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Three fund managers looking beyond value and growth

26 May 2015

Investing in either growth or value stocks isn’t the only way to run a portfolio so FE Trustnet asks three fund groups about what they look for in an attractive holding.

By Gary Jackson,

News Editor, FE Trustnet

Many fund managers categorise themselves has having a ‘value’ or ‘growth’ approach to investing, but sticking to one of these two styles is unlikely to result in outperformance across the whole market cycle.

Value investors seek out stocks that are trading at less than their intrinsic values in the hope that the wider market will recognise their plus points and they will eventually re-rate. Growth investors, on the other hand, only want companies that will grow their earnings faster than the rest of its industry and are willing to pay for this.

Both of these styles can outperform at times but can run into difficulty when market conditions change to favour the other approach. With this in mind, FE Trustnet speaks to three fund groups about how they are looking beyond growth or value in their investment decisions.

 

Evenlode Income – the evolution of free cash flow

Hugh Yarrow, who manages the five FE Crown-rated Evenlode Income fund with co-manager Ben Peters, concedes that his style has elements of both growth and value investing. However, he is really concerned with finding quality business that will still be successful decades down the line.

“Value and growth both come into it. We want to make an estimate of how those free cash flows will evolve over time. We focus on businesses with good microeconomics and we’re looking for a high return on capital,” the manager said.

“We call them ‘compounding businesses’, as they generate a lot of cash flow each year, invest some back into the business at a high return on capital and can grow over time because of that. Businesses like this can clearly generate growth in free cash flow over a period of 10 or 20 years.”

“A lot of the time investors talk about ‘what’s the valuation based on today’s earnings?’ We’re thinking much longer term than that and saying ‘how do we see these free cash flows evolving over the next 10 or 20 years?’ We are specifically looking for what we call ‘quality companies’.”

While the term ‘quality businesses’ is often overused by the fund management industry, Yarrow prefers companies that have strong intangible assets like brands, intellectual property or customer relationships, operate in sectors such as consumer branded goods, healthcare, media and software and speciality engineering, and have pricing power over their goods or services.

“We then apply a valuation filter, which is an estimate of how the current market cap of the company compares to our estimate of long-term free cash flow. We sometimes describe it as quality being our belt and value as our braces,” Peters added.

Yarrow highlights Reed Elsevier, which recently rebranded as RELX Group, as an example of a holding where the fund’s process allowed it to look past a value or growth bias and make a successful investment.

Performance of stock vs index over 5yrs

 

Source: FE Analytics


“We’ve always viewed it as a compounding growth company but when we first purchased it about five years ago it was very unfashionable with the market. For the first two years of owning it, it was the stock we got the most questions about and was seen to be dead money in a rising market,” the manager said.

At the time of investment, investors were worried about how the rise of open-access journals would impact the firm’s core business. However, Reed Elsevier went on to adapt its own business model and has proven a successful investment since.

 

Ardevora Asset Management – cognitive bias

Gianluca Monaco, partner at Ardevora Asset Management, says the firm’s investment philosophy comes down to “one unfortunate constant” in markets: humans’ capacity to make mistakes.

The approach argues that company management, investors and analysts frequently make bad decisions when they are put into situations of complexity or uncertainty and are given too much information. Understanding how these bad decisions come about can be used to find investment opportunities.

“Company managers are often prone to excessive risk-taking – their ego-centric personality type and remuneration structures give them a skewed view of risk. Instead of prudently developing their business, company managers, driven by overconfidence, are more likely to take too much risk and cause harm. One can select companies based on situations where management is either constrained or where the business is too strong to break,” Monaco explained.

“The second group whose biases can be exploited is investors. Investors are prone to overreaction – placing too much weight on a narrow range of information to draw black and white conclusions. One can look for signs that investors are focusing on old traumas that are no longer relevant.”

“Then there are the analysts. Analysts are prone to ‘under-reaction’ – although intelligent, they are often overconfident about their forecasting ability and are resistant to information that contradicts their views. Investors can look for situations where analysts are struggling to understand a company.”

Ardevora’s UK Equity and Global Equity funds, which are managed by Jeremy Lang, William Pattisson, Gianluca Monaco and Ben Fitchew, can exploit these cognitive biases through taking long or short positions in companies.

An example of a holding that is being held because of investor bias is Vestas Wind Systems, which is owned by Ardevora Global Equity. Between 2007 and 2012, the company suffered “traumatic” share price falls on the back of overinvestment and falling demand.

However, Ardevora looked past the negative factors that the rest of the market was focusing on and argued that the stock was attractive because of the clean energy boom and government regulation in the US and Germany to boost demand for wind power.

 

Argonaut Capital – earnings surprises

Instead of looking for growth or value opportunities, FE Alpha Manager Barry Norris recognises that share prices move up and down depending on how the market expectation of future corporate profits.

Norris said: “We therefore focus our research efforts on finding companies where consensus is significantly over or under estimating future profitability. We believe that if we invest in stocks with superior earnings momentum this will lead to superior investment performance.”


 

“Our belief in the primacy of ‘earnings surprise’ distinguishes us from the vast majority of fund managers who categorise themselves either as ‘growth’ or ‘value’ and believe either that investing in the best companies will generate superior returns or that the cheapest companies will generate superior returns.”

“Although ‘growth’ and ‘value’ styles are capable of generating periods of significant multi-year outperformance, the obvious flipside of this is periods of significant multi-year underperformance.”

Norris adds that sticking with a growth or value bias is “deluded”, as it often leads managers to invest only in certain industries or businesses that have certain characteristics. However, he claims that these investments often stop working after a short period of outperformance, as it becomes a consensus trade.

Instead, he says it would be much better for investors to concentrate on stocks where they see a catalyst for an earnings surprise but is being ignored by the wider market.

“We will invest in any company, industry or sector as long as we are convinced that its future prospects are better than the market currently anticipates. Our only dogma is profit and specifically earnings surprise,” he added.

Performance of fund vs sector and index since launch

 

Source: FE Analytics 

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