Fund Manager Q&A
Alex Cowie

With the climate of political polarisation, an unprecedented shift in monetary policy, and trade wars all impacting markets globally, you need a safe pair of hands to navigate increasingly volatile global equity markets. In this exclusive Q&A, we chat with Peter Rutter, Head of Global Equities at Royal London Asset Management, to explore his strategy and market view.

Rutter shares his thesis on the Buffett-led Berkshire Hathaway, whose shares have stalled in the last year, telling us that: “We actually think the investment thesis is still very strong and the valuation is very attractive, so we maintain the position”. He also shares his Brexit predictions, why the Australian economy remains appealing, and touches on the predictive power of sci-fi writer Isaac Asimov. Read on for a fascinating discussion.

Q: How would you describe your role if someone at a dinner party asked you.

I see myself as looking after other people's money and savings. Pensioners invest their money in the stock market and have a professional fund manager to look after that money sensibly for the long term. So, looking after other people's savings through the stock market – that's what I do.

What particularly appeals about fund management is that it's so multidisciplinary. There's obviously finance and maths, but there are also big social and political themes and behavioural aspects around making decisions in tough market conditions. The economy's always changing and there's innovation and competition in the world economy. How this all fits together is very interesting. We're always learning something new and I think that's a pretty exciting job to be in.

Q: As a UK based global manager, what do you think you'd miss the most if you could only trade U.K. equities?

I think the biggest thing I would miss is the breadth of opportunities. There are about 350-400 companies in the mid- and large-cap space in the U.K. Globally, the number is about 4,000, so the exciting thing about global equities is the opportunity to find really interesting names that aren't always available in a domestic marketplace.

For example, semiconductors there are almost no semiconductor companies in the U.K. It's been one of the most exciting, interesting, innovative and dynamic parts of global markets. And if you are a domestic U.K. investor, there wouldn't really be an opportunity for you to look at it.

Q: One of the central tenets of your strategy is that you divide your stocks into lifecycles. Can you give us a bit of a background on that process, the various stages, and some examples?

We allocate every company in the investment universe into one of five corporate Life Cycle categories:

  1. Early stage innovation and growth
  2. Compounding
  3. Fading
  4. Maturity
  5. Distressed/potential turnaround

We notice that companies go through a Life Cycle in terms of their profitability and growth: this is driven by innovation, which drives up profit and growth, and competition, which tends to drive those things down.

Early-stage companies like Amazon, Netflix or Tesla are investing heavily in disruption and growth. They often make quite low returns on productive capital. But, if they're successful in innovating, their profitability and growth can accelerate.

You then get successful companies that have gone through that stage like Alphabet or Nike: companies with very high returns on productive capital and decent growth rates. We call those compounders.

Unfortunately, when you're very successful, competition is a fact of life. Once you're there, there's a very powerful tendency for competition to cause returns to fade over time. You can still be a good company, but you're slowing and maturing: we call those companies fading. IBM is a great example. Or Coca Cola – as new types of drink and consumer tastes emerge, you're seeing a fade in return and profitability at some of these large incumbents.

Once excess returns have faded away, companies can still do okay, but they don't make surprising levels of profitability. A company like Ericsson would be an example of a mature company at that stage of the Life Cycle.

And, unfortunately, even when you've been around a long time and you're a decent company, competition never stops. You get companies that become distressed as their profitability shrinks or they become loss-making because of competition. You could look at Vodafone in the U.K., which is a low return on capital business, or Sony in Japan – companies at the tail of the Life Cycle that make quite low returns on productive capital.

So, as long as you have innovation driving returns up and competition driving returns down, we notice this incredible, powerful tendency for companies to move along the Life Cycle.

Q: One of the most well-known companies you hold in the ‘mature’ life cycle is Berkshire Hathaway. What are some of the signs or signals that would make you trim or sell out of that position?

For every company we own in the portfolio, we have an investment thesis. We have some investment milestones, so that as we go forward we can test that thesis. We also do valuation work and our position sizing in the fund. When we exit positions, it is driven by one of two things. It's either when the investment thesis breaks down as a result of poor milestones or it's when the valuation is no longer attractive.

So, Berkshire would be like any other company in our portfolio. If we thought the investment thesis was deteriorating or the valuation got expensive, we would sell it. At the moment, we actually think the investment thesis is still very strong and the valuation is very attractive. So we maintain the position.

I believe there are three sources of value in valuation historically at Berkshire Hathaway.

The first is the actual operating businesses, so the railroads, the utilities, GEICO – the insurance company, and we analyse those traditional companies as operating businesses and we come up with cash flows and valuation.

The second area is a portfolio of investment holdings that they have and we can mark those to market. We can see how many shares they own in different things and value that portfolio.

The third source of value, historically at Berkshire Hathaway has been a kind of future intangible value associated with Warren Buffett and Charlie Munger's ability to allocate capital brilliantly to create wealth for shareholders.

What's interesting to us when we value the business at the moment is that there's zero in for that future value creation from their capital allocation, which is pretty rational given their ages.

However, what’s more interesting is that, if you take the value of the underlying operating businesses and the marked-to-market investment portfolio, they in total are well in excess of the current share price.

So, the future wealth creation from those individuals is likely a small component of the value of Berkshire Hathaway. But the intrinsic business is very attractively valued compared to the current share price. That's why we have the shares.

Q: From an outsider looking in, how does the Aussie economy look to you at the moment?

I think there are some great structural advantages in the Australian economy:

  • English speaking
  • Highly educated people,
  • Amazing resource backing,
  • Space and land,
  • Significant immigration which brings in new people, new demand, new talent and also creates relationships back to other economies all over the world

So, there are a lot of structural things going on in the Australian economy, which I think should leave Australians feeling quite optimistic for the long term.

One observation would be the Australian economy is relatively concentrated around a few sectors compared to a lot of other economies around the world. It's not the most concentrated, but it's not as diverse as some economies. And that creates the potential risk of imbalances and threats. I think Australians know where all of those things are, to be quite honest.

That's probably the main risk. But structurally I think it’s a very attractive long-term economy.

Q: What are your thoughts for how the next 12 months play out for Brexit?

Well, we come at Brexit from two angles.

We've done all the microanalysis of all the various steps and chains that might unfold, and become amazingly knowledgeable about U.K. constitution and how parliament works in the process.

And we've also looked at it from a macro perspective. The reality is nobody really knows what's going to happen. The actual mechanisms and paths towards the end conclusion are incredibly complex. They're not just in the hands of the U.K. parliament, but also in the relationship with the EU, so we don't know the exact mechanism that we’ll end up with or what the eventual outcome will be. There's a lot of volatility around the probabilities around different outcomes. As a result, we make sure the portfolios are well balanced, so we're not taking any major Brexit risk and I think a lot of managers with U.K. domestic portfolios are doing the same.

From the macro position, I think it’s possible to draw some stronger conclusions and I think there are four potential outcomes from Brexit:

  1. A good Brexit deal,
  2. A bad Brexit deal,
  3. A hard Brexit, where just there's no deal and you go over the edge, and
  4. The possibility we stay in the EU.

The one thing we can rule out is that the EU cannot allow the U.K. to have a good Brexit deal because that would be so damaging to the overall European project that I think that is off the table. I think the other three options remain on the table.

Ultimately, we may end up staying – I think the EU would like that. A bad deal, just to get the deal done, is a distinct possibility.

There is a chance of hard Brexit, but of the three it’s probably least likely unless we have a catastrophe in terms of the negotiations, but it is still possible. But it's bad for all sides – it's actually really bad for the EU as much as it is for the U.K. – so I think they will try to avoid that as well.

Q: You told us that you thought the biggest risk year would be the yield on 10-year treasuries. How do you mitigate the impact on equities?

Different parts of the corporate Life Cycle react differently to changes in discount rates and bond yields.

  • So early-stage growth stocks tend to perform very well when interest rates are falling because the value of the cash flows they generate goes up disproportionately
  • Value stocks tend to do well more when interest rates are rising

It's quite hard to have a particularly strong view around long-term interest rates and bond yields. So we diversify the portfolio by Life Cycle categories, which removes some of the relative return sensitivity to changes in interest rates and bond yields. And it means that the risk in the portfolio is driven by stock picking, in which our investment process gives us an advantage.

Q: How will the US-China trade war impact markets?

There's a tremendous amount of U.S. production in China, and China relies on a huge amount of U.S. technology. So, I think this will run and run and will be a feature of global equity investing for many years to come.

The impact is very stock specific. For example, if you own a steel company, it has a big impact. Or there are actually quite a few U.S. companies like Yum! Brands, which is a fast-food retailer and owns businesses like KFC. The majority of their profits come from China. So, different companies are affected in dramatically different ways.

It's a genuine issue around intellectual property rights in China. There's a real structural challenge, which is that there is a limited separation between the corporate economy in China and the state. In the U.S., it's the reverse. The two largest economies in the world with two completely different methods of delivering economic growth for their citizens.

And so the belief in global liberal capitalism that you see as the U.S. model of generating wealth for society, citizens and shareholders; and the Chinese model, which has generated a tremendous amount of wealth by effectively having the corporate economy tied into the government. How these two paradigms interact is getting increasingly challenged.

Q: How can investors avoid getting caught up in a momentum trade?

I think the challenge we have with momentum is that it is backwards looking. It's what's happening right now, but what actually matters as an investor is what happens next. Just because a stock currently has good momentum, doesn't mean that will last forever.

What you really want to own is next year's momentum. If you own next year's momentum now, you're going to have outperformed. Momentum is really just telling you how something's doing right now.

So our focus is more on identifying great businesses that are very attractively priced. If we do that well, they will be next year's great momentum stocks.

Q: What are you most excited about in the three years ahead and what is it that's keeping you up at night?

There are some fantastically interesting companies that we own across the Life Cycle that are really exciting businesses. They're exceptionally well placed structurally to create wealth for shareholders over time. And they're very cheap relative to that wealth creation.

So, for us, we get most excited about the individual stocks we own and their potential. And, back to the idea that ultimately I'm looking after people's savings, I'm excited about some of the opportunities I've found at a stock-specific level to put those savings to work, because I think of the wealth those businesses are creating and what they might be worth over time.

The things that are most concerning for us as portfolio managers are, first, what the long-term implications are of very low interest rates and whether this could lead to a big structural recession at some point in the future, and with little central bank firepower to escape it. This could also usher in a massive misallocation of capital because, with interest rates so low, money just flies all over the world into growth projects, concept ideas and maybe it ultimately doesn't generate a return. So, that's the first thing that keeps me up at night – thinking about what's going to happen next in the global and corporate economy.

Secondly, the thing that's coming up on the radar for us is the U.S. political environment, particularly as the U.S. is 60% of the index. The U.S. political environment has never been more polarised between the Democrats and Republicans in my investment career of 20-plus years, with very different ideas about how the economy should be structured, regulation and things like that.

It's not necessarily that one is better than the other, but the impact on markets and individual stocks and segments of the economy of the U.S. moving from the Trump model to say a further left model where the Democrats seem to be positioning, could have massive implications for individual stocks, sectors, such as healthcare – all kinds of things. What's keeping us up there is watching that emerging... the polarisation of what could happen in the U.S. because it could have very significant impacts on what happens for stocks and portfolios.

You could extend that U.S. polarisation to pretty much everywhere, the Conservatives versus Corbynism in the U.K. Similar patterns here. We've looked into this quite a bit. A possible explanation is that after a decade of quantitative easing and low interest rates, there's been a major polarisation in wealth in the world basically between people who own assets and people who don't.

And globalisation and quantitative easing and stimulative monetary policy have polarised people's participation in the global economy and the wealth effects that come with that. Some of this polarisation really relates to the stress and strains caused by the global financial crisis, multiplied by things like quantitative easing.

Q: What's the last book or report that you read that really inspired you?

It's hard to choose between a Scifi book I read recently, 'The Foundation Series' by Isaac Asimov, and a book I read for work about information theory.

I liked the sci-fi book because it covers a huge time span and speaks to the power of long-term, almost-invisible forces that actually are almost quite predictable, but drive massive long-term change in a very small gradual way, year after year after year.

And so it's just a reminder as an investor that there's a lot of noise in the near term, but there are also these great structural forces in the world that are just going on every single day. Like a tide rising, you can't see it but it's happening and it's incredibly powerful. As an investor, it's great to be reminded of these long-term steady trends that can be invisible day-to-day, but they are there over many years.

The work-related book about what's called information theory I thought was fantastic – it was called Knowledge and Power by George Gilder. It's about how the explosion of information availability through new technology and networks is completely reorienting the global economy.

If you think about a lot of the disruption we're seeing, it's about people finding new ways to access information, which completely changes the economic decisions they make, which then completely changes the world. If you think about Amazon or eBay, they're fantastic information networks where you can find the cheapest stuff quickly versus the old way of walking around the shop thinking “I believe it's cheaper here, but I might walk to the next five shops and check”. Now you can check that at the press of a button, completely changing the economy and changing behaviours. The theory behind the book is the information age in which we're living is the next industrial revolution.

It's a fantastic book to read, giving some useful frameworks about how we should think about that for the long run as investors. The information economy is definitely not going away and I think it will structure much of what happens in the next 20 or 30 years.

Interested in high conviction investing?

Ironbark Royal London’s unique Life Cycle approach to investing allows them to identify undervalued stocks from around the globe, all at varying stages in their corporate cycle. To learn more, click here.





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Andre Louw

Much food for thought. Excellent!