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THEMATIC INVESTING Principles for long-term investing

This is the final paper in our series on thematic investing. In the first two papers we looked at some of the limitations of investing in benchmarks, and described how thematic investing may be applied to help meet long-term investment objectives.

In this paper, we discuss why alpha is more obtainable when investing over the medium to long-term, and explain the best bottom-up factors to use in order to capture it. We identify the importance of valuation, particularly when combined with quality, capital discipline and dividend.

SHORT-TERM MIS-PRICINGS CAN CREATE LONG-TERM OPPORTUNITIES

Any alpha generating investment strategy relies on the assumption that the market is not always efficient. There will only be an opportunity for the fundamental investor if price does not reflect value. We believe that in the short-term, prices are more representative of volatility or variance than value whereas over the long-term prices better reflect the returns of the underlying asset. This is best explained in a body of work carried out by Professor Robert Shiller in 19811, that price is significantly more volatile than the underlying fundamental factor that it is meant to represent.

Because stock prices can deviate from the underlying company fundamentals, we can use valuation multiples as an effective tool to identify potential investment opportunities and also provide some indication of their magnitude. The higher the earnings, cashflow and dividend yield, the greater the potential mis pricing would appear to be.

About the authorAndy joined AMP Capital in February 2012 as a Portfolio Manager / Analyst within the Fundamental Equities team, and has more than 12 years’ investment experience in Europe and Asia Pacific as a senior buy and sell side equity analyst and strategist. Andy holds a Bachelor of Science in Economics (first class honours) from Kings College London, and is a CFA charterholder.

IN THIS PAPER WE DISCUSS… > How short-term mis-pricings can create long-term opportunities.

> That valuation multiples are important, but by combining both quality and value, investors may experience the double benefit of potentially increasing expected returns whilst significantly reducing drawdowns.

> That one of the most important metrics by which we can measure management is their capital discipline.

ANDY GARDNER Fundamental Equities

insightpaper

NOVEMBER 2014

1 Robert Shiller “Do stock prices move too much to be justified by subsequent changes in dividends?” 1981. The American Economic Review

Source: Credit Suisse Quantitative Research, AMP Capital.

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VALUATION MULTIPLES ARE IMPORTANT

In fundamental analysis the intrinsic value of a stock represents the discounted sum of all future net payouts that will accrue to an investor from the company’s operations. Typically, we discount back to today some fundamental factor such as earnings, cashflow, or dividends using a Discounted Cashflow Model (DCF) or Dividend Discount Model (DDM).

However, it is more popular to express valuations in terms of multiples: earnings multiple (e.g. P/E or earnings yield), cashflow multiple (e.g. P/CF or FCF yield), or dividend multiple (e.g. dividend yield). It is important to emphasise that, rather than being competing alternatives, DCF or DDM analysis and the use of multiples are, in fact, symmetrical approaches.

They require the same information and should generate identical results. DCF calculations require explicit articulation of the elements that drive value: rate of return, growth, and cost of capital. Multiples, on the other hand, capture these drivers implicitly in permutations of growth and rate of return (we can provide proof of this but is beyond the scope of this paper). The simplicity of multiples, however, belies their power. In effect, it calibrates the market’s optimism or pessimism concerning future growth, and the rate of return generated by these growth opportunities. In short, what we are saying is that we can use multiples as a proxy to assess the difference between the price of the company and the intrinsic value of a company without having to build detailed spreadsheets, involving multiple assumptions about the future.

Watch out for the value traps!

Sometimes ‘attractive’ valuations may signify value traps (and conversely ‘expensive’ valuations may signify extraordinary potential). How do we know if the mis pricing is genuine? Unfortunately we can never be certain, but we can use different tools to help stack the odds in our favour. As Nassim Taleb summarises simply in his series of books2, “all investment decisions can essentially be broken down into two considerations. Firstly, identifying an opportunity or outcome, and secondly, assigning a probability to that outcome occurring”. Valuation multiples can help with the first part, but for the second part we need some understanding of the quality of the company and the sustainability of its cashflows, earnings and dividends.

COMBINING QUALITY WITH VALUE

Unlike value, quality has no universally accepted definition. Fortunately, a substantial amount of research has led to a better understanding of the various quality factors and their influence on stock performance. One of the most comprehensive studies, carried out by Robert Novy-Marx3, concludes that attention to quality helps traditional value investors distinguish bargain stocks (i.e. those that are undervalued) from value traps (i.e. those that are cheap for good reasons). The quality factors which were most consistent with positive investment outcomes were high gross profitability, followed by strong and liquid balance sheets, and a track record of stable returns.

Investing using both tools (value and quality) together has the double benefit of potentially increasing expected returns whilst significantly reducing drawdowns. The longer the investment horizon, the more substantial the potential performance improvement. In short, cheap and profitable firms tend to outperform firms that are just cheap or just profitable.

By way of illustration, we have taken the MSCI World All Countries index and applied screens for quality, value and quality and value combined (i.e. stocks that rank high on both factors). Stocks that ranked high for quality or value performed very well compared to the benchmark over the period, with cumulative outperformance of 100-200%. Stocks that ranked highly on a combination of both factors performed exceptionally well with cumulative outperformance of 350%.

Stock performance

Source: Macquarie Quantitative Research, AMP Capital.

But where a combined quality and value approach really becomes relevant is in protecting capital. Equities will always be exposed to cycles and not all cycles are the same. During the bear market of 2000-2003, the benchmark and quality stocks performed poorly (down 40-45%) compared to value stocks (down 23%). The bear market in 2008-2009 was different, with the benchmark and value stocks performing poorly (down 55-60%) compared to quality stocks (down 40%). Therefore, relying on only one factor can still present risks depending on what type of cycle the market is in. It’s important to note, however, that during both of these bear markets, stocks that ranked highly on combined quality and value factors sold down the least and recovered back to their previous highs sooner.

Drawdowns

Source: Macquarie Quantitative Research, AMP Capital.

Combining value and quality reduces the number of negative outcomes and increases the number of positive outcomes, which has the effect of shifting the probability distribution curve down to the left and up to the right.

2 Nassim Taleb “Fooled by Randomness” 20013 Robert Novy-Marx “Quality Investing” December 2012 (significantly revised May 2014)

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Quality & Value Value Quality MSCI World AC

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Source: Macquarie Quantitative Research, AMP Capital.

CAPITAL DISCIPLINE AND DIVIDENDS

What may be surprising to some investors is how well the dividend yield factor performed for every one of our five growth sectors. At first this may seem counter-intuitive, because when faced with a higher number of growth opportunities it may seem obvious that management should redeploy all their capital back into their business. However, there are some important considerations in this respect:

> A track record of paying sustainable dividends is, in fact, a positive sign as it indicates earnings are real i.e. backed by cashflow.

> Paying dividends should also indicate corporate confidence about future earnings (otherwise companies would not feel comfortable paying them).

> Most importantly, when companies retain a very high proportion of earnings there is a greater tendency for poor investments to be made, which subsequently leads to poor earnings growth and return on equity.

This can best be shown in two of the sectors which make up our hypothetical thematic portfolio; Telecoms during the TMT boom of 1993-2003, and Energy during the China boom of 1998-2008. During these periods the two sectors were the poster child for market growth given the almost unprecedented increase in demand from new markets. In fact, companies within those sectors which ranked higher (not lower) on dividend yield factors performed significantly better than the average.

We find here further evidence that attractively valued quality companies which are backed with real cashflows and dividends tend to suffer less during corrections and bear markets, reducing the risk of permanent capital loss. During the TMT crash post 2000, Telecoms stocks that ranked higher for their dividend yield sold off significantly less (down 40%) than the overall sector (down 70%), and by 2004 they were 30% above their previous highs whilst the sector was still 20% below as shown in the Telecommunications chart (see A and B).

Telecommunications: 1993 – 2003

Source: Macquarie Quantitative Research, AMP Capital.

Energy: 1998 – 2008

Source: Macquarie Quantitative Research, AMP Capital.

The evidence supports our theory that one of the most important metrics by which we can measure management is their capital discipline. Many of the factors that drive earnings are exogenous to the company (for example the general price for goods and services, commodity prices, currency, regulation, fashion). However, arguably the most powerful tool at a CEO’s disposal is a cheque book and a pen. What management decides to invest in, buy, sell or divest will shape the future of the company for many years if not decades. For an example of how poor capital discipline can lead to overinvestment when presented with a plentiful choice of growth opportunities, consider this: a study by Credit Suisse has found that capital intensive companies have consistently provided poor shareholder returns, and as such capex-heavy companies have underperformed capex-lite companies by 830 basis points per annum since 19894.

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ROIC FCF Yield Dividend Yield Sector return

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Stocks with high... Total Return

ROIC 365%

FCF Yield 638%

Dividend Yield 1193

Earnings Yield 674%

Sector (eq weight) 388%

MSCI AC World 152%

Stocks with high... Total Return

ROIC 638%

FCF Yield 740%

Dividend Yield 1174%

Earnings Yield 1298%

Sector (eq weight) 610%

MSCI AC World 93%

Improving the probability of positive performance outcomes

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4 Credit Suisse “Capex: Less is More” September 2014. NB focused on the Australian market

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Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital. Certain information in this paper identified by references and footnotes has been obtained from sources that we consider to be reliable, however we have not independently verified this information and cannot assure you that it is accurate or complete. The Information is not intended for distribution or use in any jurisdiction where it would be contrary to applicable laws, regulations or directives and does not constitute a recommendation, offer, solicitation or invitation to invest. The Information may contain projections, forecasts, targeted returns, illustrative returns, estimates, objectives, beliefs and similar information which is provided for illustrative purposes only and is not intended to serve, and must not be relied upon as a guarantee, an assurance, a prediction or a definitive statement of fact or probability. Actual events and circumstances are difficult or impossible to predict and will differ from assumptions. Many actual circumstances are beyond the control of AMP Capital. Some important factors that could cause actual results to differ materially include changes in domestic and foreign business, market, financial, interest rate, political and legal conditions. © Copyright 2014 AMP Capital Investors Limited. All rights reserved.

Contact usIf you would like to know more about how AMP Capital can help you, please visit ampcapital.com

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In summary, one of the greatest opportunities available to investors is to identify attractively valued quality companies which can demonstrate their ability to generate high and sustainable return on capital (via capital discipline) and high and sustainable return of capital (via dividends). Through the power of compounding, the longer the time horizon, the greater the potential reward.

For an overview of what companies around the world are doing and where we see attractive opportunities, please contact us via ampcapital.com.