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Global Equities The World has changed Whitepaper_v4
1. SEPTEMBER 2016
THE WORLD HAS CHANGED.
Active Management must change with it
INSIGHTS.IDEAS.RESULTS.
2. 2 AMP CAPITAL GLOBAL EQUITIES
Being a successful investor within
Global Equities means you constantly
have to think about secular change,
or its more fashionable term -
disruption. Had we written this
article in 1970, we would have used
typewriters, not computers, and it
would have taken several weeks to
ship printed issues of this article to
readers around the world.
But for the investment management
industry as a whole, and active
management in particular,
approaches to research, portfolio
construction, and risk management
have barely changed in 40 years. We
are now at that tipping point where
“change happens slowly, and then
all at once.”
In three sections, we summarise our
views on how the drivers of markets
and our understanding of investment
management have transformed, and
we propose some ideas and solutions
for both asset managers and asset
owners to consider.
3. AMP CAPITAL GLOBAL EQUITIES 3
In the US in 1975 85% of S&P500 value was in ‘tangible assets’
such as plant and equipment, machinery, vehicles, buildings and
land. This was because the US was still going through the end of its
industrialisation and hence if you knew where the US was in the
manufacturing and industrial production cycle, then you would
have a good chance of calling the stockmarket. During this time
industrial juggernauts like General Electric and Dow Chemical were
bellwethers of the index.
Fast forward to 2015 and 80% of the value in S&P500 is in
‘intangible assets’such as patents, trademarks, copyrights, goodwill,
brand, R&D, innovation. Today, it is asset light, knowledge based
industries and consumer services companies that dominate the
leaderboard such as Facebook, Amazon, Netflix, and Google.
100%
1975 1985 1995 2005 2015
80%
60%
20%
40%
0
Intangible Assets Tangible Assets
Components of S&P500 market value
The first key point to understand is that as economies mature and
become more consumer focused you can no longer rely on top
down macro insights to understand value creation.
We need to be building bottom up thematic insights from
individual companies in order to be a successful investor in the
digital age and in order to meet our risk and return objectives.
Consequently, investment research will need to focus not only on
the company’s tangible assets, which are commonly understood,
but also their intangible assets. Understanding a company’s
intangible characteristics such as their competitive advantages,
innovation capabilities, capital allocation, culture, and governance
policies can lead to better informed investment decisions and avoid
value destruction.
Unfortunately for asset managers, we believe the traditional tools
used by fundamental analysts may no longer be sufficient to fully
capture the impact of the increasing pace and variety of changes
being faced by today’s companies e.g. excel based linear modelling,
Porters 5 Forces, SWOT, Capital Asset Pricing Model. All of these
tools were created in the 1960s and 1970s and assume the world is
tangible and identifiable.
However, the rapid penetration of exponential technologies being
adopted across many industries is making it increasingly difficult
for companies to even define who their customers, competitors,
suppliers, and substitute products are. The advent of computers, big
data, and Artificial Intelligence has made the past infinitely easier
to model, but makes the future increasingly uncertain.
So how can fundamental analysis be part of the solution to meet
these challenges? Fundamental analysis should strive to better
understand “sustainable value creation”at a broader level and
take into consideration an uncertain future landscape. We should
assess how well companies can either lead change, or respond to
it, by assessing a company’s ability to innovate and allocate capital
efficiently whilst assessing the likely impact of structural change
and disruption.
Consideration of the investment implications of change requires
us to focus on the likely losers as well as the likely winners, and
therefore in a world of disruption, investment philosophies and
processes should be equally applicable to generating alpha through
short positions as they do through long positions.
To summarise this first section, we have identified that the
drivers of company and hence stock market value have changed.
This requires us to rewire our thinking about how we carry out
fundamental investment research.
We need to be building bottom up thematic insights from
individual companies in order to be a successful investor in the
digital age and in order to meet our risk and return objectives
The drivers of market value have changed
4. 4 AMP CAPITAL GLOBAL EQUITIES
2000 2002 2004 2006 2008 2010 2012 2014 2016
Active TotalPassive
500
2500
0
USDbn
-500
2000
1500
1000
-1500
-1000
-2000
2000 2002 2004 2006 2008 2010 2012 2014 2016
25
40
20
%
15
35
30
5
10
0
Cumulative flows into global equity funds
Source: EPFR Global, ICI, and Bernstein analysis.
Passive share of total equity fund AUM
Source: EPFR Global, ICI, and Bernstein analysis.
Before the widespread use of computers (and fax machines), the
‘edge’in fundamental equity research was seen to be in information
gathering. Consequently, managers employed armies of analysts to
‘hunt’for information.
Now, information is everywhere, owing to the use of computers,
the internet, big data, and artificial intelligence in addition to fair
disclosure of information regulations. In the short-term, market
efficiency is about news, changing risk aversion, liquidity and
transaction costs. Machines now do this much better than humans
can and their collective intelligence is multiplying at a rapid rate.
That has resulted in a substantial decrease in alpha generating
opportunities for fundamental investors in the short term.
However, most active managers remain focused on outperforming
market capitalisation weighted benchmarks over a 12 month time
horizon. Further, encouraged by consultant frameworks they often
employ largely systematic if not mechanistic processes, which
effectively expose the portfolio to a discrete set of factors, such as
value, growth, or size. This is despite the fact that one word style
descriptors are often unhelpful given that ‘Style’and portfolio
characteristics are not the same.
But given the pressure to fit processes into ever smaller style
boxes, it should therefore be no surprise that enhanced passive
and smart beta strategies have emerged. These strategies aim to
replicate these factors and hence a considerable portion of an active
manager’s process for a very low fee.
Global investors have, in aggregate, bought $2 trillion of passive
equity funds and ETFs over the last 10 years and at the same time
have sold $1.5 trillion of active positions. As such, the proportion
of equities run passively has risen from 15% to 35% over the
last decade.
In a research report, Sanford Bernstein quip that “smart beta is
growing not because it is an intellectual breakthrough, but because
like Uber, it is cheap and disruptive.”To explain why, let’s assume an
investor believes in quality and seeks exposure to it. The investor
can either find an active manager focused on quality companies or
can simply buy a smart beta product such as iShares MSCI World
Quality Factor ETF. At first glance the answer seems obvious, the
investor should choose the smart beta ETF at a cost of just 10 basis
points rather than the active manager at a cost of 100 basis points.
However, quality isn’t just one factor, it is two: (1) the spot (today)
level of returns and (2) the evolution (future) of returns. Smart beta
can help us with the first part, but fundamental analysis is required
for the second part, and this is where the majority of alpha is to be
found. Over a 5 year holding period >2/3 of stock performance is due
to value creation with <1/3 due to changes in multiple. Over 10 years,
multiples may move 50% but earnings could grow 10x, highlighting
the non-mean reversionary importance of quality growth.
The simple message here is that active managers need to focus on
the long term and on genuinely non replicable stock research, the
kind of insight which cannot be picked up by a machine.
Our understanding of investment management has changed
5. AMP CAPITAL GLOBAL EQUITIES 5
Proposals for consideration
The end of the active-passive distinction is ultimately, we think, a
good thing. Investors now have a much improved understanding of
alpha vs beta and their interaction with costs & fees.
We have moved out of the univariate benchmark paradigm of the
last 30 years to a multivariate benchmark world, where the smart
betas have become benchmarks.
This realisation requires fundamental active managers to
demonstrate true skill at stock selection, portfolio construction, and
risk management. Active fees need to be supported by meaningful
alpha potential. The key to defending active fee levels will be to
demonstrate idiosyncratic returns.
For fundamentally driven portfolios it means an explicit focus
on identifying companies that create value over the longer term.
In doing so, active engagement with companies will become
increasingly important for understanding intangible drivers of
companies – in other words, those unable to be picked up well by
passive / quantitative approaches. Further, by actively engaging
with companies we are in a better position to assess whether risks
are being managed appropriately and we can encourage boards
to shift their remuneration focus away from short term share price
gains to broader metrics that are focused on long term
value creation.
The new world requires highly active, benchmark unaware,
conviction weighted, long term orientated portfolios focused on the
understanding of competitive advantages, structural change, and
secular trends.
These portfolios should be constructed within a risk focused
framework to maximize stock specific risk. Some of the best suited
strategies to achieve this are concentrated long only portfolios, and
fundamental market neutral strategies focused purely on selecting
stocks to deliver consistent, incremental returns with low volatility
across an investment cycle and with low correlation to equity and
bond markets.
The ability to isolate alpha in this way and package it up with the
other components of returns creates many opportunities for asset
managers and asset owners to construct tailored solutions around
an increasingly customised set of investment goals. It means
investors can reduce payment in some commoditised areas, such as
market and factor exposure, and allow for spending money where
it is most valuable, such as the efficient capture of cross-asset risk
premia and also on rewarding real, true stock picking.
There are four themes which we expect will become
highly important to meeting risk and return objectives
in the new world:
1) Long short opportunities to increase in a world of
rising disruption, dispersion, and divergence
2) Concentrated portfolios to counteract
rising correlations
3) Capital Structure & Corporate Governance dynamics
4) Long Term mindsets and long term mandates
These portfolios should be
constructed within a risk
focused framework to
maximize stock specific risk
6. 6 AMP CAPITAL GLOBAL EQUITIES
We believe that the change in the value drivers of markets
combined with the need for active managers to generate
idiosyncratic returns will increasingly require listed investment
strategies to consider accessing the full breadth of investment
opportunities through long short investing.
In addition a low growth, low inflation, low return world means
that the overall pie is growing quite slowly. However, structural
shifts and secular change, predominantly through the disruptive
forces of technology, mean the shifts within the slices of the pie
are happening at an unprecedented pace.
Consumer spending might grow at 2-3% in this new world,
but Amazon Retail is growing at 30% per annum and its Prime
customers have the same consumer spending power as the whole
of Germany. Whilst not all market share donators are standalone
shorts, those which have high operational and/or financial leverage,
poor capital allocation and governance policies, are at extreme risk.
Thus the next decade should really be the environment for
fundamental long short investing to thrive.
There are a number of drivers for this:
The disrupters can be unlisted. Most disruption is being created
by capital light businesses. By definition capital light businesses,
typically in the technology, consumer, and healthcare sectors,
require less capital. So there is less of an urgency to list on the
stock exchange and for the founders to increase disclosure of their
operations, dilute their equity, or give up voting rights. This means
they are more secretive, more flexible, and more determined. This
development has coincided with the growth in the private capital
markets including venture capital and private equity.
For example, Uber and AirBnB have been incredibly disruptive to the
global travel market but are still unlisted. In the food retail sector,
Aldi and Lidl are low cost business models which have impacted
the traditional supermarket giants all over the world from Tesco in
UK to Woolworths in Australia. Both Aldi and Lidl are unlisted. The
collective growth of smaller niche and bespoke brands, aided by the
Internet and social media, are taking market share from the major
brands. Organic, farm to table food, craft beers, and identity fashion
are good examples.
Listed disrupters may not always be ‘investable’. Disruption
from below typically occurs when a new technology is applied to
rapidly reduce the cost of a good or service. If the good or service
is commoditised then the benefits are passed straight through to
the consumer rather than being held by the producer. For example,
we believe that whilst renewables are great for the world, we are
generally cautious on investing in listed companies given persistent
cost (and price) deflation and low returns. However, we believe
renewables as share of global energy mix is set to rise considerably
over next 30 years and as such it adds to our negative investment
thesis on fossil fuels.
Glamour stocks may have glamorous valuations. Some investment
themes can be highly emotional and as such the popularisation of
the theme and the poster child company can see valuations rise
wildly. For example, whilst we are big believers in the structural
transition away from traditional broadcasting and advertising
models towards online and over the top media, we find it hard to
reliably assess value in ‘hot stocks’like Netflix but in turn it is much
more efficient to be short traditional media companies.
We believe that the change in the value drivers of markets
combined with the need for active managers to generate
idiosyncratic returns will increasingly require listed investment
strategies to consider accessing the full breadth of investment
opportunities through long short investing
Long short opportunities to increase in a world of rising
disruption, dispersion, and divergence
The average age of technology companies
going public in 2014 is now 11 years. This has
steadily risen from just 4 years in 1990s.
Number of companies valued at more than $1 billion1
Public funding Private funding
Number of companies valued at more than $10 billion1
2005 2010 2015
100
400
300
200
0
2005 2010 2015
100
0
Tech companies are increasingly gaining significant scale and market share without going public
7. AMP CAPITAL GLOBAL EQUITIES 7
Environmental, Social, and Governance. The challenges of
disruption combined with management teams which have a poor
track record of capital allocation and poor governance policies can
generate large idiosyncratic and uncorrelated alpha. There have
been many company examples in recent years across multiple
industries including Tyco, Toshiba, Deutsche Bank, Volkswagen,
Valeant, Yahoo!, Hertz.
In simple terms, if as a fundamental investor you can correctly
identify structural change but you cannot access the disrupter on the
long side because it is unlisted, you can at least short the incumbent.
In technical terms, disruption creates dispersion and divergence.
Dispersion and divergence is a persistent phenomenon across
regions, countries and sectors around the globe and can be readily
captured by a fundamental equity process. One highly intuitive, but
typically unconsidered, aspect of dispersion and divergence is that
it is, by definition, always a positive number, unlike market beta,
which can be decidedly negative.
Consequently, Long Only investors may find that the value they
create through stock picking is, on occasion, overwhelmed by market
turbulence. Conversely, Long Short investors only need relative
conviction to prove justified in order to generate incremental gains
(assuming effective management of market-related risks).
It is our belief that the structural shifts underway have placed
pressure on sales growth for incumbents and increased the risk
of adverse operating and financial leverage for lower quality
companies. This is supported by evidence which shows that the
pool of stocks that destroy value (proxy for structural shorts) is
growing. Now 35%, from 25% 5 years ago, and highest in Asia.
45
35
40
30
20
10
25
5
15
0
FirmswithROIC<WACC(%)
’11 ’12 ’13
Global
’14 ’15
25.8
28.7
33.8
27.8
34.4
’11 ’12 ’13
North America
’14 ’15
14.5
20.7
25.6 23.0
30.0
’11 ’12 ’13
W. Europe
’14 ’15
24.2 26.0
34.4
29.0
35.1
’11 ’12 ’13
Asia
’14 ’15
35.8 36.2
39.4
30.7
36.1
8. 8 AMP CAPITAL GLOBAL EQUITIES
There is growing concern that an increase in passive penetration
increases correlation within stock markets. Whilst the evidence
remains mixed on a simple relationship between the proportion
of passive assets and average stock correlations, Sanford Bernstein
believer there is strong evidence which suggests that when
correlation spikes occur they do appear to be amplified by more
passive management.
Further, they appear to demonstrate that some concentrated
funds exhibit an advantage when correlation spikes higher. As
correlation increases, especially on the scale that we have seen
in recent years, ceteris paribus, it becomes harder for active
managers to outperform as, even if their views are correct, they
can’t differentiate themselves from the market. The one exception
to this is the group of highly concentrated managers who are
not diversified. If they have a concentrated position in a very
small number of names, then they can produce a return that is
meaningfully different from the market.
Of course, they have to get their views right, and periods
of increasing correlation often go hand-in-hand with “bad”
developments in markets, but at least they have the potential to
do well. The empirical evidence bears this out, showing there is a
tendency for the more concentrated funds to outperform in periods
of increasing stock correlation. Moreover, this is outperformance
that they generally don’t give back as correlation falls.
In addition, concentration can provide higher returns for a limited
increase in risk – why own your 50th best idea if you don’t have to?
% Reduction in possible average volatility with number of stocks held
Source: Fisher & Lorie - All NYSE Stocks traded 1926 - 1965
600
Index
Index
400
300
500
100
200
0
110
100
95
90
105
75
70
85
80
65
Europe fundamental fund AUM: <40 stocks vs. >40 stocks
Mar-05
Sep-05
Mar-06
Sep-06
Mar-07
Sep-07
Mar-08
Sep-08
Mar-09
Sep-09
Mar-10
Sep-10
Mar-11
Sep-11
Mar-12
Sep-12
Mar-13
Sep-13
Mar-14
Mar-15
Sep-14
Sep-15
Shift towards true active (alpha) strategies, while the traditional core flounders
100
90
1 2 8 16 32 128 Entire Market
80
70
60
50
20
10
40
30
0
CONCENTRATED PORTFOLIOS COUNTERACT
RISING CORRELATIONS
9. AMP CAPITAL GLOBAL EQUITIES 9
The figure below shows that the two best-performing tracking error categories within fundamental management were 5-8% and greater
than 8%, while the worst was the group with tracking error less than 2%. This difference still survives net of fees, with the 5-8% tracking
error category delivering the highest return and the less than 2% category having the lowest return.
130
140
150
110
120
Index
100
90
2005 2006 2007 2008 2009 2010 2011 2012 20152013 2014
0.2 to 2(11) 5 to 8(51)2 to 5(146) >8(11)
120
125
130
110
115
Index
100
95
105
85
90
80
2 to 5(41) 5 to 8(23)
2005 2006 2007 2008 2009 2010 2011 2012 20152013 2014
Gross relative performance of fundamental funds by tracking error categories
Source: eVestment and Bernstein analysis
Net of fee relative performance of fundamental funds by tracking error categories
Source: eVestment and Bernstein analysis
The opportunity to deliver better performance potential for similar risk, particularly within a highly correlated market regime, have
seen concentrated buck the trend in active AUM flows. The share of fundamental AUM accounted for by funds with fewer than 40 stock
holdings has doubled over the last five years. We expect this to continue.
The share of fundamental AUM accounted for by funds
with fewer than 40 stock holdings has doubled over the
last five years. We expect this to continue
10. 10 AMP CAPITAL GLOBAL EQUITIES
CAPITAL STRUCTURE &
CORPORATE GOVERNANCE DYNAMICS
Over time, the impact of capital allocation and capital intensity on portfolios can be dramatic. A Credit Suisse report from 2015 showed
that capex-lite companies have outperformed capex-heavy companies in Australia by 830 basis points per annum since 1989. There are
similar studies on the US market going back to the 1930s comparing the capex-heavy steel industry to the capex-lite beverage industry.
This difference in performance, spread out over 80 years, is enormous – an investment of $1,000 in the beverage sector has grown to $26m
whilst a $1,000 investment in the steel industry has turned into $57,000.
Less capex = more shareholder returns
Return of Buying Bottom Third of Capex/Sales Companies and Selling Top Third*
800
700
500
400
600
200
100
300
0
Capex-lite companies outperform capex-heavy
Capex-heavy companies outperform capex-lite
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 0807 09 10 11 1412 13
* ASX 200 ex-Fins, current constituents. Source: Holt, Datastream, Credit Suisse estimates
It is not that capital intensity is bad per se, but most managers are not effective at doing it. We have analysed why the vast majority of
management teams tend to allocate capital poorly. One of the reasons for this is that they are not incentivised to do it. In Australia, TSR
and EPS growth dominate. TSR is mentioned in 80% of incentive plans versus 50% in US and EPS growth in 40% of incentive plans versus
25% for US. Return on capital and cashflow are one of the lowest at 20% and 5% respectively, despite the fact that return on capital-based
incentive plans tend to correlate with strong outcomes.
Frequency of 2015 long-term incentive plan metrics,
for ASX 100 & S&P 500 companies
100%
TSR EPS Returns Cash
Flow
Revenue Operating
Income
80%
60%
20%
40%
0
Australia USA
Return on capital-based incentive plans tend to correlate with
strong outcomes
35%
Return
on capital
Operating
income
TSR Revenue EPS Cash flow
Sector average TSR
25%
30%
20%
10%
5%
15%
0
Going deeper, an area of research we are currently engaged with is the interaction between industry disruption and management
incentives. When faced with industry challenge, are CEOs incentivised to do the right thing and focus on value creation or are they more
concerned with short term EPS or empire building? Many CEOs try to defend disruption by making a bold acquisition for ‘strategic’reasons
which can compromise the balance sheet and future return p[potential.
11. AMP CAPITAL GLOBAL EQUITIES 11
The market’s disproportionate focus on short-term factors leads
to the market mis-pricing and undervaluing companies that can
generate secular growth and returns, and in turn, creates alpha
generating investment opportunities. The reason why long term
investment opportunities exist is rooted within behavioural
psychology and cognitive science which tells us that humans
exhibit a general tendency to underestimate long-term impacts and
overestimate short-term impacts on asset prices and economies.
In the long-term market efficiency is about valuation, growth and
cost of capital. The longer your time horizon, the more important
the difference in the rate of return on capital the company
generates and can reinvest at becomes relative to the difference in
the multiple you buy or sell at. Over a 5 year holding period >2/3
of stock performance is due to value creation with <1/3 due to
changes in multiple.
Over 10 years, multiples may move 50% but earnings could grow
10x, highlighting the non-mean reversionary importance of quality
growth. Generally, superior return premiums do fade over time
but in some rare cases they can be sustained for 20 or 30 years.
For fundamental investors, this results in a significant shift from
information advantage to understanding advantage. We can
measure the persistence of return premiums by analysing a firm’s
competitive advantages.
Longer term market performance driven by value creation
100%
1 month 3 month 1 year 2 years 3 years 5 years
70%
50%
20%
90%
80%
60%
40%
10%
30%
0
Multiple change
ProportionofEVchange,byfactor
Cashflow growth
6%
94%
17%
83%
41%
59%
52%
48%
59%
41%
68%
32%
Illustrative performance – importance of ROIC over multiple
Company A
(Low ROIC)
Company B
(Low ROIC)
Book value at year 0 100 100
Valuation at year 0 1.5x 2.5x
Market value year 0 150 250
Multiple expansion/(contraction) 33% (20%)
Return on invested capital 10% 20%
Market value year 10 519 1,238
Annualised return 13% 17%
Reward per risk Low High
As Towers Watson note in a recent paper, Long-term investing
requires the asset owner and asset manager to have, and stick to,
a long-term mindset in the face of tough times. While intentions
are often genuinely to be long-term, the resilience of this position is
invariably challenged over the investment period.
For the asset owner and asset manager it is important to have
investment beliefs regarding why a long-term investing policy is
being pursued. These beliefs should be formed through collaborative
discussion and hence commonly shared. Then, ingrained in stone,
they should represent the DNA which sets the starting point for
investment decision-making and processes.
Being long term means missing out on short-term opportunities
along the way without someone pointing the finger. During many
three-year periods the long-term portfolio manager will be in the
bottom half of the pack.
For example, despite the track record for long-term value of a
quality focused growth strategy, there are times when the market
rotates into unloved stocks, commonly termed “junk rallies”.
A typical example is when bull markets mature and in the very early
recovery stages when there is a tendency for investors / speculators
to rotate into capital intensive cyclicals that carry high operating
and financial leverage, companies which typically have a very poor
track record of long term value creation, or concept companies with
no earnings. Example periods occurred during 1998-99 and 2007-08
Although many investors try to mix styles (in an attempt to
maximize returns), we do not believe that the injection of ‘trash’
into quality portfolios or neutralizing sector bets to hedge beta in
the short term would improve our ability to meet our long-term
objectives. Periods of underperformance tend to be relatively short
lived, as high quality firms tend to maintain attractive operating
returns while poor quality firms generally remain disappointments.
However maintaining this view can lead to reputation risks,
career risks, regret and pressures both externally and internally to
repeatedly justify poorly performing investments as peers produce
superior results and, in the case of a DB pension fund for example,
funding deficits worsen. Long-term investment in public markets
is not the norm and requires resource, skill, internal support (for
example appropriate compensation mechanisms) and a contrarian
attitude to execute well.
The reason why long term
investment opportunities exist
is rooted within behavioural
psychology and cognitive science
LONG TERM MINDSETS AND LONG TERM MANDATES
