Veritas – blogging the AlphaGenerators in Munich
Investment Europe’s David Walker is blogging from the Alpha Generators manager roadshow today in Munich. We present to you the thoughts, outlooks and cautionary notes from the five speakers.
Today’s manager speakers are:
Michael Constantis, on European equities from BlackRock;
Suzanne Hutchins, on multi-asset absolute return investing from BNY Mellon Asset Management;
Chris Taylor, on Japanese equities from Neptune Investment Management;
Peter Meany, on infrastructure from First State Investments; and
Philip Ehrmann, on Chinese shares from Jupiter Asset Management
Michael Constantis, BlackRock
Constantis runs the firm’s European growth fund. He says growth has a bad name, tied up with concepts of the TMT boom and ‘value winning’ over the longer run, but that this is wrong. Why? It is because of how a lot of the analysis for this is done. Before 2003, MSCI ranked pan-European stocks by price to book and divide by half – one half was growth, the other half value. But this was “wholly inappropriate”, he says.
Since 2003 that definition changed, to a “more logical” definition including measures of long-term growth over three to five years, and shorter term, and how much companies can reinvest in their own businesses.
Constantis says the PIIGS and financial components of MSCI European growth index are small. His team looks for quality management teams, exposure to growth markets and competitive advantages in companies. Competitive advantages include installed bases, world-class brands, technology/patent and domination of niche markets. The team has over 700 meetings a year to source ideas.
Growing compounders presently include Kone, Swedish Match, Nestlé, and Atlas Copco. He gives another example – Eutelstat in France is a long-term holding at BlackRock.
There are significant barriers to entry to the satellite industry, with high industry concentration and expertise needed. Eutelsat will increase its capacity by 30% soon, “but that’s needed for demand. It has a PE of about 16 times, which is not cheap, but worth it.”
Constantis says once Europe’s problems are brought under control European growth stories should be positively re-rated.
BlackRock’s BGF European Growth fund has between 40 and 60 stocks and a tracking error of 3% to 7%. It is benchmarked against the MSCI Europe Growth index, a pure benchmark, and it remains a growth style fund.
“We can also invest in the UK, which helps as a lot of good companies are listed there.” Over 5 years to 31 August, it made 1% a year, or 2.7% over three. “If you turn over enough stones you can still find enough ideas.”
Q&A – Large vs mid-caps and small-caps
Constantis says the team has not taken views on risk premia of market cap strata: “it is a function of bottom-up analysis”. Now the fund is overweight quality mid-caps and he says, “though mid-caps have been hurt, size is not identifiable as a factor driving returns.”
He says some world-class brands can be found in Europe. The US may dominate technology, but Europe dominates EM consumers or luxury autos. “A lot of UK mid-caps have all their earnings overseas. In my fund you find very few retailers and financials. Most of the growth comes from EMs, and the company just happens to be listed in Europe.”
What about yields? The best yields are among telcos, so why have these stocks underperformed for many years?
Constantis says it is because they do not grow. “The trick is to have the yield, but marry that with growth in earnings. Otherwise you end up buying stodgy, low growth companies,” Constantis says.
Suzanne Hutchins, BNY Mellon Asset Management
Suzanne Hutchins’ fund is a multi-asset absolute return fund, part of a broader and longer-running strategy. “Our DNA is a thematic approach, we have always invested globally and across multiple asset classes to pick easily identifiable securities that are easily priced and transparent.”
Focusing on themes cuts out short-term noise, she says, and this fits in with their longer term. Currently they include state intervention, unwinding of debt, inflationary consequences of loose monetary policy.
Hutchins says there is too much debt in the developed world. The days of steadier returns from 1980 to 2000 are over, of an upward sloping curve with long cycles. Over the next decade Hutchins’ team expects more volatility.
Fed rates have plunged and 10-year bond yields, too, since the 1980s. “We are in a very different place to the 1980 and the whole psyche of taking on debt has really come home to haunt us. Now it’s more like what it was in the 1930s and 1940s and 1950s.”
How to invest in the new environment where the risk free rate of return is negative? Be unconstrained, she says.
Hutchins’ strategy has guidelines, but no absolute constraints – it tries to find return-seeking securities. “We are absolutely indifferent to what we own.” Core investments can include equities, linkers and bonds, and then offsetting positions around the edge. “We made about 11% return on bond like volatility since 2004. We made a positive return in every calendar year, even 2008.”
There is a euro-based fund, and GBP and USD. The fund takes very active currency positions.
Hutchins says her firm prides itself on its organic approach to teams sharing ideas, with specialists identifying industry and company opportunities. The fund has a benchmark of one month Euribor + 4%, but capital preservation is key to the strategy.
Hutchins’ first question to analysts will be will be the chance of a security losing money? And then, what chance of it making Euribor plus 4%?
One theme as an example behind the fund is deleveraging, or paying down debt, which implies lower growth, more dirigisme and uncertainty and volatility. Rates will be lower for a lot longer.
The fund has exposure to high yield securities in safe companies “where you can get yields of 2-3% over sovereigns. There are many companies with equities yielding 5% to 6%. For example Roche is 6% and I can take the CHF risk. If they compound at 5%, I am more than happy with the [total] return.”
Hutchins can also use derivatives around indices for controlling risk. The core of the fund is equities with beta < 0.8, convertibles which might be volatile but are safer ways into equities, and corporate debt. The fund can dampen volatility using currency hedges, or use gold (ETCs or equities) or agriculture.
“Every single security has a role to play in the portfolio, it is either return seeking or risk reducing. For us, ‘risk’ is the risk of losing money.”
Q&A – How to adjust processes for the changing world?
Hutchins says her strategy can invest directly in companies’ debt or equity. She says one of the cheapest ways to get access to EMs is through developed markets companies. “We have chosen not to invest much money directly in EMs.”
The hunt for yield?
“I am quite happy to take a 10% return including yield than a couple of bps with cash in bank.” Hutchins says dividend payers tend to have better capital discipline and have better management. Over half a stock’s total return comes from reinvesting dividends, she reminds the audience.
Global macro outlook
“Bond markets are telling you one thing, equities quite another. We think equities will provide return if you pick wisely, but you can use put spreads and gold and cash to protect portfolios. We have a lot of cash at the moment.”
Chris Taylor, Neptune Investment Management
Japan has many problems. “You’re investing in Japan for global world class multi-nationals.” The fact Japan “is a basket case and will get worse” means the companies have looked elsewhere, Taylor says.
The gross debt to GDP ratio is 230% and the budget deficit ranks Japan 134 of 139 countries. Furthermore, the population is ageing and paying for healthcare and pensions.
“Japanese companies have been investing outside Japan very heavily for 15 years. If they don’t they will shrink because Japan’s population is shrinking by 1% a year.”
The market with a PE of 9.3 times is cheap, and ROE of 10% is low, Taylor believes, but Japan’s companies are overcapitalised and they have much cash on their balance sheets.
“Investors rightly have been underweight. They have bought then sold, but now there is a structural change in Japan offering growth for the right sectors.”
Taylor says Japanese companies control the global carbon fibre, small technology and flat screen materials industries, among others. Nissan and Toyota have almost as many sales outside OECD and in Japan. Before the crunch 80% to 90% of earnings came from OECD sales. Now sales and operating profits from overseas for the Topix industry companies are 41% and 44% respectively.
For the six months to September 2010 companies’ pre-tax profits jumped 2.4 times, profits recovered 96% to levels of 1H fiscal of 2008, they lowered the level of sales they needed to operate in the black, by 13%. They have very high levels of cash on their balance sheets.
“The portfolio is focused on big global multi-nationals. What can be bad for a country can be good for its companies. I do not want domestic demand [plays], as the population shrinks by 1% a year, and Japan’s labour force as a percent of its population [is back where it was] in 1955.”
Q&A – What of global uncertainty?
“People fail to understand EMs are major players throwing off more GDP than the US does. If you assume ‘the US grows at 3%, so earnings cannot grow at over 15%’, you’re nuts. Things have changed.” History does not simply repeat itself, he adds.
Peter Meany, First State Investments
“We are looking for structural, not cyclical growth,” says Peter Meany of the globally focused listed infrastructure fund.
The First State fund has many peers, thematic in nature and often in Ems, but Meany feels it important to look at capital-intensive core businesses that give good income streams, most often in developed markets where there is less danger of dirigisme. The fund focuses on about 100 assets, “they are regulated and tend not to suffer from cyclical downturn”. Infrastructure earnings fell 10% in 2008/2009, versus 60% from shares more generally, he notes.
Meany also wants to keep up with rising markets as well, despite being a defensive investor.
One area of growth he sees is the mobile towers industry. “With iPhones and Blackberrys the use of wireless data is expanding significantly, but there is risk picking the appliance or telco provider, it is highly competitive. The one certainty is the wireless infrastructure. In the US three listed players dominate the building and leasing of structures, on 15-year, inflation-linked contracts. We have seen a double digit rise in the number of towers and prices they could charge – so you can tap into the structural growth of the industry, but not take the company specific risk.”
Another attractive industry is energy storage, as security of energy supply becomes “ a big issue”. Countries are looking to build more storage capacity to manage the industry and reduce geopolitical risks. “Twenty years ago there was refining capacity in each country. To build scale there are now massive refining hubs, for example in Singapore, and end-products are being shipped. Therefore you need more storage tanks to hold each product.”
Meany says regional hubs may have 70 or 80 individual product tanks, not just one Crude tank. He likes Vopak in oil storage, in Rotterdam. Vopak compounded EBIT 20%pa 2005 to 2010 through price, capacity and productivity, he says, and over four years is adding 20% to capacity.
“There was demand destruction in 2008, or about 0.5% from 2008 to 2010, but because of the scarcity of the tanks and access, companies are not willing to give up capacity, and so Vopak can charge good money. There were 5% to 10% pricing increases all the way through the recession”.
Meany notes a distinct advantage in infrastructure for fighting inflation. “Many infrastructure assets have regulated contracted businesses that automatically allow them to pass through inflation.” This is sometimes done programmatically “it’s the way it’s happened for the last 30 years and we believe it will do so for the next 30 years. They’re pushing through 3% to 5% price increases linked to inflation.”
Over 20 years, when inflation sat between 3-4%, outperformance of infrastructure was about 6%. “Things don’t work so well when things are good and inflation’s under control, infrastructure will probably not keep up with strong performance you would see in the MSCI. The higher inflation goes, the bigger the outperformance, that’s because of pricing pressures as inflation goes up.”
Meany says “as essential services and regulated assets, the number one risk infrastructure faces is the risk of political intervention.”
In Germany chancellor Angela Merkel introduced taxes on nuclear generation and closed the program after Fukishima’s disaster in Japan, with a “15% to 20% earnings impact in utilities in Germany. In Japan after the disasters the utilities got hit hard by the events, and in Italy Silvio Berlusconi put a Robin Hood tax on motorways and airports in Italy.
“But by and large, where we have had stable governments – Asia, the UK and North America, where we have had sensible outcomes from politicians – we have had good returns from infrastructure stocks.” He adds a lot of assets coming up for privatisations.
SWF and pension fund investments have about $200bn in the sphere – one fifth the size of real estate industry – although the stock of assets is about the same size, “so there is room for growth. But half the assets are still in government hands, so we are seeing takeovers of listed stocks by pension funds and strategic investors”. Meany’s fund had six takeovers in four years at an average 35% premium.
Philip Ehrmann, Jupiter Asset Management
Ehrmann says China has become more important and relevant to investors, though it is not yet institutionalised. YTD just over $8bn has “fled the markets”, due to concerns of filling black holes elsewhere, and whether Chinese growth is sustainable.
He says it is not the big five or six banks – 40% of the index – and insurers and telecom companies that drive the index: “It is the new areas in the market, sectors that have not been available to foreign investors.” As China opens up he says it will more broadly based driven by consumer activity.
Over 10 to 15 years China has made 9%+ economic growth, though Ehrmann says this does not necessarily translate to share prices – margins and earnings and future growth opportunities do that, he says.
China’s GDP per capita is one tenth that of Japan, car ownership at five per 100 households (90% bought for cash only), and it has a high savings rate and evolving financial markets.
Local government debt for infrastructure was a concern three months ago, but it is still “very manageable” as a proportion of GDP, he says. Recently local governments have issues ‘muni’ type bonds to help take debt from bank balance sheets.
“The centre has enough money to ensure it can fund and grow things going forward.
“The surprise will now be how quickly inflation falls back.” Loan growth has subsided to 16% in August, versus 31% in 2009. “The tightening cycle has entered almost its final phase.”
China must be able to sustain productivity to sustain and afford the growth in its economy, and Ehrmann says Beijing is capable of that. Many manufacturers are moving jobs to the inland where labour is 20% to 30% cheaper, or moving it overseas to lower cost centres.
The 12th Five Year Plan in March build on the previous one, to keep the economy moving and spread economic growth across society. Its tenets broadly align with Ehrmann’s portfolio.
There was also a new GDP target of 7%. Ehrmann notes the previous plan had 7.5%, but over five years the GDP has averaged “above 11%”.
Ehrmann’s portfolio has themes such as rising incomes, social security spending, financial services and infrastructure spending.
The press may be full of scare stories but it is not what is happening at a company level, he says. “PEs are as cheap as at any time I have been investing in China, and looking at EMs. When you get this point of pessimism you know you are getting to an interesting entry point.”
Mid and small caps stand on eight times earnings. Ehrmann’s portfolio stands on a cap-weighted PE of less than eight times, with a 2012 estimated earnings figure of over 20%. Ehrmann expects Chinese GDP growth of 8-9% next year and inflation falling to 4.5% to 5%.