Spotlight
ACTIVE EQUITY
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This is not a consumer advertisement. It is intended for professional financial advisers only and should not be relied upon by private investors or any other persons. The views expressed are those of Legal & General Investment Management Limited, who act as investment manager to the fund. The value of investments and any income from them may fall as well as rise, and investors may get back less than they invest. Changes in exchange rates or medium to long-term interest rates may cause the value of an investmentto fall. Past performance is not a guide to future performance. Legal & General (Unit Trust Managers) Limited. Registered in England and Wales No. 1009418. Registered office:One Coleman Street, London EC2R 5AA. Authorised and regulated by the Financial Conduct Authority.
Welcome
The ‘active versus index’ debate has become part of the furniture for investors in funds, where each of these types of strategies offers a different set of risks, costs and benefits over time. While active managers can add value through their expert stock selection and research capabilities, ‘index-tracking’ strategies can provide broad access to markets, offering diversification at lower costs. If combined intelligently, however, they can work well together in an overall portfolio. This has been LGIM's approach. The group's product offering within active equity is focused on only those strategies where the management team believe an active investment style can sustainably add value for their clients compared to index alternatives. In this Spotlight guide we review how LGIM's active equity approach complements and diversifies the group's broader investment offering.
Nick Hartley, co-head active equities
If you’re in the top 10 shareholders, you get the opportunity to go as deep as you want – you can meet with multiple levels of company management
Rod Oscroft, co-head active equities
The more concentrated the portfolio is, the higher its active share will be, which in turn means it has a greater opportunity to outperform its benchmark
We benefit from industry-leading corporate access. That’s a massive informational edge.
Too few people realise the breadth of our active products and the investment talent that we have within the business
LGIM’s Active Equity funds are positioned as concentrated, high conviction and high active share. Rod Oscroft and Nick Hartley discuss their active equity approach and how it complements and diversifies the group’s broader investment offering
NH: Going forward, there are certainly other geographic areas that we are interested in adding capability to but they will be at the active end of the spectrum with a view to generating alpha. They will be concentrated, fundamental and bottom-up focused. Then from a distribution perspective, we’ve got a strong position in UK retail. We’re looking to increase the involvement of, or the inclusion, of the active equity funds into the institutional market as part of the broader development that LGIM is focusing on from a distribution perspective. We are also looking further abroad and the European market is a real focus for us too.
What are your mid-term plans for the Active Equity business?
RO: I’ve been running active equity money at LGIM for 17½ years and when I joined we looked like a balanced fund house with a variety of lower-risk portfolios. Then five years ago LGIM reanalysed its active equity proposition to ensure it’s positioned to deliver the most effective client outcomes and how that can complement the index business. It was a matter of acknowledging that the market has moved dramatically since 2000 and LGIM has been phenomenally successful within that move towards more index fund management. We reviewed our active range to make sure that it is fit for purpose and, where necessary, merged funds, closed funds, and achieved a much sharper focus about what we’re offering. That led to the launch of the global funds and the European Income Fund earlier this year. It’s been long continuum of change but there was very clearly a step change within that continuum five years ago. Quite a lot of the stuff we’ve been talking about today is a result of that review.
How has the active equity product range evolved over the years?
RO: From our point of view it’s about acknowledging that these issues exist and the answer is to collaborate effectively, share research, share ideas and encourage debate. What we are trying to do at the end of the process is to ensure that the individual who is running their fund has absolute accountability for it. Running a concentrated fund is an incredibly effective way of overcoming some of these biases because every time you have a new idea, you have to reassess and think ‘which is my lowest conviction idea and should it drop out of consideration?’ So it’s a real one-in one-out operation and that in itself really forces us to think about the current position, the current valuation and the current opportunity. Most of our income-focused fund managers actually run with an investment process that has a real value bias. So having both a growth bias and a value bias encourages the team to challenge one another’s ideas and avoid groupthink.
Often, innate investment biases need to be addressed and overcome. How does LGIM’s management team tackle this problem?
NH: ESG has been core to the LGIM proposition for a long time, and the way that we incorporate ESG illustrates the complementarity between the index and active business. The scale and breadth of LGIM allows our corporate governance team to engage with companies on a host of material issues, from company specific topics such as management succession to sector wide issues such as remuneration and climate change. In particular, the active fund managers help with this by providing industry context and fundamental analysis for certain companies, but we also benefit from the insights, data and perspectives of the corporate governance team. It is a close working relationship that is mutually beneficial and we are excited to be launching a new range of funds that highlight our ESG capabilities in the coming months.
What are your views on ESG?
NH: It comes down to what the investor’s desired outcome is. History suggests that the future returns we can expect from beta are likely to fall short of many people’s expectations, and importantly their requirements, given current valuations. If beta alone isn’t enough to deliver the outcomes that clients are looking for, we need to provide some outperformance, or ‘alpha’. That could range from smart beta and factor based solutions through to the high conviction alpha-oriented funds we are running to deliver the outcomes investors are seeking. For instance, if an investor is looking for predictable, consistent cash flows from diversified sources, we could deliver this from several of our income-focused funds. In a nutshell, that is how we think about combining active and index-tracking investments from a total return perspective.
In what ways can investors combine alpha and beta strategies to deliver best outcomes?
NH: The best environment for our fund managers to generate alpha is to be concentrated and high conviction. That concentration allows each of our holdings to be well researched from a bottom-up, fundamental standpoint. RO: We use active share as a shorthand to show how differentiated we are from the index. The more concentrated the portfolio is, the higher its active share will be, which in turn means it has a greater opportunity to outperform its benchmark. It’s the outperformance that helps sell the fund and the active share is key to delivering outperformance. We use active share as a measure since it clearly demonstrates our difference from the funds’ benchmark indices.
How would you characterise your investment approach in terms of the guiding strategies you invest in?
Nick Hartley: We have an industry-leading index business, which provides clients with equity beta in various forms. Our active equity range is set up to complement this, so our funds are designed to provide alpha. In our view, concentrated, high-conviction portfolios provide the best opportunity for alpha. In addition, we have set our funds up to target several outcomes that are hard to achieve with beta or indeed smart beta products. Firstly, we have funds that are concentrated growth portfolios. These are for investors seeking longer-term capital growth, and you could characterise them as providing concentrated exposure to some of the most compelling long-term growth themes that we have researched. The second area is what we describe as diversified income portfolios. If you’re looking for a stable and diversified cash flow from the equity market we think that is better provided from an active perspective than from an index perspective. The UK is a great example of this. About half of the absolute income in the UK All-Share comes from 10 stocks. So theoretically you’ve got a 1,000 stock index but in terms of your income, it’s extraordinarily concentrated on a few very large and somewhat cyclical stocks. So if you’re trying to get a diversified stream of cash flows, you’re better off having an active manager because they are deliberately diversifying for you.
What is LGIM’s active equity range designed to do? Why do you run concentrated, high conviction portfolios?
Rod Oscroft: The Legal & General Asian Income Trust is a good example of this; it is particularly valuable for our clients because it’s a diversifier of income. If you think about the Asian market excluding Japan it’s not really thought of as an income market. So the fact that we’re offering a product that allows people to diversify income in a growth market is particularly attractive to investors.
NH: Well, I think people often pigeonhole LGIM as an index house for equities and too few people realise the breadth of our active products, and the investment talent that we have within the business across all asset classes. In terms of ‘where does active add value’, there is an inter-dependence between the index business and the active business, particularly on the equity side because we benefit from industry-leading corporate access. That’s a massive informational edge. And because we are the front line of engagement with many of our company holdings we also provide substantial input to corporate governance and ESG issues that are high on the agenda for our index proposition. RO: Yes and this means it’s more beneficial to be an active fund manager in a large index house than you might think. Having a substantial index position gives us priority on the shareholder list to meet those companies. NH: And as active fund managers, we cannot overestimate the importance of this access because if you’re outside the top 100 shareholders, there’s a reasonable chance you may get to a group meeting with some management; maybe the CEO or the CFO. If you’re in the top 50, then there’s a decent chance you will get a one-on-one meeting. But if you’re in the top 10, you get the opportunity to go as deep as you want. You can meet with multiple levels of company management.
The index business at LGIM is much larger than the active business. Is this a challenge? Where does active add value?
Opening the door to alpha opportunities
Recently, companies that have exhibited disruptive innovation to fuel growth have been rewarded by shareholders. Such companies may either be disruptors or incumbents, but they will all share the characteristics of a strong franchise and unique asset, says senior fund manager Gavin Launder
Our view is that companies experiencing change – either secular or structural – are most likely to be mispriced by the market
As active managers, we aim to outperform the market by providing long term capital growth. Our investment process sees us deploy a bottom-up approach to stock selection, where we construct highly concentrated, high-conviction growth portfolios. Typically, consisting of 25-40 stocks, we believe we can identify and exploit mispriced growth opportunities. This focused approach ensures we build a strong fundamental knowledge of the companies in which we invest, where selection is predominantly driven by intensive proprietary research and corporate engagement. We favour companies where potential growth drivers overshadow macro concerns, and management teams are focused on building sustainable growth platforms, not short-term profitability. Across our range of growth funds, this focused approach has delivered attractive compound returns. Looking ahead, we reiterate the view that growth companies are still fairly scarce. Accordingly, as business investment picks-up, M&A provides support and firms become less risk averse, this bodes well for an environment primed for growth. In the context of scarcity, we expect growth to remain a prized asset.
Investable opportunities
This will often bring about the question of valuation, and presents the biggest debate for growth investors. Often, the wider view is that these stocks are simply too expensive relative to the market and peers. However, we seek to invest in companies with strong prospects that are, in our view, reasonably priced, relative to its growth rates. On this basis, we believe it prudent to view these stocks in light of the longer term growth potential in the business. Importantly, our analysis will consider mispriced change, particularly when multiple change drivers are combined. Our view is that companies experiencing change – either secular or structural – are most likely to be mispriced by the market. We believe the companies in which we invest justify their valuations, given relative potential returns. Providing we have visibility of future earnings and find industry fundamentals to be compelling, then we are able to have conviction in our analysis. Weighing up various factors, we must then consider if we have confidence that changes are not yet priced in.
What about valuation?
Typically, investing in growth means exposure to global leaders across all industries. These companies may either be disruptors or incumbents, but they will all share the characteristics of a strong franchise and unique asset. These businesses benefit from the network effect, cost advantage and global scale. Often with technology-led growth, barriers to entry can be low but a first-mover advantage can establish high barriers to scale. Further, the ability of a company to generate returns above its cost of capital is a strong driver of value creation. Importantly, these firms look to deploy cashflow back into the business, in the form of reinvestment, as a means to fuel future profit growth. On this, we consider self-funded expansion a priority of our investment thesis, given its ability to future-proof returns and drive market expansion. Notably, we do not simply invest in companies that offer ultra-high growth. Often these levels are unsustainable in the long-term, and are more-so driven by investor hype and expectation, not proof of concept or delivery. A crucial pillar to investing is determining if future growth is currently factored into the share price and long-term forecasts. Growth businesses can often re-rate quickly as they accelerate top-line returns and successfully execute operationally. Yet it’s the strength of the business model and focusing on the durability of that advantage in the context of future growth, which we consider most important. In short, by how long can the growth beat ‘the fade’? Even beating the slowdown in consensus earnings by a year or two can dramatically lower the valuation.
Clear message around growth
During the past ten years, ‘growth’ investing has proven to be a lucrative strategy for investors. Relative to value mandates, it has delivered considerable outperformance. This is perhaps not surprising, if we consider the number of compounding factors behind alpha generation: the secular and structural growth within a number of end-markets, the rise of thematic investing and an investor base with appetite for the sanctuary of quality growth names. The question remains, can this strategy continue to deliver the goods? In our view, we remain positive. Fundamentally, investors have rewarded growth assets due to their scarcity. After the financial crisis, corporates endured a difficult operating environment in the face of what has been – up until 2016 – a very gradual economic recovery. More recently, however, synchronised global growth has supported a pro-cyclical environment and a positive recovery in corporate earnings. Companies exhibiting disruptive innovation to fuel growth or those that are less capital-intensive (asset light) have been rewarded by shareholders. We find this is reflected in market leadership, as growth companies have widened their relative earnings and return on equity strength. In a world that is rapidly changing due to developments in areas such as ecommerce and the platform economy, we believe the combination of structural growth themes and the competitive advantage of a business able to adapt, creates exciting opportunities for investors.
investing in a scarce asset
Growth -
“Typically where there is a consensus trade, there is likely to be a material opportunity,” says Stephen Message, UK Equity Income. Value investing is about buying companies at a better price than their fundamentals might otherwise suggest. Sometimes this is when they are out of favour but at other times it is about spotting underappreciated assets or growth prospects. If one buys companies astutely then this can deliver outperformance as valuations revert to mean or the hidden value comes to light. Growth investing, on the other hand, is often more about trying to ride rising earnings expectations on the back of long-term growth. It can work well in an optimistic environment but can sometimes lead to very expensive valuations where momentum drives exuberance and valuations are justified on decades-long growth assumptions. Any disappointment then leads to sharp price falls. “An income style with a value tilt can therefore potentially offer steadier appreciation than the growth style over the long term” observes Paul Hilsley, Asian Income Trust.
Another truism is that in the long term, valuations matter. This may be why value outperforms growth over the long term. We continue to believe that buying good-quality, dividend-paying companies which we know well at attractive valuations is a robust investment philosophy. This margin of safety can contribute to long-term outperformance in terms of yield and total return. It is also something we have a long and successful track record of achieving.
In the long term, valuation matters
Trying to time the market’s switch between styles is notoriously difficult. The inflection point of when one style yields to another is often rapid and not signposted. As active investors, we are very focused on maintaining the integrity of our investment process and providing a transparent, consistent, disciplined and ultimately repeatable income approach.
No drift
Value is not synonymous with income but they both tend to favour companies with cash rich balance sheets who have generated consistent free cash flows and who have business models that tend to better weather downturns. Growth has been a one way bet for an unprecedented period of time as can be seen from the chart below. Could the value style be set for a resurgence?
Value versus growth
The UK is traditionally seen as the home of income investing. Many household names are global enterprises, such as BP, are domiciled in the UK and have a history of maintaining a consistent dividend policy through the highs and lows of the equity market. However, lately both the UK and the income style have been out of favour. As can be seen in the chart below though, a very similar yield and yield premium to the UK is achievable in non-Japan Asia and Europe. These areas are often underrepresented in many investor portfolios today.
An array of regional opportunities
Investors can often hold and believe in seemingly conflicting views. For example, many of us simultaneously believe that ‘a trend is your friend’ while being enthusiastic advocates of the concept of ‘mean reversion’. Within Legal & General Investment Management (LGIM), the Active Equity team is split between ‘Income’ and ‘Growth’ teams. Rather than a case of ‘doublethink’, we believe this acknowledges that two different approaches, each rooted in fundamental analysis, have the ability to outperform over the full market cycle. However, the key to success for either style is often maintaining the discipline to not drift from one style to the other throughout the cycle. In our opinion, effective income investing requires a total return mindset, where the manager utilises an income investment philosophy to outperform not just in terms of yield but also on a total return basis. Sacrificing future capital appreciation to boost current income is likely to have rather limited appeal to long-term investors.
A consistent dividend is a combined indicator of quality and value, illustrating that an enterprise is generating high levels of free cash flow and that the management team have a shareholder orientation. Instead of chasing the highest dividends, we look for businesses which we believe can deliver predictable and sustainable dividends as a key part of its strategy. Therefore, we do not set a yield floor but instead search for companies who are now committed to growing dividends.
Yield tomorrow as well as today
The almost continuous appreciation of equity markets over the last decade was temporarily interrupted in 2018. The first quarter saw material declines across most major regions only to be sharply reversed in April and May with new highs being attained. Volatility is likely to continue throughout 2018 but this should offer opportunities for active fund managers. In this context, the transparency and resilience of income stocks may find renewed appeal. Income is often counter-cyclical which neatly illustrates the diversification opportunity. For example, an income approach is often better able to protect capital on the downside. “Patience and a long-term horizon are the characteristics of an income manager. We are often contrarian, eschewing momentum stories”, says Andrew Koch, European Income Fund.
A useful diversification tool
Why quality and value need a long-term horizon
LGIM's active equity managers give their view on why effective income investing requires a total return mindset
Paul Hilsley, senior fund manager
An income style with a value tilt can potentially offer steadier appreciation than the growth style over the long term
Source: Bloomberg, LGIM
ASIA, UK AND EUROPEAN FUNDS’ DIVIDEND YIELD VERSUS BMs
Value has underperformed for 10 years
Source: Bloomberg
MSCI WORLD GROWTH VERSUS MSCI WORLD INCOME
At LGIM, thematic research focuses on identifying long-term trends that will disrupt businesses, change behaviours and affect consumption. The group find this a more helpful way to orientate their research efforts than the traditional focus on sectors and geographies as a lot of the changes cut across sector boundaries and are global in scope. LGIM focus specifically on three key thematic pillars – technology, energy and demographics – which they believe will have huge effect at the sector and stock level. Ultimately, as active investors, LGIM look for stocks that are mispriced by the market. The more significant the change that is underway, the more likely it is that a company is mispriced, which increases the opportunity set for idea generation particularly over longer-term investment horizons. Naturally this approach lends itself to finding the beneficiaries of structural change, which are most obviously found in the group’s growth portfolios. However, it can equally apply to idea generation for value orientated portfolios, as the market can be prone to overstate the risks of ‘disruption’ to business models that are surprisingly durable. Having confidence about the durability of growth or the durability of a companies’ cash flows ultimately requires the same thing: strong fundamental research. Whilst LGIM’s thematic approach is anchored around broad ‘top down’ themes, the focus of their efforts is incorporating thematic thinking within their bottom-up fundamental research. Understanding the changes that are underway, and how they are likely to impact demand, supply, the market structure, the industry value chain and the business models of the companies impacted. Ultimately the best source of information for LGIM’s research, they say, comes from the companies themselves, which is why they so highly value the access to company management teams. Because ultimately, it is the interplay between a theme, the industry fundamentals, the company specifics and the market valuation that is crucial to generating strong investment ideas.
Themes from the investment floor: we review how LGIM is investing in a changing world
Thematic investing – playing the long game
Past performance is not a guide to future returns. The value of your investment and any income taken from it is not guaranteed and may go up and down.
The fund is positioned as an equally weighted, core equity portfolio of the best UK ideas. The fund is managed with a global perspective, where the management team seek to deliver strong returns through conviction ideas. A key focus of portfolio construction is the fund’s ‘nightclub policy’. Accordingly, the fund manager adopts a one in, one out approach to stock selection. This strategy helps promote a strong sell discipline and forces the team to consider the merits of each position. It also ensures the fund is kept up-to-date with the best growth ideas. Thirdly, the group approach to growth focuses on whether a company is ‘reasonably’ priced relative to its growth rate. The fund manager analyses the growth potential of each company, seeking to determine whether the market its mispricing future earnings opportunities. Importantly, the fund will seek exposure to companies that invest self-generated cash flows in order to drive future earnings growth.
Reasons to invest
The L&G Growth Trust is an unconstrained equity portfolio of 25 – almost equally weighted – ideas. The fund places emphasis on investing in secular, structural and cyclical growth companies, where earnings growth is ahead of the market.
As a highly concentrated fund, the L&G Growth Trust is primed to deliver attractive growth
£2bn
Capacity
£210m
Fund size
90%
Active share
25
# of Holdings
Concentrated, high conviction ideas
Portfolio construction
Large / Mid-cap
Market cap focus
Growth
Fund style
Sept 2014
FM start data
Gavin Launder
Lead Fund Manager
GROWTH TRUST’S KEY CHARACTERISTICS
GROWTH TRUST’S PERFORMANCE (AS AT 31 MAY 2018)
IA Sector Median
FTSE All Share Index
Growth Trust
5 Year
3 Year
1 Year
YTD
May
13.3%
12.9%
9.0%
7.3%
7.8%
7.5%
6.5%
1.9%
6.6%
6.1%
2.7%
2.8%
8.1%
A focused UK growth portfolio, designed to enhance alpha
Back Row (L-R): Matthew Courtnell, product specialist, Simon Reid, analyst, Andrew Koch, senior fund manager, Nigel Masding, senior fund manager, Stephen Message, fund manager Front Row (L-R): Rod Oscroft, co-head active equities, Anna Walsh, product specialist
Back Row (L-R): Gavin Launder, senior fund manager, Jennifer Wong, analyst, Andrew Davies, analyst, Veeral Gandhi, analyst, Olivia Treharne, fund manager Front Row (L-R): Paul Hilsley, senior fund manager, Nick Hartley, co-head active equities
A team of active fund managers, building high-conviction, concentrated portfolios, delivering alpha via a high active share
The LGIM Active Equity team
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