It was 1992 when Eugene Fama and Ken French published their famous paper showing the enduring returns characteristics of value and size among stocks. But, while fundamental drivers of markets may endure, active managers continue to improve their processes and simple value models seem out of date.
As funds management continues to evolve and adapt to changing global conditions, so too do the tenets on which its theory is based. Neither managers nor their clients can stand long periods of underperformance, notwithstanding the time horizons on which most super fund investors should be focussed.
For active global equities managers, for instance, the impact of new technologies on the world has presented amazing opportunities and some challenges over just a few years.
In an interesting presentation for a recent CIE conference, Hardman Johnston Global Advisors, a boutique US-based equities manager, spoke to a white paper the firm had written to show how the systematic adherence to the three styles of growth, quality and value (GQV) as measured by their screen (pre-fundamental analysis and stock picking) provided persistent outperformance in both risk-on and risk-off markets. Speaking separately from the conference, James Pontone, Hardman Johnston portfolio manager in the international and global teams, said the firm’s fundamental philosophy was that earnings growth drove price growth over time. The second key tenet of the philosophy is that markets are often emotion-led and provide opportunities to buy high quality growth stocks at value prices. “You don’t often get the opportunity to buy high growth, quality business at a cheap price, but there’s enough of them around for us to be able to focus and understand the opportunity that a market presents from time-to-time” says Pontone, “albeit it means we run concentrated portfolios, and given the longer term perspective they have relatively low turnover.”
The firm recently completed a study testing the efficacy of its screen which narrows down the universe to secular double-digit earnings growing companies that are cheap relative to other double-digit secular growers. The study employed the Factset alpha-testing module. The study, covering nearly 20 years, evidenced that a high growth strategy employing a strictly applied value hurdle produced a group of stocks – pre fundamental analysis and stock selection – that significantly outperformed the second, third and fourth quartiles of value in that high growth group, and perhaps more notably the broad market index.
“It confirmed that we’re fishing in the right pond. We always believed that if you buy high quality growth stocks cheap, then you should do well relative to most measures, but we thought we should test it to give us some measure around that.” says Pontone. “It also evidences that a growth biased multi-factor strategy is likely to outperform the broad market” added John Schaffer, who’s firm Catallyst Advisors represents Hardman Johnston in Australia and New Zealand.
Hardman Johnston’s process starts with this screen. It narrows down the stocks of interest to those with three years of forward earnings growth of 10 per cent a year or higher. It then ranks those double-digit growers by value using the firm’s proprietary value ranking algorithm, essentially a value for secular growth formula. Only the top quartile of value is eligible for deep research. The screen is the main idea generation tool.
The fundamental deep dive is the key element of the firm’s search for stocks with sustainable growth, with a projected minimum of 10 per cent a year over three years, high barriers to entry, signs of innovation, “sensible” business plan and secular tailwinds.
Quality and market leadership are then assessed in terms of strong management, strong balance sheet, brand loyalty across products and services and recognition of ESG principles.
“We have a growth manager’s mindset when we are looking for companies and a value manager’s mindset when we buy them,” Pontone says.
Schaffer says that technology and services are becoming more pervasive and this affects the relevance of the value metric in equity portfolio management in years to come. “I believe that in that type of environment there will be a continued long period where value as it has been traditionally defined will not win out as has historically been evident,” he says.
Generally, Hardman Johnston tends to be overweight technology stocks. “That’s the environment we’re in,” Schaffer says. “Technology and disruption have a long runway ahead and will likely become even more pervasive, particular in the listed space. In that environment metrics such as price to book or historical PE will become less relevant in identifying value.”
As to how this technology led disruption cycle might manifest is unclear and possibly even concerning according to Schaffer. “For example, artificial intelligence is unpredictable in what it means for society. There will be profoundly positive benefits but [AI] can also be highly unpredictable. The Musk/Zuckerberg debates on this subject have been quite public.”
Pontone says that, in the firm’s experience, more than two-thirds of the candidate stocks which show up after the initial screen fall short of eligibility for more in-depth analysis at the stock level. “We only pick a handful of names each year and our average turnover is 25-30 per cent, although we have drifted up to 40 per cent at times.”
Over the past 12 months, financials have proved the best performing sector of Hardman Johnston, although not so much for most other growth-orientated managers.
The one-year returns (net in US dollars) to March for the firm’s global equity composite strategy totalled 7.22 per cent against the MSCI ACWI’s 2.60 per cent. Over three years returns totalled 18.91 per cent versus 10.67 per cent for the index.