Measure what you value — so long as you don’t value just what you measure
Looking through The Sunday Times recently, I was confronted with the following headlines: “Fund managers face crackdown after Woodford scandal”, “Who needs a Woodford? Build a cheap DIY pension” (with index trackers) and “Try to find where your fund manager is investing — I dare you”.
Woodford Investment Management had been run by Neil Woodford, a “star” fund manager who set up the firm following a long period of managing assets at Invesco Perpetual. However, the record at his new firm was poor, and the resulting outflows revealed that the scale of the firm’s investments in illiquid smaller companies was incompatible with meeting redemptions in a timely manner. As a result, an avalanche of liquidations resulted in both the gating of funds and ultimately the demise of the firm.
The whole debacle has demonised the fund management industry in the UK, and as the headlines above attest, active managers in particular. This led me to ponder what issues the marketing veneer of Woodford’s firm had somehow masked for so long.
In our view, the issues that matter relate mostly to trust. These specifically include whether the investment manager delivers what it promises, whether it prioritises the client rather than itself and whether it invests in companies that deliver profitable growth in the right way. While prior investment performance does not determine whether your manager is on the right side of these important issues, deeper analysis of the issues can.
Trust — sticking to your philosophy
Thirty-two years in the industry has given me plenty of time to observe how markets can condition the behaviours of investment managers. Being measured on how well you perform every single day — a wholly inappropriate time period — is a pressure that is best mitigated by the clarity and confidence of an investment philosophy that does not waver with market volatility.
As a team we are very clear that our focus is on only picking companies globally that meet our Future Quality criteria. A shift away from our defined philosophy would be, in effect, a breach of the promise we have made to our clients. It appears that this is what occurred at Woodford Investment Management, raising the question of whether your manager can be trusted not to alter course.
Past performance is certainly debated by some as a tool for selecting active managers, but delving below the headline returns can provide insights on whether the excess returns are resulting from the managers’ prescribed philosophy or other factors, including luck. The average fund factsheet provides limited details on where investment returns are really coming from, while the greater insights from third-party analysis of portfolio returns is generally only available for professional managers who pay for such services.
Trust — putting clients first by managing capacity
The Woodford situation is a timely reminder of how forced liquidation at an investment firm can significantly impact client performance when the scale of the unwinding is large relative to available market liquidity. It would appear that delving down the market cap curve was a primary cause of Woodford’s demise, but it’s worth considering other sources of illiquidity. The investment management industry has seen an increasing concentration of assets into fewer players. This is a result of mergers amongst both managers and consultants and of underlying client flows. However, for these already successful managers the question is: what level of client assets is appropriate to deliver the investment philosophy and scale of excess returns that were delivered historically?
Recent events highlight that sudden firm-wide outflows, whilst a relatively low probability event, are a risk that can have significant client impact when the firm’s overall exposures are large relative to market liquidity. Hence, we would not be surprised if clients have a much greater focus on the level of ownership and ability to trade at the firm level rather than just at the individual fund level. Many managers do the right thing and close the door to clients when these predictable issues become relevant. But history would suggest that for some, the profit motive can also be of greater importance than promises to clients.
Trust — investing in companies that deliver returns in the right way
As we highlighted earlier, the Woodford situation has generated multiple headlines that question the efficacy and motivations of active managers. We know that the statement “active managers don’t add value” is a fallacy as we are part of a cohort of active managers that has been able to demonstrate consistent excess returns over the long term. It is also worth considering that good active managers know exactly what they are looking for when they pick stocks and willingly avoid companies that don’t meet their designated criteria. This is increasingly important as clients are quite rightly questioning whether corporations are delivering profits and growth whilst also looking after all stakeholders. Many of these stakeholders are increasingly focused on the social and environmental challenges we all face.
We wrote last quarter about how important it is that companies address the requirements of all their stakeholders, rather than just shareholders. Our Future Quality philosophy is to seek companies that we believe will attain and sustain high returns on capital, with the quality of the franchise and its management team being key pillars in this analysis. Companies that are solely focused on shareholder returns at the expense of other stakeholders such as employees, customers and broader society are less likely to sustain high returns on capital over the long term. We believe that our investment philosophy is completely aligned with ESG principles, which are now the focus of the entire investment community.
Another headline from the Sunday Times paper I mentioned above, on an unrelated matter, was “Measure what you value — so long as you don’t value just what you measure”. This would seem a rather appropriate summary of what I have outlined above: performance, or the comfort of joining a large roster of other clients, is easy to measure but not necessarily highly predictive of future returns. Whilst more difficult to assess, other factors to consider are how the managers’ philosophies may have migrated over time, the degree to which firm level AUM is a hindrance to alpha delivery and whether the strategy is one that can combine alpha and ESG investing. None of these factors are easy measures, but assessing them may be key to selecting the right active manager.
From Woodford to Woodward — a leader in engine efficiency
In November, we added Woodward as a position. Woodward is an innovation leader in the area of energy efficiency for aerospace and industrial engines.
Whilst electric vehicles will no doubt see greater penetration and further use, the improvement in energy usage of existing modes of transport will be a key element in alleviating the environmental challenges the world faces. Woodard is well placed to help deliver this.
Like many of our stock picks, we seek drivers of growth and profitability that are unique to that business rather than those that are wholly dependent on broader demand trends. Market share is one such driver and we believe that companies that spend more than 6% of their revenues on research and development can sustainably outgrow the competition. We expect a steady improvement in cash return on investment, with the roll out of its latest technologies being a key driver.
Technology — a shift from selecting technology to selectivity within may be underway
The technology sector is a fantastic hunting ground for Future Quality stocks, with the power of innovation at the company level creating opportunities to grow rapidly and deliver consistent high returns on capital. However, we need to be realistic as this thesis is already widely adopted by investors. The technology sector, and software sector in particular, are valued more highly relative to the market than they have been for many years with historically high levels of profitability.
The importance of innovation has not lessened and will remain both an opportunity and threat for individual companies. However, we also need to ponder a couple of issues that will influence how investors assess the overall sector in the coming years.
1. Supply. The technology sector appears to be undertaking a bout of excessive investment, though the visibility is limited as it is taking place in the unlisted sector. Third-party research has indicated that the level of funding for private equity in the US is at record levels. High and increasing proportions of this funding are heading into the technology sector—software/loss-making businesses in particular. The scale of this capital allocation relative to the US GDP is similar to the mutual fund frenzy around the TMT bubble in 2000.
The good news is that the dry powder is still at high levels and a capital shortage does not appear imminent. The bad news is that a wide array of companies are being supported in their search for new customers and profitability even though there is no evidence of a significant upward shift in end demand. Hence, there is a risk that the focus on the demand side for technology (some examples of durable growth drivers are 5G, Edge computing, cloud AI) is blinding us to a wave of new and typically unlisted competitors. There is typically a lack of pricing power given the deflationary environment that characterises technology, and this will not be helped by a proliferation of providers.
2. Policy. As we approach almost a decade of QE it may become more evident that the low cost of capital and scale of investment in technology are contributing to both the overall low rate of inflation and the low share of incomes to GDP. Whether there is a proven causal link between technology-led productivity and the wage rates for less skilled jobs, this may not matter as the political narrative could demand change irrespectively. How this will develop, as is always the case when politics are involved, is difficult to predict. However, it is reasonable to assume that the environment in which record levels of profitability are deemed acceptable may be coming to an end.
3. Politics. Whilst the political cycle may result in a lessening of trade tensions in the coming quarters, the hegemonic war between the US and China is out in the open and technology is an integral part of the weaponry. We should assume, therefore, that what has been a global market for technology products may become a more regionalised one over time. This is a challenge that is not limited to technology, with both consumer and industrial goods and services in the firing line.
We are fully weighted still in technology but our confidence in the individual business models is more important than broader demand growth. Companies that meet this criteria for us are Microsoft (cloud leader), Adobe (creative software leader), Hexagon and Keyence (digitisation of industrial world), Dolby (next generation sound and vision) and Accenture (IT consultancy).
The future return on investment and the growth of a company's cash flows are key focus points. We seek companies where the future is not reflected in today's valuations. To find out more click the contact button below.
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Will heads up the global equities investment team at Nikko AM. His extensive career in asset management, spanning three decades, includes director of equities at SWIP; director at Blackrock and investment manager at Dunedin Fund Managers.