Investors looking for companies that can weather a downturn in markets should steer clear of the financials, pharmaceuticals and energy sectors, according to Lazard Asset Management’s Bertrand Cliquet.
With lower expected returns, increased volatility and wider dispersion between winners and losers, investors should begin thinking about how to best defend their portfolios, said portfolio manager Cliquet.
After a prolonged period of low volatility, 2018 saw an increase at the start of the year as investors became more sensitive to negative economic data.
As the below chart shows, volatility as represented by the closely-watched Cboe VIX index – which measures 30-day expected volatility of the US stock market – has increased in 2018 after extraordinarily low levels seen in 2017.
Performance of VIX over 1yr
Source: Cboe
“The challenges we face are really the result of the very supportive environment for the past two years,” said Cliquet. “We’ve had low interest rates, healthy earnings growth… and this is changing as we have seen in the US already year-to-date: we’ve had rising interest rates, rising inflation.”
Indeed, a change in the current macroeconomic conditions could create challenges for investors, particularly given the high valuations that are being witnessed in the market, he said.
“We have lower expected returns and you should be prepared for those lower returns going forward,” he said.
As such, the manager of the $219.3m Lazard Global Equity Franchise fund said investors should focus on companies with the potential to weather any downturn in markets.
Cliquet looks for companies with a high return on assets, market-leading positions in attractive industries, large and sustainable barriers to entry, a stable return history, low financial leverage and sound corporate governance.
Companies often derive their advantages from high switching costs, a natural monopoly, cost leadership, network effects, or from brands and intellectual property.
The qualifying criteria for inclusion in Cliquet’s portfolio are quite high, however, leaving an investment universe of around 250 companies globally – less than 2 per cent of all listed companies.
There are some types of companies that the manager will not hold given the dynamics of the industries they are locate in, most notably the financials, pharmaceuticals and energy sectors.
“Most financial companies will have low margins, high levels of leverage and low switching costs,” he said, making them particularly unattractive.
However, the Lazard manager said the fund does hold Visa and Mastercard, which are classed as payment processing firms and considered technology stocks from an index perspective. Both companies are in demand from retailers and others who use the payment systems.
Pharmaceuticals companies, on the other hand, face challenges over patent expiry and dependence on positive drug testing results. Finally, energy stocks and commodities – which Cliquet said are “unforecastable by nature” – are another area to avoid.
Performance of indices over 10yrs
Source: FE Analytics
One other sector that the manager will not invest in is tobacco stocks. Although this was mainly for ESG (ethical, social & governance) considerations, Cliquet said it was difficult to forecast the long-term growth and value of tobacco companies given the challenges facing the sector.
The Lazard manager said investors can benefit from companies with strong economic franchises as they are often easier to forecast earnings compared with other sectors. In addition, they have performed well during more challenging periods in the market.
As a result of the process and philosophy, Cliquet said the fund is benchmark “unaware”, noting that it has not held any consumer staples stocks for two years and more recently cut exposure to the IT sector, despite its market leadership.
“We used to have 38 per cent of the portfolio in the IT sector and in December we reduced that to 18 per cent,” said Cliquet, noting a re-rating in profit expectations.
“We’ve increased utilities [exposure] which might seem surprising given interest rates… but it’s not a macro call,” he said.
As such, the manager increased the weighting to utilities adding UK companies National Grid and United Utilities and US-based PG&E power company within the portfolio.
There are some challenges to investing in strong global franchises in the current macroeconomic environment, however. A recent concern for global businesses have been signs of a trade war developing between the US and other major economies.
US president Donald Trump’s decision to impose tariffs on Canada, Mexico and the EU has been met with retaliatory measures and surprised investors given the strong diplomatic ties.
However, for companies that fit the manager’s criteria it is less of a concern, he claimed.
“It has increased volatility and magnified share price movements,” said Cliquet. “In terms of our forecasting, we put a margin of safety into our numbers. I don’t think it [trade war] will be meaningful.
“It’s quite an exciting time for us because there are really great challenges ahead for investors and we think focusing on these on these highly forecastable, high-quality businesses but with a long-term view.”
Cliquet has managed the $219.3m Lazard Global Equity Franchise fund since 2013 and is also manager of the £1.4bn Lazard Global Listed Infrastructure Equity fund.
The largest holding in the fund is French commercial satellite owner SES, which represents 6.9 per cent of the 25-strong portfolio.
Other top holdings include healthcare company Express Scripts, compliance company Stericylce, software firm Oracle and information provider Nielsen, which all represent more than 6 per cent of the portfolio.
Performance of fund vs sector & benchmark since May 2016
Source: FE Analytics
Since the start of data in May 2016, the Lazard Global Equity Franchise fund has returned 50.25 per cent, according to data from FE Analytics. This compares with a 44.66 per cent gain for its MSCI World benchmark and a 43.04 per cent return for the average IA Global peer.
The fund has an ongoing charges figure (OCF) of 0.91 per cent.