Episode 9: Finding Sustainable Alpha in Global Equities

Simon Steele of Fiera Capital and Darren Beasley of Evidentia discuss the following points

• The impact of higher interest rates and inflation when selecting managers
• The concept of style adjusted alpha
• We've seen a switch from growth equities to value. Is this likely to be a short-lived phenomenon or could higher bond rates dampen the performance of high growth stocks?
• The search for protection against inflation in the current environment
• Ukraine and Russia and any impact on growth 
• Predicting long-term profitability and success of individual companies
• Regional preferences within global equities and the importance of geographical exposure. 
• The importance of valuation and short-term performance?

Transcript

Episode 9: Finding Sustainable Alpha in Global Equities

In this podcast Darren Beesley of Evidentia Group and Simon Steele of Fiera Capital will be discussing:

What are investors asking their adviser about?

1.     What is the source of inflation – supply driven or labor market – which will prove significant in the long run?

2.     How quickly will the Fed raise rates and what are they watching most closely?

3.     How are investors reacting to rising interest rates?

4.     How might market respond in 2022 to the current economic conditions?

5.     What is the role of real assets in the portfolio?

6.     What role do real asset play for Australian investors?

7.     What are the implications of the Ukrainian conflict for investment markets?

Has the spike in energy prices accelerated the potential to include alternative energy sources in portfolios?

Moderated by David McDonald,CFA - IMAP Investment Specialist

Jenny Phimleut- IMAP (00:02):

This podcast series is not meant for retail investors, but instead is meant for financial advice and investment professionals. Please refer to IMAP's website imap.asn.au for more details.

David McDonald - IMAP (00:17):

Welcome to this podcast in the IMAP Independent Thought series. I'm joined today by Darren Beasley, from Evidentia and Simon Steele from Fiera Capital, and our topic for today is finding sustainable alpha in global equities. Now, Darren is a partner with Evidentia Group based in Brisbane, and Simon is the head of the Fiera Atlas global equities team. And Simon has joined us from London. 
 
 So Darren, perhaps if I can just start with you, obviously there's a lot of talk at the moment about inflation globally and rising interest rates in most markets. I'm just curious, how does that impact your manager selection process? How do you take account of that or does it impact your process?

Darren Beasley - Evidentia  (01:06):

Thanks. Thanks, David. Yes, it definitely does. I think to answer that I probably want to step back and just talk a little bit about manager selection, , in the context of underlying funds and the role of Simon's funds in a broader mix of multi-manager portfolios. When it comes to manager selection, I think also something we really should focus on today is the role of benchmarks, and how benchmarks should play a role or not play a role in managing money, which I also know Simon will have some opinions on, but as I said, just to rehash manager selection is that stage in the process where for almost any pool of assets, you set an objective. 
 
 For that objective you set a long term mix of, asset classes that you believe will achieve that objective, whether it be a mix of equities, bonds, alternatives, real assets, and once you have that asset allocation, you may dynamically adjust it over time, but then once you have that allocation in a multi-manager portfolio, a big part of the process is how do you execute that asset allocation?

Darren Beasley - Evidentia  (02:16):

So for global equities, which is the topic of today, you go out and you pick a bunch of managers that you believe will deliver a great outcome for your client, that will outperform an index or, deliver the particular objectives of that fund so once again, how much should, we just say to each underlying manager, please deliver the most consistent alpha you can verse the benchmark. 
 
 We're assigning to that asset class, "Please Simon ,deliver you A) a couple of percent alpha and really worry about the benchmark, worry about what you're holding, worry about, whether you're in certain sectors or B) how much do you just say, please ignore everything about the benchmarking, give me your very best high conviction ideas. Give me your very best portfolio. Don't hold things you don't want to hold, just because they're in the benchmark.

Darren Beasley - Evidentia  (03:09):

So this kind of latter idea of "just go for it" kind of makes sense, right? it's combining the best bunch of ideas. But the problem with that is that if each of those underlying funds, sorry, going back. The idea is that if I'm combining 3, 5, 10 managers, we can diversify away the ups and downs of each underlying portfolio, even if it is concentrated. 
 
 But if all those portfolios invest in a certain way, if all those portfolios pursue a style of investing, such as buying cheaper stocks on evaluation basis or buying high quality stocks or buying stocks with the highest earnings growth potential, there's these periods as we've seen over the past five years, where certain styles of stock selection go through persistent periods of under-performance and out-performance. 
 
 So this is the problem for myself as the kind of asset allocator, or kind of multi-manager portfolio is how do I blend these funds with the best mix of concentrated best ideas, but without potentially underperforming for many years, because, , I've got too much of the same style, or too much of the same type of process and that underlying manager, so that that's why factor analysis comes into play - style analysis, understanding what a manager does, and their process when blending them.

Darren Beasley - Evidentia  (04:33):

And that's a long intro to answer the question because in a rising rate environment, what does that mean? It means that the textbook answer is in a rising rate environment. , what you see is that very far out earnings when assessing a company's valuation, if company is going to earn $20 mil in 10 years for every year after, but nothing between now, and then that's a lot of earnings growth out in the future compared to a company that's going to earn a lot of money in the new term, if discount rates change, if interest rates rising, if inflation's rising, that materially affects the relative valuation of those two companies. And that dynamic, I just described as the value growth dynamic, a lot of underlying fund managers hate that. We talk about that because they hate being bucketed, but that's the important dynamic in interest rates. It means we have to really think about that mix of long duration earnings growth, versus short duration earnings. So I'll pause there, but that's how interest rates affect our manager selection process.

David McDonald - IMAP (05:36):

Thanks, Darren. Yes I mean you mentioned there the significant periods of one style performing and we've obviously seen growth doing very well for quite some time and a switch now to value people have seen the last little while. I guess the question for both of you really is, .....is that something you think's going to be short lived or is it the change in the macro environment means that it's going to be an extended switch to, to more value oriented funds and stocks performing Simon?

Simon Steele - Fiera Capita (06:09):

For sure. I think the first thing, if I may just step back a little bit and, just to make some comments on kind of higher rates, and inflation, and you know, I, I totally agree with Darren instantly and I like the way Darren talks about benchmarks because, in his world that's a very personalized concept to meet a client's specific objectives and risk tolerances. 
 
 And yes we feel similarly about benchmarks that, we are not there to build a portfolio that looks like a randomly constructed, technically weighted artificially weighted, index of companies. We are there to buy companies that are entirely appropriate with meeting the objectives of the fund. And so we we're in that sense, benchmark agnostic, but just touching first on, on higher rates inflation, and then maybe a little bit on my thoughts around that style.

Simon Steele - Fiera Capita (07:05):

And I'm really interested in what Darren has to say, because he's probably better placed to answer that question than me, but yeah, I think time horizon is a really important element here which sometimes gets overlooked.
 
 And if we think about investor returns and just decomposed them, that they're ultimately made up of two components. The first component is the component that comes from valuation. 
 
 So, you know, how much valuations change during your holding period. And then the second component is what we describe as kind of fundamentals, which is how your value markers of cash flows, earnings and dividends change over your holding period as well. So ultimately share price returns are defined by those two factors and in all honesty, valuation owns the short term and fundamentals own the long term. And that's because by definition, returns from valuation are kind of capped and less scalable, less repeatable.

Simon Steele - Fiera Capita (08:02):

You can't live off re-ratings for ever, and valuations are generally perceived to be mean reverting over time. And there is a valuation for a ceiling that kind of limits the returns that one can source from valuation alone. 
 
 Whereas fundamentals speak to the changing cash flows over the holding period, upon which the multiple is applied and long term research shows that actually fundamentals the compounding of earning and dividends is the most important contributor to long term return. 
 
 And that's why I say time horizon is pretty important here, but when we think about higher rates and inflation, there's, there's two impacts to think about the first one is valuation. And the second one is fundamental because both of those variables are potentially impacted. 
 
 And the first one around valuation, when we talk about a combination of higher interest rates and inflation, which presumably is relative to current expectations.

Simon Steele - Fiera Capita (09:02):

So in other words....higher rates and inflation than we're current expecting what we're ultimately talking about is a hike in the cost of capital. And that increases the discount rate down (alluded to earlier), and it's important to note that actually no assets escape an unexpected rising in the cost of capital. It doesn't matter whether they're listed, unlisted, real or, nominal ultimately that cost of capital increase is born by all assets. 
 
 There is a perception, I think that higher multiple stocks and this will lead to the growth value debate, but there is a perception that higher multiple stocks face a greater impact from higher rates when discount rates change, which is true to a degree, but it's too simplistic a view in my mind and not necessarily all the case. And the reason I say that is because the difference in levels of multiple evaluation is explained as much by differences in financial structure so leveraged...

Simon Steele - Fiera Capita (10:00):

Explained greatly by the extent to which companies can or cannot generate an excess spread over the cost of capital. So the curve is kind of evidence of that and indeed the stability of the cash flows itself are all going to influence multiples. So it's not just about growth, it's multifaceted and the fair value price..the multiple.. The fair value multiple for a given stock is going to differ according to all four inputs, not just growth. 
 
 So they're only comparable with that context in mind. And so valuation is one impact. Second impact though is fundamentals because higher rates, higher inflation that we're currently expecting, can ultimately be demand destructive and perhaps accelerate the maturing of an economic cycle, which is already reasonably mature. You know, if you look at how earnings have recovered since the COVID pandemic, you are now a long way above pre COVID peaks.

Simon Steele - Fiera Capita (11:05):

And so, you know, the earning cycle is reasonably mature. And if we do get demand destruction .....that clearly upsets the part of fundamentals upon which the multiple is then applied. And that's why I think it's important to consider that second part. So some companies are more impacted than others. 
 
 For example, low return, mature cyclical, levered companies, often those characteristics go together. They typically attract low multiples. It's not that they're necessarily cheaper. It's just that the fair value price for those assets is lower and they are likely to face a greater impact on their cash flows in that environment of lower growth, compared to companies that are facing structural growth trends that carry little or no leverage, and therefore are somewhat alienated from higher cost of capital in a direct sense, and that are highly profitable. 
 
 So there is a fundamental question as well when thinking about that, and I do think that's quite a good lead onto style.

Simon Steele - Fiera Capita (12:08):

And as I say Darren is going to be better placed to talk about this than me with my biases as a long term value created growth investor, but ultimately share prices are being determined by valuation and growth and fundamentals.
 
  Anything not explained by fundamentals is by definition valuation. And that's the bit that can be influenced by styles, in my view and, styles exist and can persist for a pretty long period of time. But it's important, I think not to conflate structural fundamentals with styles. And just to give a quick example, if we take growth, your growth has definitely enjoyed a re-rating over the last five years at the expense of value. 
 
 So all the whole hallmarks of a "style bet", but it's important to remember, and I'm just going to use the US as an example here, use the S&P 500 if we take the five years to March, 2022.

Simon Steele - Fiera Capita (13:12):

So the last quarter, the S&P value index grew its earnings over that five year period, by just over 44%. Now, the S&P growth index grew its earnings over the same five year period, by more than twice that level 91.5%. So almost 92%. 
 
 Now growth has outperformed value in a US sense by 2.7 times. So significant outperformance over the last five years, but it's important to remember the outperformance of earnings was 2.1 times. So there is clearly a lot of re-rating or style at play. 
 
 The difference between 2.7 and 2.1 is rating. But it's also clear that a large part of the explanation in the difference between the two outcomes is structural rather than style. 
 
 And so in my opinion, it's important to decompose returns and isolate what is genuine idiosyncratic, fundamentally driven alpha versus the impact from valuation, which tends to house that kind of style component to return.

Simon Steele - Fiera Capita (14:24):

And I think that's true of growth and value. 
 
 I do have some further thoughts around growth and value, and that rotation and how long that might persist for, if that's helpful, but I think be really helpful to hear Darren's views on this. Anda question to you Darren, which is you set a long term strategic asset allocation framework to meet your client goals. And then you are taking tactical views around that. 
 
 And I guess my question where are you at the moment in that kind of tactical cycle and what are the catalysts that you'd be looking for that might change that kind of tactical view?

Darren Beasley - Evidentia  (15:05):

Yes thanks Simon. That's a good question. In terms of talking tactical, it can be asset allocation, it can be, let's go overweight or underweight equities. It could be overweight duration and so on. 
 
 So I think I don't want to get into all the details of that. We're fairly neutral across equity growth complex, and for bond duration, we were underweight, but we're moving towards neutral now given the sharp rate rises in rates, but what's really topical now is our tactical positioning in the value growth complex or quality first, junk or smalls first large, that's another factor in the tactical mix that we talk about. 
 
 And I think you nailed it exactly in our concerns, I agree with everything you said, but the observed impact of rising bond yields, if you divide the market very simply into high PE stocks and low PE stocks that you do see a very strong correlation when bond yields go up cheaper stocks tend to outperform the higher PE longer duration earning stocks.

Darren Beasley - Evidentia  (16:10):

So that's just a very simplistic observation that's hard to argue against. Whether it's logical in the long term is up for debate and we can come back to that. So where we've got to is, is mid last year, we kind of saw, you know, the, the rates coming off their bottom, the rhetoric around inflation starting to become more serious. 
 
 The fed becoming more hawkish, those signs around the duration or interest rate cycle and bond yields made us go from a growth bias, (which probably structurally is something we do prefer) to be more cautious around that, and to actually recommend to our clients, to neutralize that by adding in some value exposure tactically, to neutralize the growth value complex so that we could ride out this rising rate environment.
 
  I think that's been the right call, or always depends on the particular manager or picking.

Darren Beasley - Evidentia  (17:06):

But we've seen in general your value style stocks having a good, having a good period, and absolutely that could be short term. It could be long term. And the persistence of that rally is important where we're going to now, we are still recommending, neutrally, even mild overweight in some cases to value, but you absolutely nailed it. 
 
 That interest rates and yields can only rise so far before they become the cause of the end of the cycle. So it's almost like this environment which makes us lack value style stocks, (which is rising yields, Government bond yields) is actually self-detrimental to value because when the proverbial hits the fan, and a recession hits, it's the high growth quality stocks that typically outperform the less quality value stocks. 
 
 So it's like this rate normalization has to be perfectly balanced and hit a sweet spot for this value rally to continue..... if it goes too hard, it'll actually be the thing supporting value stocks, (which is rising rates) will actually cause them to roll over and back to where we started. So that's a complex answer, but it's a bit of a knife edge, or double edged sword with the current environment and value versus growth.

David McDonald - IMAP (18:27):

I guess a lot is about how much faith we have in central banks getting it just right, with others getting more hawkish, does that put more risk on the cycle continuing, and the value rally continuing?

Simon Steele - Fiera Capita (18:46):

If I make a start from my perspective, there's a huge amount of focus on growth and value and policy .... understandably at the moment. Darren will know this better than me, but there are lots of components to that discussion. 
 
 It's a very complex, nuance discussion. And from here given that the profits and the economic cycle is maturing, I'm not saying that it's mature and that the caveat actually here is that I don't claim to have any particular insight or edge into short term macro, or, economic cycles, or market cycles. 
 
 I'm a long-term investor. I have a good understanding of what drives fundamentals that ultimately drives share prices. And that's kind of where I spend my risk, because that's the skill set that I and the team have, but given that the profits in the economic cycle is maturing and has come out of the initial recovery phase and given the growth of sole offer.

Simon Steele - Fiera Capita (19:53):

I think the path of forward returns here in my view is much more likely determined by fundamentals. And, that's difficult because there's never a crystal ball into these turning events, but it strikes me that fundamentals become more important.
 
  And particularly if we have a more uncertain macro environment, which may be as you say, policy, amplifies, we'll have to wait and see, but, you know, there's a lot of policy reversal, unconventional policy reversal that needs to happen over time. And we don't really know what the impacts of that are or how easy or difficult that is to, to control. 
 
 But, you know, when I think about those two camps of value versus growth, which is where the debate is my own view is that they're very broad churches, and they're not that well defined because companies are characterized by much more than whether they sit just in value and growth.

Simon Steele - Fiera Capita (20:47):

And just a quick look at the dispersion of returns in each of those camps over the last three years, five years, and 10 years just demonstrates how broad and how un-homogenous those groups really are. 
 
 However, it's fair to say that companies that are mature and cyclical, and those two characteristics are very often related as is competition and rivalry, and maturity tends to encourage those things, and are levered perhaps because they want to boost low returns on capital to a more acceptable return on equity.
 
 Those kind of companies structurally will find it difficult to increase their intrinsic worth over time. 
 
 And many of those companies just happen to sit in the value camp. And for me, it's when I look at those companies and some of those stocks and sectors there, you are actually facing prospects of decline over the long term.

Simon Steele - Fiera Capita (21:46):

You know, think of fossil fuels, for example, may not even exist in 30 years time, but it's hard to imagine that those companies are going to be worth more tomorrow than they are today. 
 
 And on the other hand, companies that can genuinely compound their profits at a very high level of profitability for a long period of time are much more likely to be worth more tomorrow than they are today. They will increase their intrinsic worth relatively in absolute terms. 
 
 And they happen to sit in the growth camp. So I guess if I was forced into a corner right now, and I'm showing my biases here, of course, but I think I would say that cyclical investing is by definition reasonably short term, because you don't have that structural support to create value at an acceptable level over the long term in the main, then I'd probably be pushed into the growth camp, but really only because in that very broad church, that's where I'm going to find these highly profitable long term compounding machines.

Simon Steele - Fiera Capita (22:47):

And they're likely to become more valuable over time. But the caveat here is that, I'm saying this within the framework that has a very long term time horizon. So we are making investment decisions for a minimum of five years. We're hoping that companies stick with us for a lot longer than that. 
 
 So, you know, I'm able to look through those kind of shorter term gyrations and let fundamentals do the work for me. But I think, you know, in that debate now, I would feel more comfortable with companies that can increase their fundamentals at a relatively attractive rate, because that offers some protection against the cyclical concerns or the policy mistake concerns, and given where we are in the economic cycle, that kind of feels a bit more comfortable for me. But with that long term house on

David McDonald - IMAP (23:36):

Where does inflation actually sit in all of that Simon? I mean, we've got 8% plus in the US and not far behind in the UK now. And I mean, does that concern you when you're looking at the companies within your portfolio?

Simon Steele - Fiera Capita (23:52):

Yeah, it's a really good question. And yes it's difficult to understand what is transitory and what might be more structural. And clearly a lot of this I suspect, is going to prove transitory, but over what period, I don't know, but you can see that inflation is building into the consumer psych now. 
 
 So we have to think about an environment that where inflation is perhaps, a longer term feature. For me, I think the protection really, if that's the question, I would naturally fall back to fundamentals because we talked about the potential longer term economic consequences of inflation interest rates being higher than expected and how that can impact demand. And therefore you owning companies that are less cyclically exposed would seem a sensible protection to me. And that means focusing on companies where the growth drivers are less macro sensitive and more structural.

Simon Steele - Fiera Capita (24:53):

So that might be things as simple as the move from on-premise computing to cloud computing, which still has, you know, a long growth trajectory ahead of it, or it could be a more sophisticated growth trend, like the move from laparoscopic surgery to robotic surgery, or the increase in research and development dollars going into biologics drugs, as opposed to conventional drugs. All of those are very long term structural trends and therefore taking economic share because they're structural means that you have some protection against that cyclical influence. But I think the real protection from inflation comes from two factors. Firstly, your ability to absorb costs and then, your ability to pass on that residual cost. And so the first part of that question for me is answered by focusing on companies that are very profitable, because if you have a high margin, you actually have to put through less output inflation to offset your cost rises.

Simon Steele - Fiera Capita (25:59):

So you are better protected. You have a better cushion equally. If you have a high return on capital, you have better protection, a better cushion against inflating costs of capital. So more profitability means much, much better opportunity to absorb, and less requirement to put up prices to offset that cost increase. 
 
 The second component of that around inflation is to say, what pricing power do I genuinely have? And if you have pricing power, then it's easier to pass those costs on. 
 
 And when I talk about pricing power, I'm thinking about long term structural pricing power, not temporary cyclical pricing power due to shortages because that won't last, you know, energy price is being high at the moment.... That's not sustainable pricing power. What I mean by pricing power is companies that are delivering products and services to customers that are crucial and critical to their own value creation journey and where the value of that product and service goes way beyond the price of that product.

David McDonald - IMAP (27:13):

Okay. So Darren, Simon's just talked about how he sees high inflation impacting his portfolio. Just wondering how do you protect against high inflation in your portfolios, particularly in global equity,

Darren Beasley - Evidentia  (27:30):

In terms of kind of the way we think about inflation, a lot of things, we talk similar language, but Simon's discussion around pricing power is very much a stock selection issue. And my role as combining managers and combining asset classes, inflation really represents different issues and concerns. 
 
 The biggest one of those is, is that over the last 25 or 30 years when equities, (which is the biggest risk in a multi-asset portfolio), when equities sell off, you want something to protect you. You want something to be performing at that point. 
 
 And over the past 25 or 30 years, we've seen this really strong negative correlation between government bonds or bond markets and equities, and that's just because simply those equity selloffs have been deflationary think of the tech wreck and the GFC and, and COVID everyone expected lower inflation, therefore they expected lower future or future looser monetary policy.

Darren Beasley - Evidentia  (28:32):

And that means looser, monetary policy means lower forward yields - bonds go up & equities go down, bonds go up, you've got your protection. And thinking about portfolio construction in the multi-asset space. 
 
 Once again, I think investors have become very used to this offsetting protective nature of bonds. You know, if I hold 60 or 70% of my portfolio in equities that, that other 30 or 40% in traditional bond indice is really going to help me at that stage. 
 
 The problem is if inflation is the thing that kills the cycle as it was in the seventies. And in some cases, the eighties, if inflation is what drives the equity sell off because it's becoming out of, control the market doesn't price in future central bank dovishness. They actually price in future central bank hawkishness and bonds sell off at the same time.

Darren Beasley - Evidentia  (29:28):

So summarizing all that together when deflation is the problem, you get equity and bonds offsetting each other in their moves. When inflation's the problem, bonds and equities actually correlate, and you can have a simultaneous sell-off, and this is exactly what we saw in January. 
 
 You saw the equity market sell-off because, , investors were getting spooked about inflation and what that means about future, , interest rate settings and future discount rates. And we saw bonds sell off at the exact same time, and that's a very scary thing for a multi-asset investor because that's the core protective pillar traditionally in multi-asset very simplified portfolios. So we need to think beyond that. And that's where modern thinking and trying to think outside the box comes into play. 
 
 What performs well when inflations a problem? Well, it is harder. You have to branch out into different sorts of alternative investments, but alternative investments themselves, particularly hedge funds and liquid alternatives have had a pretty rough 10 years.

Darren Beasley - Evidentia  (30:30):

And it takes a fair bit of conviction, , to find the right manager in that space. You could get quite niche. You could think about commodity funds or, or other certain sectors that perform well in late cycle, but it's becoming very niche, and tactical. 
 
 So, I think part of the answer is also to be nimble it's to think about where we are in the cycle use dynamic allocation to potentially even allocate to cash. If your fear is an equity led selloff, that's driven by inflation where long bond duration will not protect you. So I have given a simple answer there, but I think what I'm highlighting is that there's a bit of complacency I think around the correlation and the protective nature and the offsetting characteristics of bonds and equities. 
 
 And I don't think that should be relied on going forward. And, multi-asset investors such as myself really need to talk about this to clients and think about how portfolios can be better constructed to deal with this.

David McDonald - IMAP (31:40):

For you Darren ... do you see real assets as offering that inflation protection in your portfolios, you know, infrastructure

Darren Beasley - Evidentia  (31:47):

Property? We do, particularly, I think this is a really strong place for active management in that space. So we've been talking a lot, particularly to our property investors and our property funds and what is observed over history over a very long history is that in inflationary periods, property funds do slightly better than non-inflationary periods.
 
  And they show the data for that. And they're of course doing that because they're trying to promote themselves in the current environment. 
 
 The issue is if, once again, just like very long duration, growth stocks, very long duration properties that don't have inflation resets in their leases or infrastructure that doesn't have inflation resets in their government contracts and soon then you can get this thing where if you don't have inflation pegging up the earnings, then all you have is the discount rate that those earnings are being discounted at going up. 
 
 And that actually causes the value to go down, you know, bigger discount rates, higher interest rates make a stable cash flow less valuable today. So it's, it's a time for active management to really, sift through and find who has the more dynamic leasing power, the pricing power who's owning the buildings that have high demand for the tenants. 
 
 And it's probably a place for the very highest quality of property and infrastructure at this point in cycle to get that inflation protection. So yes, it does have a role. Absolutely.

David McDonald - IMAP (33:21):

Thanks. Well this has been a, a great discussion. there's some really important topics in there and we could go on, but we, we probably even run over our time today. So it just remains for me to say thank you very much to Darren Beasley from Evidentia