• 11/09/2017

Principal Hong Kong Delivers

Principal Hong Kong Delivers

Principal Hong Kong tells BENCHMARK how its investment philosophy provides stellar returns.

BENCHMARK (BM): What are the characteristics of companies that you like?

Principal Hong Kong (PHK): Our investment team believes that attractive stocks consistently demonstrate three characteristics:

  • Positive fundamental change – We seek companies offering improving and sustainable business fundamentals with a particular emphasis on accelerating earnings trends. This can be in the form of rising top-line growth stemming from product innovation, pricing power or market share gains, or favourable margin-expansion trends stemming from operational efficiency gains and effective capital deployment. We evaluate the underlying business drivers of positive fundamental change to assess their sustainability and potential vulnerabilities.
  • Rising investor expectations–Our objective is to be early, but not alone, in identifying positive fundamental change. We carefully ascertain consensus expectations,probe disparate views, and carefully review estimate-revision trends to identify opportunities offering the greatest potential for positive earnings surprise.
  • Attractive relative valuation–The performance potential of positive fundamental change is greatest when accompanied by discounted valuations, and greatly diminishes amid valuation premiums. We carefully analyze key valuation metrics and challenge underlying assumptions to determine those best aligned with industry specific business drivers and different stages of economic and market cycles.

BM: What is your valuation methodology and how do you define a value company in the large cap zone? Please describe your large cap key selection process. What is your focus in terms of market cap level (seems to be leaning more towards giant) and return on invested capital?

PHK: We keep the pulse on all companies in the investable universe, regardless of market cap level, through the efficient use of a proprietary ranking framework called the Global Research Platform (GRP). The GRP provides breadth and objectivity to our research and is used to help us isolate a manageable focus universe demonstrating high alpha potential. This proprietary system is one of our competitive advantages, especially within a broad universe, such as international small cap equity. Below are the details of the system.

The GRP provides our analysts with rankings (1-100) of each company’s fundamental characteristics relative to regional sector peers. Our research has shown that historically the most attractively ranked stocks, for example, those ranked 1 to 20, tend to outperform those ranked 21-40, which, in turn, tends to outperform those ranked 41-60 and so on. This gives us an information advantage in terms of stock selection and narrows the focus of our analysts to those stocks with the most performance potential.

While the companies ranking in the top 20% are considered the primary focus universe for our research analysts, companies ranking outside of the first quintile may be included in the portfolio, if the analyst has strong conviction and believes that the GRP rank will improve. Importantly, each member of our research analyst team has integral familiarity and visibility of the underlying factor models and inputs for each stock in their coverage universe. A key element of the analyst’s responsibility is to ensure that the factor rankings are free of data anomaly and that comparisons are made within sectors and regions on a consistent basis. This interaction between the GRP and our research analysts provides a forum for the validation and challenge of investment ideas that ultimately results in attractive stock selection.

As an information management framework, the GRP helps to make efficient use of the analyst’s time to focus on a condensed list of companies providing us with a distinct information management advantage that results in a consistent and repeatable stock selection framework. The integration of the Global Research Platform with our analyst’s insights provides a focus for the validation and challenge of investment ideas.

BM: What level of trading discounts attracts your attention? Where do you still find value in large to giant caps?

PHK: First, valuations (including trading discounts) make up one of the key three characteristics outlined in the response above: attractive relative valuation, positive fundamental change and rising investor expectations. Additionally, we carefully analyze key valuation metrics and challenge the underlying assumptions to determine those best aligned with industry-specific business drivers and different stages of economic and market cycles. This gives a relative valuation discount, rather than an absolute level of trading discount that would attract our attention.

BM: What is your average turnover as compared to your peers? How are price targets set and under what circumstances are they being adjusted? What is your average holding horizon and what triggers a sale?

PHK: Our average turnover has been around 96% over the last three years. Our portfolio review process also utilizes the proprietary GRP, where portfolio holdings are regularly monitored and evaluated using the same three characteristics that define our investment philosophy: rising investor expectations, positive fundamental change and attractive relative valuations. As long as holdings continue to demonstrate these key characteristics, or until there is better relative value found in other stocks, we will continue to hold them. Within this context, our risk control process may also determine when a position may need to be modified (i.e., liquidity concerns may limit the size of investment.).

BM: With almost 18% concentrated in your top five holdings in financials and technology, it looks like you are more enthusiastic and off-benchmark in these sectors over your peers. What is the rationale?

PHK: As bottom-up stock pickers, these positions represent our conviction of the holding having the three characteristics that define our investment philosophy: positive fundamental change, rising investor expectations and attractive relative valuation. Any overweights to specific sectors typically represent our degree of conviction on each stock that makes up the overweight to the sector, rather than a specific view of the sector.

BM: What is your risk control methodology? Do your bottom-up ideas lead to significant sector and country deviations?

PHK: Risk management is embedded in our investment process, as it is important to us that we preserve the alpha we generate. We manage and monitor risk exposures through a series of weighting constraints relative to the benchmark, as our focus is on the management of stock-specific risks and the avoidance of unintended systematic risks such as beta, country, currency, sector and industry biases.

Where possible, we try to minimize sector or country deviation to isolate superior stock selection as the primary source of outperformance. Occasionally, however, our bottom-up stock selection will lead to some deviation in sector or country allocation, due to superior attractiveness (as measured by positive fundamental change, rising investor expectations and attractive relative valuation) being seen in individual stocks within the sector or country overweight.

BM: Please describe how decisions are made and how they contribute to the portfolio’s overall risks.

PHK: Our portfolio managers have a full Portfolio Manager Workbench at their fingertips to ensure they do not have any unintended biases in their portfolios. Responsibility for the control of risk lies with the portfolio manager who reviews risks in the portfolio on an ongoing basis and is monitored by investment peers and the chief investment officer. Our portfolio and risk management tools allow for senior management to view portfolio positioning for all strategies at any time and the chief investment officer is charged with supporting risk management efforts that quantify the portfolio manager’s success in achieving risk and return objectives.

Asian outlook

BM: Where do you see drivers for growth in 2014 and what sectors are still showing attractive valuations? Which sectors do you favor and which appear to be more vulnerable?

PHK: As we enter 2014, our view is that the key challenge for many emerging countries this year is going to be maintaining growth momentum, while undergoing macroeconomic adjustment and structural reforms. With further recovery in the US, it is likely that the Fed will continue to normalize monetary policy and remove the QE-related excess liquidity.

Countries with current account deficits, such as Indonesia, India and Thailand, will have to experience an increase in their real interest rates, slower growth and/or weaker currencies in order to adjust to a new equilibrium. To complicate matters, many emerging countries also have elections this year, rendering policy making difficult and ineffective in the run-up to the elections. We are likely to see heightened political volatility in the near term. BM