The contention that the S&P 500 is to all intents and purposes completely efficient has been cited as the reason why there is little point in trying to beat this market. As a result, it is widely accepted that investors would be better off using a passive strategy when allocating to the US.
So, if fund manager Stephen Yiu says he does not doubt the S&P 500 is “100 per cent efficient”, why then a little under two years ago did he launch the LF Blue Whale Growth strategy, which operates in the IA Global sector, dominated by the US?
Many of the active funds that do manage to outperform the US market do so through a higher allocation to small caps – these offer higher growth potential and receive less coverage than their larger counterparts, making it easier for managers to gain an edge in this area.
However, even though the average market cap of a company in LF Blue Whale Growth is above $100bn – meaning it is operating in the most efficient segment of the most efficient market in the world – it has returned 41.11 per cent since launch in September 2017, more than 15 percentage points ahead of the S&P 500 and more than double the gains of the MSCI World index and its IA Global sector.
Performance of fund since launch vs sector and indices
Source: FE Analytics
Yiu said the reason the fund has managed to outperform goes back to the point about the US market being completely efficient – which he said is true, but only when applied to the next quarter.
“We have a lot of US companies in the fund and typically US companies do quarterly earnings,” he said.
“What we’re not trying to do is forecast quarters or quarterly earnings. If you say the market is efficient, the market is 100 per cent efficient for quarters, because firstly, the management would have given guidance to what they’re going to achieve.
He added: “Secondly, there are a lot of analysts trying to cover quarters and trying to come to a sensible view on how much money this company’s going to make. And that’s a lot of information there.
“But if you look a bit further out, so let’s say after 18 months to two years, this is where we come in.
“There’s a tendency for sell-side analysts not to focus on that because that is not how they get paid, they get paid by the shorter-term kind of businesses which depend on how much money they can make for their client.”
The Blue Whale Capital founder used the example of Amazon – which he said was the first stock the team at Blue Whale ever analysed – to show the benefits of taking a longer-term approach to earnings forecasts.
He and Blue Whale’s analysts began by breaking down Amazon into its sub-businesses such as the cloud, e-commerce, advertising and Prime membership, before forecasting the growth in margin for each of these over the medium term. Yiu came up with a final figure of 15 per cent, which is well above the market consensus.
“To summarise, the market doesn’t look that far out,” he continued. “If we are right, that Amazon can continue to increase its competitive positioning, being a disruptor, taking more market share from the traditional retailers, then the operating margin can continue to go up.
“Even if you just look at the last five years, Amazon’s operating margin has gone up from -1 or -2 per cent to 5 or 6 per cent, and in two years’ time it will be 8 per cent. That is how it works.”
Performance of stock vs index over 5yrs (share price only)
Source: Google Finance
Yiu and his team begin their process by taking the 1,600 or so stocks in the MSCI World and screening out large parts of the index.
For example, banks, which he finds impossible to analyse; Japan, as there are no Japanese speakers on the team; areas that are structurally challenged, such as high street retailers and traditional advertisers; and anything that is at risk from a change in the macro environment.
This leaves him with about 100 investable stocks, which the team will analyse to see if they can unearth a medium-term edge that is being underestimated by the market. Importantly, Yiu said that this only works if you take a genuinely active approach.
“Valuation is very important to what we do,” the manager added. “When I say valuation, we put a lot of emphasis that our forecast for how much money a company is going to make over the next three years is ahead of what the market forecasts [if we are going to buy it].
“Let’s say we forecast a company will make £110 pounds in three years’ time and the market forecasts £100, then we are 10 per cent ahead. It doesn’t matter which valuation you use, it is likely the shares are undervalued.
“If we are proved correct, then the market will revise up the earnings. And likewise, if we have forecast a company to make, let’s say £95 and the market is expecting £100, it is likely if we’re right, then the shares are overvalued.”
Yiu will sell out of a holding if a new piece of information comes to light that suggests a stock will not do as well as he originally predicted. However, he will also sell out if a stock is expected to do better than he originally predicted – so if he expected it to make £110 compared with a consensus of £100, then the market revises its forecast to £120 and the stock re-rates accordingly, he will pull out.
“Without doing anything, we’re now behind the market expectations, so to us then the shares are overvalued,” he explained. “That is part of the sell-discipline or how we size the position.
“We continue to evolve the portfolio. The top-10 we have in the fund is quite different and new [compared with since launch]. We always try to keep the portfolio fresh so that we can look forward to the next 12 to 18 months.”
While Yiu accepts LF Blue Whale Growth has a limited track record, he is confident it can continue to outperform. He said that its focus on mega caps means it is unlikely to run into liquidity problems faced by managers who generate their outperformance through holding smaller companies before attracting large inflows.
When asked why more managers don’t take a similar approach to him, considering so many in the US and global sectors struggle to keep up with their benchmark, Yiu said he gets the feeling that many of them aren’t that competitive when it comes to performance.
Performance of index and sector over 20yrs
Source: FE Analytics
“They will always say, ‘you should really take a five-year view if you invest in our fund, in five years, it will be doing better’,” he said.
“But for us the next year is important as well because we are a start-up and in a start-up you need to do significantly better than your competitors.”
Yiu added: “If you look at our sector, the majority of active funds have underperformed the benchmark.
“How do they justify why people should be paying them a fee? I don’t know. Maybe they’re being complacent. Maybe it’s because the market is not very transparent and no one is taking money out. Maybe they’re not under pressure at all. Maybe they feel they don’t really need it?
“I mean, we’re talking about quite a lot of funds that are underperforming and they’re still in business,” he concluded.
The LF Blue Whale Growth fund is £173m in size and has ongoing charges of 0.89 per cent.