INVESTMENT OPPORTUNITY May 2014 For professional investors
ROBECO GLOBAL PREMIUM EQUITIES FUND
Three circles + one strategy = nine awards • Undervalued equities have proven to outperform • Businesses must have momentum to improve • Fundamentals dictate a company’s true potential Chris Hart, long-time manager of the Robeco Boston Partners Global Premium Equities Fund, has won Morningstar Awards for best fund in a record nine European countries. Here he describes the secrets of his success. Ultimately, it comes down to three circles – and one highly disciplined strategy.
Achieving success Achieving success in any equity market comes down to a very simple premise. You buy stocks low and sell stocks high. Where it becomes more difficult is taking a
view on what exactly is low, and what is high? We’ve been in a bull market for a while and it is becoming harder to find true value – those companies that have a mix of three characteristics. They must have a low valuation, positive business momentum (the ability to grow) and good business fundamentals. Put another way: what am I buying, why am I buying it and what is the real return? These are the three circles, and they have done us proud. Here’s why. A drawback of both the bull market
and the current low-growth environment is that investors chase growth – and sometimes at a price that isn’t really worth paying. The market is currently paying high prices for momentum, top-line and earnings growth. Small cap stocks globally (under USD 2 billion) seem to be somewhat expensive. The portfolio currently has the smallest percentage of small cap names over the past six years. We’re now finding more opportunity in the mid cap range.
Investment Opportunity | 1
Dislocation, dislocation, dislocation What we’re really looking for is that dislocation between valuation and fundamentals, and earnings. Over the last five to six years we have been able to find pockets of opportunity at the industry level names that were generally cheap. We’re not really finding pockets any more, but one-off names. For example, advertising as an industry was undervalued for a while. There would be 2-3 advertisers that might be interesting, and now it might be one. So it’s even more security-selection driven because of where we are in the market, and what the market is paying for. Being as disciplined as we are with the application of our three circles philosophy and process, the portfolio will always maintain a quality bias and always own companies that have earnings momentum that is better than the market, with valuation support.
‘We are not going to throw away our discipline, chase momentum and give up our valuation criteria’ The portfolio today has become more value orientated. The level of relative valuation to the universe that we look at is almost as wide as it’s ever been. That’s a reflection of the fact we are not going to throw away our discipline, chase momentum and give up our valuation criteria.
What keeps me awake at night The thing that I fear most is a highly speculative market where the reasonable concepts of growth do not apply. My concern is twofold –
Figure 1: The Holy Trinity - the three circles
that the market pays excessive levels of valuation for top-line or bottom-line growth, or the somewhat unknowable where the market hits a bubble phase, and then we have a complete meltdown. Bubbles are always easy to identify in hindsight, but if we do have a blow-off or correction in the market, I don’t think it will be a Lehman type of event or anything like that. But we’re starting to see some things out there that are not necessarily positive, and the concern is the market going down because of a speculative nature, or investors overpaying for growth.
Top-down analysis isn’t for us Geopolitical risk doesn’t really bother me, because it’s not controllable from an individual company perspective. The US and EU aren’t going to do anything about Ukraine – it’s outside our sphere of influence, and it’s just noise. I’m more concerned about a bubble emanating in China than
anything that’s going to happen in Ukraine or Iran. Rates come down to a theoretical discussion. The Fed has been pumping billions of dollars into the system, and what’s been the result? I don’t know, because I still don’t see the big banks lending. We’ve only seen growth in loans over the past two years and it doesn’t even come close to reflecting the amount of ‘liquidity’ that the Fed has been pumping into the system. So I don’t know where that liquidity has gone to. If you take a step back, you see that the companies that we own all have great free cash flow. They’re not in a situation where they need to raise debt; companies have utilized debt levels to optimize their capital structures, but they are still flush with cash. Loan growth in the European banking system is contracting, with a crowding out effect, because banks are not lowering risk by getting rid of their government bonds, they are
Investment Opportunity | 2
lowering risk by cutting back on corporate lending instead. All the companies we own generate significant amounts of free cash flow and their capital structures are pretty stable. From a bottom-up perspective I don’t really entertain the idea that QE is going to be tapered, and therefore the market is going down. I look at underlying companies and say – so what did QE really do? Keep the top five banks in the US alive? And now they don’t lend. They say they lend, but really it’s just a surrogate for shadow banking. So I’m somewhat sanguine about it. I wouldn’t say the QE hasn’t pushed up the whole market, because it has, but the bigger risk is what’s happening in the economy, and the US economy is doing OK.
A truly global fund I would dissuade any investor from thinking this is a US-centric fund. When you look at the contribution to return by region, the US is generally underweight in the portfolio. The portfolio is very active, so if you look at the opportunity set over six years, the US averages at about 50%, but has been as low as 40% and as high as 58%. There are a lot of active bets in there.
‘I would dissuade any investor from thinking this is a US-centric fund’ Every region has contributed to performance. Alpha is completely driven by security selection, and the highest level of contribution to the
Periodic performance Period
Calendar year performance Year
*Performance for periods longer than one year is annualized. Robeco BP Global Premium D EUR figures are net returns to 31 March 2014. Benchmark: MSCI World Index (Net Return) (EUR). The value of your investments may fluctuate. Past results are no guarantee of future performance. Source: Robeco
fund is from continental Europe. Europe has had an average exposure in the fund of about 25% over six years, but it has made the highest contribution, despite being half the exposure of the US. It’s a truly global fund that adds to alpha across all regions. There is no home country bias. Generally, on average we have 20-25% in Europe, 15-20% in the UK, and the rest in Japan and south-east Asia.
We don’t chase dividends Dividends for me are an afterthought. It’s a result of bottom-up stock selection but it comes down to the question of what companies we are focusing on. We are not a traditional deepvalue fund that will pay up for dividends. In fact, when the dividend yield trade was all the rage two years
ago, we basically sold out of all those stocks, because although they were very well-run companies, they became too expensive for us. We weren’t going to play that game because it didn’t fit our valuation criteria. The dividend yield in the portfolio is purely the result of where we are in a cycle. Historically the fund has always had a dividend yield lower than the market. We are not opposed to higher dividends; we just want to ensure that a company with free cash flow makes a positive choice as to how to employ the free cash. The options are:
• • • • •
Pay dividends Buy back stock for cancelation Pay down debt Reinvest in the business Engage in M&A
Investment Opportunity | 3
Figure 2: Sector weightings through time for the fund versus the benchmark. Source: Robeco
It comes down to what’s the best use of capital. For M&A you have to be very cognizant of a management’s history and capability to reinvest favorably in the business. We have to make sure that when a company gets to the next level of growing the business through capital expenditure or M&A, that management does a good job of it. Historically many managements overspend, or they make dumb acquisitions, and that history is all factored into the bottom-up analysis of the individual companies themselves. The best of both worlds: looking for value AND growth with strong momentum (and near-term catalysts). The companies that we own that have high free cash flow tend to be companies that are maturing or mature; it’s the way that we look for quality. We don’t say that we want to buy a company because of its dividend. One of the aspects of our process and philosophy is that
we have a valuation bucket, and that focuses on value, but what we are really looking for is that dislocation between value and core concepts, such as its ability to grow.
‘I’m looking for the biggest dislocations between the underlying and expected earnings of companies’ On one level, it comes down to value, because we are buying companies that are less expensive than the market and offer a good valuation relative to the expected growth of the company. It’s the other concept of looking for quality that throws some investors, because it means it is not a true value fund. We look for high quality, but make sure it’s associated with earnings growth, because otherwise you
would get yourself into a position where you are buying cheap companies that used to do well but now don’t do so well. You could end up buying bad companies that are secularly in decline, and that’s what we want to avoid. We want to make sure we have growth associated with the names that we buy.
Adhering to the three circles It all comes down to adhering to our three circles approach from an individual company perspective. We build the portfolio with three circle companies, which means at any given time, a snapshot of the portfolio will exhibit these characteristics. We are completely agnostic to the index, and that results in very high active share ownership. For example, I look at food maker Greencore relative to the mining group Rio Tinto, and look at food maker Nestle relative to mining group BHP. I’m agnostic between
Investment Opportunity | 4
Figure 3: Regional Weightings through time for the fund versus the benchmark. Source: Robeco
sectors – I’m looking for the biggest dislocations between the underlying and expected earnings of companies. I want to find the best company where there is a disconnect with the valuation that the market is currently placing on it. It means looking over the medium term and long term at the embedded assets that the company has employed. Navigating the current market requires the strong level of discipline that we have, because it would be very easy to go out and shift the portfolio to buying higher momentum stocks. But that would be violating the valuation principle and we won’t do that. In this type of market, when it becomes highly speculative and there is a disconnect between reasonable valuations and growth, then it makes me somewhat worried from an underperformance perspective. But somehow or other, we are keeping up … through security selection.
Knowing when to sell Knowing when to sell is as important as knowing when to buy. As a firm, our discipline is evident in all our portfolios and the way that we invest. We also have a strong sell discipline.
‘We bought it when no-one else understood it’ A good example is the Daily Mail and General Trust, a British media group which we had in the portfolio for four years. We bought it when no-one else understood it; it was cheap, its management was doing the right thing, and we had confidence that the medium to long-term fundamentals were going to improve. They were basically taking an old set of embedded assets, monetizing them, and then investing in a higher-growth set of assets. The market did not recognize it but we met with the company and felt very
comfortable with their ability to reach their targets. It became one of the largest contributors to performance over the last four years. Then it hit our target price, so we completely sold our position. You need a significant amount of discipline when these types of events happen. The price went outside our valuation range: the company still has good strong earnings growth, but we felt that the valuation was too rich. There are two major reasons why we sell a stock. One is hitting the target price, which is always moving, and so we don’t set a perfect, intrinsic target value of a company as we’re more interested in the longer-term quality. The other is a break down in mediumlong term fundamentals or shortterm earnings momentum; the decision to sell is then based on whether the dislocation we identified was short-term or
Investment Opportunity | 5
medium-long term. In the medium to long term we don’t know perfectly how a company is going to do fundamentally from an earnings perspective. We can have some confidence in the near term on what we think it can do, but in the medium to long term that variability expands exponentially. So, from an earnings perspective we’re only really looking at that short-term momentum where we can understand it’s a particular company’s earnings level for the next one to one and a half years. Henkel is another example where we have cut our position significantly over the last few months. Both the DMGT and Henkel are great examples of compounding names, where we thought they were mispriced from a valuation perspective, and they traded in a valuation range that we thought was reasonable for the level of growth that the company was exhibiting. They continued to compound and hit their targets over time, but the market never really recognized those companies, and as their earnings grew, the multiples stayed somewhat the same. And then over the last four to five months that we owned them, the market really picked up on the success of those companies. The multiples expanded outside the range that we felt comfortable with
Top 10 Holdings Company
% of fund
Johnson & Johnson
Holdings and percentages at 31 March 2014. Source: Robeco
relative to the companies’ free cash flow generation and expected growth rates, and so we trimmed back and then sold out. That’s how we think about target prices, and how those target prices can move over time.
Sectors: we like pharma and mature US tech On sectors, we’ve been overweight pharma for quite some time. Everyone knew that the patent cliff was occurring for the major drug companies, but we looked at these big pharma names and the amount of free cash flow that they were generating, and the valuations that were being placed upon them, and a lot of them were priced as if they would be going out of business in 10 years. We recognized that these pharma companies had a lot of competencies to generate new molecules for the health care market, and it was hard for us to
believe that with the scientists that they have, they would not create a new round of drugs coming out in the next few years. That’s still how we feel today. They are not as cheap as they were, but we’re seeing a lot of drugs being developed that will come onto the market in the next few years. So we feel that pharma still offers a very favorable risk/return characteristic. We tend to be more on the mature side of tech, and our holdings tend to be much more orientated in the US. There are a lot more mature tech opportunities in the US, so we do own Microsoft, and Apple has been a new holding since the end of 2013. We feel that the gross margins at Apple have somewhat stabilized and the current valuation relative to free cash flow generation is very favorable. If you take the name ‘Apple’ off and look
Busy shaking hands all year round Our analysts meet with over 200 companies a year. We do the bigger conferences where we meet companies one-onone or in group settings, and talk to managements to understand what they’re doing. I meet personally with probably 100 companies a year, or two to three a week. We put the companies through our screening process, so we don’t meet a company that we’re never going to invest in. So we focus on the 25-35 companies that we’re interested in and then each of us in the team meets with 15 or so names. Even though we might not buy them right now, we will have met with the company, and understand what they do and what their plans are. We build a library of names that meet that underlying quality criteria; they might not meet the valuation criteria right now, but it’s a name we can refer to when it hits our valuation levels. I probably meet personally with two companies a week. Investment Opportunity | 6
underneath it offers a very compelling opportunity from the risk/reward perspective. We also own Western Digital and NetApp, and these are more mature names. We don’t own semiconductor equipment names because they’re mostly businesses which always have to reinvest in their businesses and hope they can maintain pricing, which is never the case. In PC manufacture we own Lenovo and Samsung, where we took a step back to look at valuation. We bought Lenovo and then sold out of it when it hit our target price in Hong Kong dollars; the share price went back down, and so we
and HP do not. So it can address those emerging markets that have incrementally better growth prospects than developed markets. These are metrics that we can identify, so we feel comfortable owning it.
And finally: happiness is being a human sponge
Hold the front page! Our News Flash reporting Chris Hart's ninth Morningstar award on 16 April 2014
bought it back again. PC sales are somewhat difficult in the world but Lenovo is winning in the market share game because it has a great distribution channel in emerging markets and China, whereas Dell
Professionally what makes me happy is winning; you don’t want to be in this business and not win. For me though it’s a balance. I don’t think you can be successful as a real investor unless you have a keen level of intellectual curiosity and always wanting to learn something new and different. That’s what keeps me going. You have to have a sponge-like attitude that wants to absorb information.’
Investment Opportunity | 7
Important information This document has been carefully prepared by Robeco Institutional Asset Management B.V. (Robeco). It is intended to provide the reader with information on Robecoâ€™s specific capabilities, but does not constitute a recommendation to buy or sell certain securities or investment products. Any investment is always subject to risk. Investment decisions should therefore only be based on the relevant prospectus and on thorough financial, fiscal and legal advice. The information contained in this document is solely intended for professional investors under the Dutch Act on the Financial Supervision (Wet financieel toezicht) or persons who are authorized to receive such information under any other applicable laws. The content of this document is based upon sources of information believed to be reliable, but no warranty or declaration, either explicit or implicit, is given as to their accuracy or completeness. This document is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation. Historical returns are provided for illustrative purposes only and do not necessarily reflect Robecoâ€™s expectations for the future. Past performances may not be representative for future results and actual returns may differ significantly from expectations expressed in this document. The value of your investments may fluctuate. Past results are no guarantee of future performance. All copyrights, patents and other property in the information contained in this document are held by Robeco. No rights whatsoever are licensed or assigned or shall otherwise pass to persons accessing this information. The information contained in this publication is not intended for users from other countries, such as US citizens and residents, where the offering of foreign financial services is not permitted, or where Robeco's services are not available. Robeco Institutional Asset Management B.V. (trade register number: 24123167) has a license of the Netherlands Authority for the Financial Markets in Amsterdam. The prospectus and the Key Investor Information Document for Robeco Global Premium Equities Fund, a sub fund of Robeco Capital Growth Funds SICAV, can all be obtained free of charge at www.robeco.com.
Investment Opportunity | 8