Invesco tells BENCHMARK how its value-driven approach identifies market winners.
Along with 13 awards for stellar performing funds, Invesco was awarded Provider of the Year – Mutual Funds at the BENCHMARK Fund of the Year Awards 2013 gala dinner. The most noteworthy of the bunch was the Invesco Pan European Equity Fund which has produced some eye-catching results. Despite the difficult economic backdrop, the fund posted gains of 39.45% in 2013 and 121.05% during the corresponding five-year period.
Stock selection Fund
Manager John Surplice credits the fund’s success to the value-driven approach he takes to stock selection. Each company is selected according to a strict valuation criterion based on what he thinks a company could earn in a normal environment, whether his expectation differs from the market view and if his expectations are reflected in the share price. He said, “For me, the best way to make money long term is by buying fundamentally undervalued companies. Buying moments can work in a short period of time, but over the long term that strategy doesn’t work.” He tries to look as far ahead as possible and always takes at least a three to five year view. “If you look at where companies are going to be over a two, three and five-year time horizon, you can really spot some anomalies in the market where you can make money,” he said.
Surplice creates a risk-reward matrix for every company he considers. Most stock selections begin with an idea, which is then developed through meetings with senior management, research on the company’s strategy and funding, and analysis of earning potential across a range of different scenarios. He said, “You need to really try to explore not just what you think that company is going to earn in a particular year, but the range of earnings outcomes under different scenarios: bearish, steady state, bullish.” He then looks at how the company’s balance sheet would fund the different scenarios, considering whether it is internally funded or whether it would be reliant on external funding. “You work through as many iterations as you can and you build up a risk-reward matrix. If you can identify a company with not a lot of downside, some reasonable upside on a base-case scenario, and a lot of upside on a bull case one, then that gives you a really good risk-reward framework,” he said.
Unsurprisingly, companies that have the best risk-reward framework have the highest weighting in the portfolio. Surplice also creates a macro framework that drives decisions on which sectors he wants exposure to. “I look at economic turning points, as the top-down viewpoint can be quite important. But the bottom-up valuation decision on individual companies is usually the driver on which sectors or countries we are going to be overweight in,” he said. Surplice is constantly reviewing his portfolio. He sets up target valuations for companies, and when these are reached, he reassesses whether to keep them in the portfolio. He is prepared to sell stocks, even if they have strong momentum, as momentum can change very quickly. He does not have stop losses, which he describes as being “intellectually lazy”. He points out that if a stock has fallen steeply, it is generally due to a macro trigger or a reappraisal of the fundamentals of the business. In either case, he prefers to do his own reappraisal, rather than to simply follow the market. “If I look back on building my financial position during the crisis, I started buying European banks at the beginning of 2010. If I had a stop loss limit of 10% or 15%, I would have been stopped out of that position innumerable times over the last few years and I’d have lost the opportunity of making so much money during the last 12 to 18 months,” he said.
Unsurprisingly, risk control plays a big part in portfolio construction. Surplice explained that he and his colleagues continually reassess the businesses in which they are invested, while they also use tools to assess risk at a portfolio level. Surplice said, “I am paid not just on my performance, but on my colleagues’ performances as well, so I have a big interest in what investment decisions my colleagues are making, as they do with me. That is a very good risk-control measure to make sure no fund manager is taking on too much risk.” Invesco’s investment oversight team also continually monitors his performance. While he has twice-yearly Chief Investment Officer Challenge Meetings in which he has to account for his investment decisions and give his outlook for the next six months, daily VAR analysis is also run on the portfolio. “There are quite a few levels of risk monitoring, but I would say the most important one is trying to get things right the first time and making sure the stocks you are buying have been properly assessed from a risk point of view before they go into the portfolio,” he said.
Environmental, social and corporate governance (ESG)
ESG forms an integral part of stock selection and Surplice is not afraid to walk away from a company if it does not meet his ESG criteria. “If a company isn’t run ethically or sustainably for the long term, that will trip it up,” he said. Invesco meets regularly with management to discuss governance issues, while it also votes at annual general meetings and extraordinary general meetings. But Surplice adds that it is not always easy, and there can be conflicts, such as if a company has arrangements in place to minimize its tax bill. He points out that even if this benefits shareholders, he is likely to be more critical about some of the other ethics within the business.
Surplice thinks it is a good time to invest in Europe. He points out that politicians and the European Central Bank have tackled many of the underlying issues, while equity markets are still looking cheap. Surplice is also optimistic that normality is returning to the periphery as bondyield spreads come down. He said, “In 2015 and beyond, I think Spanish growth will be getting back towards the top of what European countries achieve. I don’t think the market really expects that yet.” The countries he expects to disappoint on growth are the ones that remain unreformed, such as France. Across Europe as a whole, he points out that challenges still remain, and even optimistic growth forecasts are just above 1% of GDP. Meanwhile, the banking union project is being set up, under which banks are undergoing a stress test and asset quality review. He warns that if the capital requirements put on banks are too onerous, it could kill the economic recovery.
In terms of individual sectors, he likes financials, which he says look cheap. ”Financials are on a Case-Schiller P/E of around 10 times versus a historical long-term average valuation of around 21 times. Earnings are down about 60% from their 2007/2008 peak. We are looking for exposure to companies and sectors that can actually benefit from an earnings recovery,” he said. He also expects aerospace and transport stocks, particularly some of the airlines, to continue to do well. But he has almost no weight in staples. He points out, at the beginning of last year, there were global defensive stocks which had unsustainable valuations that weren’t supported by their own organic development. “People didn’t want exposure to financials or the periphery and they all hid in these massive staple companies,” he said. “If you look at the consumer goods sector, it is on a Case-Schiller P/E of a 40% premium to its long-term average. From the market as a whole, it is on a 30% discount; that consumer goods sector looks pretty expensive.” BM