Few things strike more fear into the hearts of investors than waking up to an unexpected “Market Update and Outlook” on a key holding in the portfolio. While it sometimes brings good news, more often than not, a big fall in share price follows. Situations like this can create panic, and if investors allow their “System 1 thinking” to take control, capital-destroying mistakes can result.
To help get a better understand of how the professionals handle these situations, we reached out to some of the top global equity managers in the country and asked them: What do you do when a stock you hold is hit by a downgrade?
Responses come from Matt Reynolds, Capital Group; Warryn Robertson, Lazard Asset Management; Peter Rutter, Royal London Asset Management; and Stefan Marcionetti, Magellan Asset Management.
Short-term weakness is an opportunity
The action we take depends on what is driving the downgrade.
If there was a profit downgrade because of an investment in new technology or an acquisition that is a short-term hit to earnings, we would adjust our valuations models, but not necessarily sell the stock.
When our long-term thesis for retaining the stock remains in place, we often use any short-term weakness to increase our position.
As an example, a stock we hold, US medical waste disposal business Stericycle announced the acquisition of Shred-it International, the global leader in secure information destruction services. Although adding to Stericyle’s growth opportunities, Shred-it is in a different and more competitive industry. Stericycle subsequently issued guidance that the synergies they were anticipating from the acquisition were not coming through as quickly as they hoped. The market reacted negatively to this news but it did not surprise us.
Typically, any synergies from an acquisition do take a little bit of time to appear, it is not a linear improvement in earnings. Often you will see no improvement in cost synergies for years one and possibly two and then in the third year, you start to get improvement in profitability. So in this case, the guidance was in line with what we had already forecast and we saw the market’s reaction as being an opportunity.
On the other hand, where a stock issues guidance that indicates a fundamental deterioration of its operating environment, that would force us to re-assess. In particular, if the company is showing signs that its economic moat or competitive position was being eroded this would be a great concern to us. Once our thesis for holding a stock is broken, we would exit the position.
What is an interesting feature of markets today is that the market can overreact to downgrades that we believe are not material to a company’s long-term intrinsic value. While this does give some variability to short-term performance patterns in portfolio, it may provide a good long-term opportunity.
A clearly defined process is key
Peter Rutter, Head of Global Equities, Royal London Asset Management
We have a clear process for how a stock gets into the portfolio, what its position should be and when we should sell it. Capturing what to do with a holding in a company that has issued a downgrade is integrated into this process. A bit of background is probably useful first though.
In our portfolios we look for companies with two clear attributes.
- The business must be a superior wealth creator for shareholders. We’re focused on identifying a sub-set of companies globally that are truly run for you and me – the shareholders – and are managed with advantaged strategies and business models. In our view, capital that is treated well tends to perform well.
- There must be a valuation opportunity or mispricing of the shares in that company. So, we’re looking for companies that are not just great wealth creators run for shareholders but are also attractively valued.
In order to buy a stock in the portfolio we need conviction in both these elements. Our position size is then a function of our conviction in each element and our sell discipline kicks in when we lose conviction in either one of these two attributes.
How we then deal with a stock hit by downgrades is directly tied into this. For every company we own we have a thesis, milestones and a valuation assessment. When we experience a downgrade, we update our milestones around our wealth creation thesis and we also update our valuation assessment. Sometimes that downgrade leads us to sell (we lose confidence in either the thesis or valuation), sometimes we reduce the position (lower conviction) and sometimes we add!
It may be that the downgrade is irrelevant to the long-term wealth creation and valuation and the fall in the shares that can be associated with downgrades is just a great opportunity to buy more at a lower price.
An example of this might be a trucking business we own in the USA called Old Dominion Freight. A few years ago, the company downgraded its earnings because it was investing heavily in long-term growth. It was buying more trucks and expanding its depots nationally. The shares sold off on this news and the company issued downgrade to near term expectations. However, our investment thesis was about long-term growth and factoring in the investment increased our long-term valuation estimate so we bought more.
So, the answer is ultimately dependent on the reasons behind the downgrade. The key for us is making sure you have a process that can deal with the complexity of the real world and long-term investing rather than following simple basic rules about selling on a downgrade which may just be the opportunity for someone else.
The value is relative
Stefan Marcionetti, Portfolio Manager, Magellan Asset Management
We continuously update our views on value and risks in response to the latest information. We have no set rules as to whether or not we would sell, add or make no change in response to disappointing news. We are aiming to optimise the risk-reward profile of our portfolio so all decisions around stock weightings are relative to the opportunity set. An investment might become more attractive if the share price falls, but it might not reach a level where it is more compelling than other investments we could make.
We invest only in high-quality companies and we take a long-term view of value and risk. When new information comes to light, whether it’s positive or negative, we ask ourselves:
“Does this materially change our view of long-term quality, value or risk of the investment?”
A company’s share price will typically fall following a downgrade, although there are times when the market anticipates bad news. Share prices can even go up if the news isn’t as bad as the market expected.
If a downgrade were due to a substantial degradation in business quality or an increase in risk, then we would be more likely to reduce the position even when its share price had fallen. If a downgrade were due to a near-term slowdown in earnings and held few implications for long-term value, we would be more likely to add to the position. This is because the share market generally puts too much emphasis on short-term issues and underweights the long term.
A great example is Apple. We initiated a position in Apple in late 2015 when the share price was depressed. The market was concerned because year-on-year iPhone volumes were declining for the first time in Apple’s history. This wasn’t because the latest iPhone wasn’t popular. It was simply that the previous year Apple launched the highly successful iPhone 6, the first of the big-screen iPhones, which boosted that year’s sales volumes by almost 40%. In this instance, the market was putting too much weight on the short-term volume trends and ignoring the long-term quality of Apple. The number of iPhone users was still growing at a brisk pace, which meant the long-term health of Apple’s business was still very strong.
Two questions to ask yourself
Jonathan Moog, CIO and Portfolio Manager, Pengana Global Small Companies
The first question we always ask ourselves when entering an investment is what is the quality of this business and their competitive advantage? Then we have a financial outlook that forecasts what we think the business should generate over time. So, when we get hit with the downgrade, the first question we ask ourselves is, has there been a change in the competitive advantage of the underlying business that we own?
Then the second question; is any piece of our thesis really broken? Or is this just a temporary problem? Those are the two things we try to ascertain.
If the answer comes that we were wrong about the competitive advantage or the financials of the business, we look to exit. If we felt our thesis was still solid, we would probably add to the position or sit through the downgrades.
Every downgrade is different
Earnings downgrades come with the territory of investing, and although we hope to avoid companies issuing downgrades (through careful and rigorous research), inevitably it sometimes happens. Capital Group portfolio managers rely on the research carried out by our experienced investment analysts when making investment decisions. Our investment analysts are focused on analysing companies over the long-term, usually 3-5 years but also often supported by medium-term expectations. When a company does issue a downgrade, it is usually time to reassess the investment thesis in light of new information. The key question is whether something has fundamentally changed and is there a structural issue? Or is this a short-term or temporary headwind affecting the company’s earnings expectations? Our analysts don’t have a set process for this, and each instance of a downgrade would be assessed carefully on its own merits.
Every company is unique and assessing the reasons for a downgrade need to be analysed on a case-by-case basis.
For example, in July 2018 Facebook delivered weak guidance to the market for revenue growth and margins after narrowly missing consensus revenue expectations. This was the first quarter in over three years that Facebook didn’t meaningfully beat the consensus earnings expectation. Our view was that Facebook faced short-term headwinds, a result of investments into data protection, and a negative impact from new European regulations (the EU General Data Protection Regulation, or GDPR). Our analyst felt that over the mid to longer-term the business model remained intact, and user fundamentals would ultimately be a better indicator of the strength of Facebook’s business. Our view at the time was that Facebook was trading at an attractive valuation relative to the market, and offered superior revenue growth, profitability, returns on capital, balance sheet strength, competitive positioning and strong management. As a result, we took the opportunity to add to our investment.
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