough,’ Ficklin said. ‘We are in a moderate growth economy and interest rates are low with supportive monetary policy, and we think we will continue to see the same picture.’
Data as of December 31, 2019. Past performance is not indicative of future results.
TUCKER WALSH Lead portfolio manager Polen Capital US Small Company Growth UCITS Fund
Alger’s Amy Zhang often sees a tenfold increase in the small companies she invests in. She talks to Margaryta Kirakosian about the benefits of being benchmark-agnostic and why the intersection of healthcare and digital transformation is a rich hunting ground
Alger’s Amy Zhang has followed a rigorous stock-selection process for the last 17 years, which in her view is a key contributor to her positive performance track record. ‘I started managing funds at the end of 2002 and most of my peers were overweighting and underweighting the index. But I have always been benchmark-agnostic. ‘When you look at our three-year alpha it is 9.24 and beta is only 1.02, so it is an alpha-generating strategy,’ she says, referring to the Alger Sicav-Alger Small Cap Focus fund she runs. ‘But more importantly, you need to understand the downside part of the equation to have a credible long-term track record,’ she says. Zhang adds that growth investors must be able to understand valuations properly as well as having a good grasp of downside risk – something she learned to do on her first job on the trading desk at CitiCorp Securities in New York.
‘Our three-year upside capture ratio is about 119.57 and the downside is 77.61. This upside/downside capture is very important because our strategy invests in potential growth companies that have very high financial quality and can be compounders over multiple years.’ She says companies she invests in often go up almost 10x in the three to five years after the first allocation. More importantly for her, however, is making sure the losers don’t go down lower than 50%. ‘Within our Sicav strategy, I am happy to say our three-year batting average is over 60%, but even if it was below 50% it would continue to work,’ she says. ‘I always like to put odds in my favour. I think it is important to have that kind of high-quality set-up.’ MEASURING UP Zhang says one thing that differentiates her from peers is how she defines the ‘smallness’ of any given name based on its revenue stream rather than its market cap. Her fund generally invests in companies that have $500 million (€449 million) or less in revenue. ‘Our sweet spot is probably lower: $100-200 million. ‘It is very beneficial to have a small revenue base because then it is much easier to double or triple revenue, and then cash flow and EPS growth will follow.’ Technical fundamental aspects aside, the main thrust of her strategy is following multi-year themes such as healthcare or technology, with both areas being at the cutting edge of innovation. One of the top holdings in the fund is US cloud-computing company Veeva Systems. The Sicav fund, launched in January 2016, has consistently invested in Veeva since inception, while the original American strategy bought into the company even earlier. Veeva has 12 years’ operating history and when Zhang started to invest in the firm, the part focused on life sciences CRM was doing well, although its growth was slowing. However, another business line, Veeva Vault, a regulated content management solution, was in its infancy. Zhang says she has always gravitated towards companies with good cash flows and Veeva Systems is a case in point. ‘The stock has gone up six times. Veeva Vault is now the fastest-growing part of the business and contributed 51% of revenue in the last 12 months, compared to almost nothing back in 2015.’ Zhang expects the company will expand margins further as it has spent 19% of its revenue on research and development over the last year. ‘The company is at the forefront of turning data into actual information through machine learning and AI. ‘It is also expanding beyond life sciences as it has customers in chemicals, cosmetics and consumer packaging industries,’ she says.
If ever there was a reason for ETFs it has to be the super-efficient S&P 500 but increasingly- sophisticated passive products have moved way beyond this. Margaryta Kirakosian talks to investors and asset managers about pastures new and no-go zones
The ever-expanding range of ETF approaches to the US market shows no signs of diminishing: from strategies tracking vegan and marijuana-related stocks to new fixed income funds, there seems to be something for everyone. But where is it best to apply passive strategies and are there any areas where active funds still reign supreme? For Daryl Liew, head of portfolio management at Reyl Singapore, passives remain the best option when it comes to US large caps. He uses ETFs tracking the S&P 500, as this highly-efficient market is notoriously difficult for active managers to outperform. ‘Where it is hard to add alpha – those are the areas where we tend to use ETFs,’ Liew says. Generally, he uses passives in areas where he can’t find a suitable active manager, especially when he wants exposure at a particular time – his increased allocation to Chinese A-shares in 2019 is a case in point.
BONDS AVERSION Where fund selectors might still be hesitant to use passives, however, is the fixed income space. Liew, for instance, is reluctant to use passive solutions for bonds, even though there are many new strategies available. ‘I am not so sure about using ETFs for the bond allocations. I prefer to get a good manager who is able to do company analysis to make sure there won’t be a default.’ He adds that one of the main arguments against allocating to such strategies is that you are investing in the most indebted companies and governments in the world on a market-cap basis. If the markets turn against you, you don’t want to be invested in companies with quite so much debt, he says. Nevertheless, there’s no shortage of passive strategies in these markets. Sebastien Faucher, who is leading HSBC’s passive fixed income operation, says his firm provides a vast array of different products. In the US-dollar denominated space, for example, the unit is offering indices tracking US treasuries. ‘In future we may have more products that cover the US market, but it will be mainly driven by client demand.’ Faucher says clients have mainly been demanding emerging market debt and high yield strategies over the last two years. Generally, he thinks passive solutions sit alongside active funds perfectly in the context of multi-asset portfolios, which means they don’t have to be seen as rivals. ‘We see it more like a fund of funds. When investors look at passive versus active, they have a budget to manage fees. So if they see that an asset class is better for active on a risk-adjusted basis, they might go for this. Similarly, if they see that a chance to add value is limited, they can opt for passives.’ SMART ADVANCE Elsewhere, increasingly sophisticated products are hitting the launch pads. The smart beta market, for instance, is growing every year, although investors are still hesitant about the space. Reyl’s Liew, for example, hasn’t bought into such strategies yet as he thinks they are too similar to quantitative systematic funds. ‘You just have it in an ETF format rather than an active fund format, but they use the same kind of factors that a quantitative equity fund will be using. ‘Of course you can say there are lower fees potentially but the question is how often do you tweak your factors?’ There’s also a degree of caution around these new products on the asset management side. HSBC’s Faucher says smart beta approaches are still novelty in the fixed income space. ‘Our first step is to have proper research at HSBC so we can independently verify what other sources have claimed already.’
CHAPTER 4
Following a solid 2019, investors remain positive on the outlook for US equities but many are edging towards a more defensive posture. Chris Sloley gets the lowdown from top fund managers
The only way is up, it would appear, but what does that mean for long/short managers who also look for opportunities on the downside? Kurt Feuerman, Citywire AA-rated manager of the AB SICAV I-Select Absolute Alpha fund, believes a return of volatility in 2020 could pose problems for investors who are more familiar with last year’s relative calm. ‘One of the continued challenges for long/short managers is the “v-bottom” nature of market corrections experienced throughout this cycle,’ Feuerman says, whose $869 million (€778 million) fund has most recently been focused on the US’ IT and financials markets. ‘This type of quick, aggressive correction and recovery makes it difficult to manage portfolio exposure around a positive longer-term market view. We will evaluate each correction as it occurs to determine whether our long-term view remains intact. Then we will look to optimise our exposure to changes in market conditions.’
Feuerman believes the US market has been relatively calm after what he calls a ‘year of angst’, which was typified by the market collapse seen in Q4 2018. However, expecting the mellow markets of 2019 to persist forever could be a mistake. ‘The prospect of higher growth and low interest rates could fuel further stock gains,’ he says. ‘But, we would be remiss if we ignored the many variables which could cause market volatility in 2020: trade tensions, global growth projections, central bank policy and US elections. While these could create more volatility, that volatility could, in turn, create both long and short selection opportunities for long/short managers.’ Even those in the know would struggle to stay ahead of the pack if market conditions change too quickly, says Fabrice Seiman, a fund manager at boutique group Lutetia Capital. ‘Our biggest advantage when it comes to delivering outperformance in a complex environment, remains our ability to act on changing market conditions by constantly creating new, superior knowledge. ‘In the arbitrage space, and particularly in the US investment market, market participants quickly become aware of how pioneers exploit market inefficiencies and anomalies and copy their approach. The result is that these investment opportunities are arbitraged away very rapidly and no longer offer profitable strategies for active management. Research and innovation are key to remain relevant,’ he says. FINDING NEW HUNTING GROUNDS For some managers it makes sense to go fishing for stocks in under-researched areas of the market, especially when longs and shorts appear so highly correlated. Christopher Hillary, CEO and founder of hedge fund Roubaix Capital, has focused his fund, and its Ucits-compliant equivalent, Prosper Stars & Stripes, towards long and shorts centred on small-cap stocks. ‘We had pretty poor earnings results in 2019 and that is a big part of the narrative. It looks like earnings for smaller caps were down to high single digits this year compared with the S&P which is about flat. ‘It looks more likely that small-cap earnings could exceed 20% in the year ahead, according to a Bank of America projection of 14% growth for the S&P 600. I think we had an earnings recession in 2019 for all markets but especially for smaller companies. Historically, small caps have been more sensitive to things like global growth.’ Hillary says there has been a general bottoming of data in major markets such as China, Europe and the US. ‘If you get that then you get better sentiment towards small caps and we have seen that play out. Small caps lagged large caps again last year and it has been a relatively wide gap. ‘It isn’t our job to forecast these things but there has been an unusual divergence in earnings growth and with small-cap stocks lagging large-cap stocks and it seems like some pieces are in place for that to change in 2020,’ he adds.
This has drawn Hillary to back many ideas that actually weighed on performance in 2019. He names companies such as advanced composite materials firm Park Aerospace, Canadian communications group Rogers and medical device company Transmedics. All of these ideas, which sit within Hillary’s long book, have suffered from the heightened correlation and top-heavy nature of the market, he says. ‘As we head into 2020 we feel that a number of our most compelling investment ideas haven’t played out. ‘So, that said, we are particularly enthusiastic about a number of our largest positions and if those stocks continue on track, the value of those equities coming up is likely to be quite strong next year.’ POLLS APART However, even the most confident of manager, whether long-only or long/short-focused, cannot move too far without bumping into the topic of the US presidential election. For Feuerman this sits at the top of his ‘to-do’ list and will go a long way to determining his thinking over the course of the year. ‘One of the largest risks for markets is the US election. What is particularly concerning to us, is the prospect of a far-left Democrat winning the presidency alongside a democratic sweep in Congress. ‘If this were to occur, we believe markets could become significantly more volatile. More volatility may create dislocations in the market where the stock prices of high-quality businesses with solid fundamentals come under significant pressure.’ Feuerman says the need to evaluate all exposure becomes much greater in a scenario such as this, and would prompt him to assess all new and existing positions for their respective merits. ‘We cannot predict the outcome of the election, so we will be monitoring the situation closely to ensure that we are prepared to optimise our exposure as changes occur in the political landscape. Currently, one of our largest short positions is a hedge against political risk. This is a basket of companies that could be negatively impacted by an Elizabeth Warren presidency. ‘As is the case on the long side, we will evaluate short opportunities on a stock-by-stock basis.’ Not everyone has placed such a strong emphasis on how the US decides to vote. Fellow long/short equity investor Seiman believes the market is more important than the politics that sit above it. ‘Much attention will focus on US politics, and if investors have learned anything in recent years, it is that one man can throw many spanners into the political machinery. ‘That said, in our arbitrage space, this factor won’t have a strong impact. The main drivers will remain the rise of quantitative strategies combined with the decline of investment bank trading, which together led to an unprecedented level of equity arbitrage opportunities. ‘Mispricing is on the rise and we expect this trend to continue.’
The greenback has a huge influence on how EM bonds are likely to perform but investors shouldn’t view the currency’s health as a full-proof predictive model. Those relying on this factor alone are only seeing part of the picture
A key question asked by those interested in investing in emerging market bonds is: will a strong/weak US dollar affect performance? I have heard many convincing arguments deployed to tackle that question but none has ever convinced me systematically. That is because the US dollar is not the only variable at work. As seen in the last few years, the correlation between the USD and EM bonds looks unassailable. In 2018 (a USD bull year), EM bonds had negative returns. In 2017 (a weak year for the USD), EM bonds produced a respectable 10%. But EM bonds also returned around 10% in 2016, a pretty stable year for the USD. This year, EM bonds have brought stellar returns of around 14%, while the USD has consistently strengthened, confirming these two factors cannot alone explain one another. There are two typical explanations for the link between the USD and emerging markets. A strong USD means weak local EM currencies and thus, higher export revenues for emerging countries. That should be good for the latter’s economic performance. But a strong USD means higher servicing costs for those EM countries with dollar-denominated debt. That is certainly negative for those economies. Therefore, an accurate model linking USD performance to EM debt performance must take trade and indebtedness levels into consideration. But such a model cannot bundle all EM countries into one basket and as a result, it has specific, rather than all-encompassing predictive power.
Raphael Kassin EM Debt Consultant, Sandy Lane
AND THERE’S MORE It is also important to consider other indirect factors related to a strong USD that can – and do – affect emerging economies and the performance of their bonds and stocks. A key influence is the state of the US economy. A strong USD generally goes hand in hand with a strong US economy. As the US is the world’s economic engine, most other countries’ economies benefit and grow when the US economy is strong. In case of a US recession, the opposite is obviously true, with EM countries suffering economic weakness. Meanwhile, the level of US interest rates is closely linked to the state of the US economy and thus, indirectly affects emerging countries and the valuation of their assets. When the Federal Reserve sets its Fed funds target, its objective is to manage US inflation and unemployment so that the economy does not overheat or drop precipitously. Depending on how high or low those rates are and their expected path, they can affect the flow of capital to emerging economies. A comparatively attractive USD risk-free rate will bring investment flows to US assets rather than to those of EM countries, while the opposite will support EM economies. While the level of US interest rates will generally be closely linked to the US economy, difficulties will arise when rates do not match a future economic path that is unclear. That is when complications arise.
FINE-TUNING Despite the shortcomings of trying to link only the USD to EM bond performance, it is possible to build a more robust model. To do that, investors should link EM bond performance to more US variables, such as the level of US interest rates, their momentum and direction. It’s also important to consider the state of the US economy and its expected path. It is imperative to gauge the level of consensus among market participants and the Fed regarding the future path of the economy. Lastly, investors should be aware that the level of risk aversion in markets and country-specific developments could have a significant impact on any expected link derived from this model and could ultimately easily derail its predictive power. But if elections go wrong or political wranglings threaten stable governments in a few countries at the same time, index performance will be affected negatively. In that case, the predicted correlation will suffer. Who said it was easy? So, next time someone tries to sell you a simple explanation for EM debt performance, question it with a typical French approach: it depends...