A manager’s investment style is the anchor and lens through which they analyse companies. We view this as being a manager’s investment DNA. Disciplined implementation of an investment style (which leads to the investment process) should, under specific market conditions, ensure that a strategy will be able to perform to expectations. It also ensures that a manager stays true to the investment process and does what they say they do. To use the jargon, there should be no style drift.
The ‘value’ and ‘growth’ straitjackets
The most commonly used investment style categories are value and growth. Simplistically, Value is based on mean reversion with stocks trading on multiples less than the market or their sector peers.
Growth stocks are generally considered businesses that we expect to grow earnings greater and for longer than the market. They will generally trade on higher multiples than the market. Both of these styles have investment merits and there exist managers who have proved successful over time by implementing either a growth or value style.
The alternative view is that these style buckets straitjacket managers, overly constrain them and are a naïve and simplistic approach to analysing managers.
The manager selection industry has become, in many instances, a box-ticking exercise. Good stock pickers should have the flexibility to buy either growth or value stocks, irrespective of labels, based on the manager’s assessment of a stock’s fundamental attractiveness.
As investors, we have sympathy for this perspective as our investment approach doesn’t neatly fall into the commonly used style labels and is not constrained by the conventional definitions of value and growth.
Our portfolios can and have included a combination of value and growth stocks. This is because our investment style is based upon the ‘capital cycle’ investment philosophy. This is our investment anchor and the starting point for identifying fundamentally attractive stocks. There is not a lot that is unique left in the investment industry (commoditisation of information, the advance of quant, exponential proliferation of hedge funds has arbitraged away a lot of market inefficiencies).
Nevertheless, we believe we are among a select few investment practitioners applying a capital cycle investment approach to stock selection.
Capital cycle investing in practice
The capital cycle is mainly focused on understanding and quantifying the level of supply in an industry rather than trying to forecast the short-term levels of demand - where most active fund managers apply their energies. We believe this focus gives us greater insight and a differentiated view in understanding the fundamental attractiveness of businesses and industries.
All industries go through a capital cycle, albeit to varying degrees. The duration and severity of each company and industry’s capital cycle is dependent on the barriers to entry for new entrants and the behaviour of existing competitors. There are industries (principally cyclicals) with lower barriers to entry that swing from excess optimism with new entrants attracted by high returns on capital, to excess pessimism due to a glut in supply and a resulting decline in returns. We are looking for companies in these industries that have experienced excess pessimism, but where consolidation and structural change is underway.
Generally, these businesses trade at attractive valuations as the market is slow to identify and understand the changing industry dynamics. Consequently, excess supply is taken out, a number of competitors exit and the remaining, principally dominant players, become price setters (possess pricing power). Thus earnings visibility, cash flow, and profitability improve, resulting in a rerating of valuations.
The capital cycle approach also works for investing in less cyclical, long-term structural growth industries. These industries typically experience less severe swings in sentiment as they have higher barriers to entry.
However, as the capital cycle’s principal focus is on understanding supply, it can identify long-term structural growth businesses that dominate an industry i.e. possess a moat: being the lowest cost producer, benefiting from economies of scale, having a unique product offering or possessing proprietary technology. Given they are dominant market players, these businesses are generally, though not always, fully valued. Simply, there are fewer mispricing opportunities for us to exploit as investors. Nevertheless, we look to take advantage of the market’s short-termism when these businesses are sold off and become attractively valued due to short-term issues, such as an earnings miss or temporary operational problems.
We believe that applying a capital cycle investment lens to the analysis of companies and industries ensures a differentiated perspective from the market in general and many of our competitors. This approach has made a significant contribution to our ability to generate alpha for our clients through different market cycles over the last 18 years, and our experiences have made us even better investors today.
As portfolio managers, we take seriously the fiduciary responsibility of managing clients’ capital. Hence, we want to keep clients fully informed on all aspects of our investment philosophy and process and what it means for clients’ portfolios.
Christopher Garsten & Charles Glasse are portfolio managers in the European equity team at Waverton Investment Management. The views expressed above are their own and should not be taken as investment advice.