Finding earnings “surprises” before they happen

Jeff Thomson

Alphinity Investment Management

Company earnings are forecast to drop off as we move past the post-COVID bounce back in markets. That means that outperformance will be harder, but not impossible, to come by.

That’s where Alphinity's Global Equity Fund comes in. It adopts an all-weather, agnostic approach to investing that is centred around earnings leadership.

We try to identify companies in positive earnings upgrade cycles that are being driven by some fundamental event or change that's having a positive impact on the company, such as a new product release. 'Positive surprises' as we call them.  

There is an element of timing involved here, but it’s not the typical market timing you think. Rather, by timing these earnings 'surprises' we are able to ride the share price hikes that typically follow.

In this fund in focus, I'll take you through the nuts and bolts of this approach to investing, and explain why it’s so well suited to the the current earnings environment. 

Earnings have peaked

What you're looking at in the first slide is the US ISM Manufacturing Index in green and alongside that, you've got the MSCI World Earnings Revision ratio. So that's not actually earnings themselves, but it's expectations for future earnings. And you can see there, a very clear pattern in the last two, three years, a very dramatic COVID sell-off, historically outsized relative to anything we've seen in the last 20 or 30 years, and an equally explosive recovery as we came out of COVID, and as the world and central banks and government stimulated, and the world opened up again.

The biggest takeaway is that you've actually seen that impulse, that earnings recovery, that economic activity recovery peak sometime in mid last year, and subsequently to that it's moderating quite significantly. 

And in actual fact, in the last couple of months, I think with the uncertainty around inflation, the Omicron wave, and more recently the invasion by Russia of the Ukraine, uncertainty has really spiked, and you could probably say that the downside risks have increased, certainly a relatively more challenging outlook for equities.

We believe that the Alphinity investment process is very well positioned to continue performing through this environment. And as I'll describe in a moment, really, because we invest in earnings leadership and are somewhat style agnostic, we feel very set up regardless of how this actually plays out in the next year or two, that we can still produce very good opportunities for investors.

So moving forward, just introducing Alphinity Investment Management, we're a equity boutique, started in 2010. We have about $18 billion in funds under management, across both global and domestic funds, in four distinct equity strategies. We're also underpinned by or backed up by Challenger.

There's four somewhat distinct things that make us a little bit different from many of our peers. The first is the track record. We do have a very successful track record across all of those funds since 2010. We have a very experienced team in the global side. We have average experience of close to 20 years in terms of the five portfolio managers. We also have a very flat structure. We don't have that typical hierarchical structure where you have one or two very high profile portfolio managers with a whole pyramid of analysts underneath them. We have a very flat and co-PM structure. We also have very strong alignment. 

We all co-invest in the funds, but also very incentivized in terms of the performance of the business, but also the performance of the funds themselves. 

So very strong alignment with underlying investors.

And finally, we have a investment process, which is somewhat of a religion at Alphinity. And I'll describe in a little bit more detail coming up, but it's really around investing in what we call earnings leadership. And what that means is that the process is very style agnostic. The process can and has proven to work across very different market regimes. So value, growth, bull, bear markets. 

We are somewhat agnostic as to what is the preferred environment. We can perform across all of those.

So just moving forward that slide presents the global team. So five portfolio managers, we have dedicated ESG and sustainability resources, dedicated quantitative analyst, as well as a dedicated trader. And as I mentioned earlier, we have the support of Challenger/Fidante, with over 160 staff that help us in the back office, but also with distribution and marketing.

An investment process that likes surprises

So moving on to the investment process itself at Alphinity, really, there are two fundamental investment beliefs we have. The first is that earnings surprise drive share prices. And the second is that these earnings surprises are serially correlated. I think we'd all agree that surprise in earnings, that's fairly intuitive that generally speaking is well received by the market and generally associated with strong stock performance. And secondly, these surprises are serially correlated. So when you do get one surprise, you typically get 2, 3, 4 coming after that. There's a quote by Warren Buffett. He has so many good ones, but it goes along the lines of where you meet a cockroach in a kitchen, generally speaking, you tend to meet his family over the course of the next few days and weeks. And what he's referring to is generally speaking, when you get a profit warning from a company, a negative surprise from a company, typically that is followed by 2, 3, 4 other negative surprises.

And what Alphinity's trying to do is invest in the opposite of that. We are trying to identify companies that are in a positive earnings upgrade cycle, where there's an underlying positive product launch or a launch into a new business, something fundamentally that's changing and improving the company, that's manifesting in these positive surprises. So this chart really just to describe what you're looking at, the bottom line is the MSCI World, going back to 1988. It's given you 6% per annum CAGR. The black line above that is really with no foresight at all. You're simply investing in companies that have already experienced the top quintile, the best earnings revisions in the market over the last three months. That alone gives you a 3% uplift in performance, which is interesting.

If you can identify with good fundamental research, if you can identify companies one month in advance that are going to be receiving positive earnings surprises you're rewarded with quite abnormal performance. 

So obviously we're not promising that, but it does, I hope explain to you why, if we do what we say we do, if we do that well, there's going to be an enormous tailwind in terms of performance.

Combining earnings leadership and high quality

So, going one step further. We then try and invest in that earnings leadership when it's backed up by high quality. 

So strong businesses with strong cashflows, high and rising margins, good returns on equity, strong management structures and good industry structures, because those earnings cycles we think are more consistent. 

They're more reliable and more dependable when backed up by quality. And then finally, obviously you don't want to overpay for that. So there's a very strong value discipline in everything we do at Alphinity to making sure that we are not overpaying for these earnings upgrade cycles. So it's really those three things we're looking to do, earnings leadership, high quality and valuation.

On the right hand side in the slide, you can see what we call the earnings lifecycle clock. And really what it tries to do is describe a typical cycle in a company's earnings, where six o'clock is that point of maximum pessimism, typically after long period of negative surprises, where sentiment around the stock is very negative. And then from that point in time, it starts to surprise positively and goes through this positive cycle where it peaks out at 12 o'clock with the reverse, where there's point of maximum optimism. What we try and do, obviously in a perfect world, you'd invest at six o'clock and sell at 12 o'clock. In practise, it's almost impossible to do that. So what at Alphinity we try and do is invest at that 7:00 AM moment, after you've actually had the first positive surprise. And what that does is avoid the value trap, which is so painful for performance and really increases the hit ratio in the process.

And then using our value discipline, primarily, we seek to sell out of the stock before it hits that 12 o'clock moment, before proverbially, when we are on the dance floor, the music stops and everyone's running for the exit. That can be very, very painful for performance. So typically we are trying to exit at 10:00, 11:00 AM on that clock. Really trying to bring that to life in terms of two stock examples, I've included one value cyclical stock that's in the fund at the moment, and also one more structural growth stock. And you can see both are fully within process, and you can see that the process really is very comfortable investing in both value and so-called growth stocks. 

Bank of America, the United States leading consumer bank are really leaning into digital, but also very geared not only to higher economic growth, but also very geared to higher interest rates.

And you can see there, on the left hand side, the blue line being earnings expectations. The black line is the share price, and the shaded blue area is where we've owned it. And you can see again, that earnings upgrade cycle that we're looking to invest in. And on the flip side, on Prologis, the world's leading industrial logistics player, enjoying very, very strong tailwinds from the restructuring of supply chains around e-commerce and translating to very strong rent increases. And again, you can see the blue line being that earnings upgrade cycle and you can see how the share price and performance has actually followed suit.

Taking that to a portfolio level, this slide shows you the Alphinity Global Portfolio since inception in 2015. The red line is the earnings expectations for the MSCI World, so in other words, for the market more broadly. For every calendar year through that time period, you can see that generally speaking, most of the time, analysts enter the year, quite optimistic, and then generally have to downgrade expectations.

The blue line is the outcome for the Alphinity Global Equity Fund over that time period. And you can see that every year we've managed to identify and invest in a portfolio of high quality businesses, which are seeing superior earnings outcomes. And really, this is the tailwind that drives performance in the strategy. And more than that, you can see that this has actually occurred through very, very different, distinct market regimes. Through that, we've had strong periods of strong cyclical recovery. 

We've had periods of slowing global growth, and in all times we've been able to invest in good quality companies that are seeing better earnings upgrades.

Slide nine is the top 10 of the fund. You can see quite concentrated at a stock level, the top 10 being just less than 50% of the fund, but very diversified again from a sector perspective. So there's three tech stocks in that top 10. There are three healthcare stocks, three consumer stocks, as well as a bank, but all high quality and all seeing superior earnings outcomes.

Slide 10 gives you a sense of the geographic and sector diversification of the portfolio. So you can see we're invested across most sectors, and also most of our exposures through multinational companies with very wide and diverse underlying geographic exposure.

And finally, slide 11 just gives you a sense of the performance of the strategy since inception in 2015, which has been positive. But I think more pleasing from our perspective is I guess just the consistency of that performance through very different parts of the cycle and different types of market. And again, very, very typical of what we would expect from an Alphinity strategy.

So just finishing off the last slide, just give you some contact details, if you did want to reach out to Fidante for more information about the fund, but thank you very much for your time.

Managed Fund
Alphinity Global Equity
Global Shares

1 topic

1 fund mentioned

Jeff Thomson
Global Portfolio Manager
Alphinity Investment Management

Jeff is a Global Portfolio Manager of Alphinity Investment Management. His focus is on the Banks, Insurance, Property and Consumer Staple sectors, as well as portfolio management oversight. Jeff worked as a global fund manager at K2 Asset...

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