Investments

Conviction in Active Management


Julia Ainsworth , Assitant Director, Investments

julia.ainsworth@bluebridge.ca

It is no easy feat for active managers of public equities to outperform their benchmarks net of fees. Many – including some professional investors – make the generalization that active managers can no longer add value in modern investing. Indeed, it is quite true that there are very few who have succeeded with consistency. Blue Bridge aims to identify those who can. We believe that those who invest with conviction, in accordance with a rigorous process, are well-placed to differentiate themselves. This article will discuss two of our managers – one investing in emerging markets and the other in developed markets. Their unique approaches have served them well over the years and we are confident in their ability to manage the market turbulence of 2020.

At Blue Bridge, we construct our equity portfolios from the viewpoint of an international investor. The funds to be discussed have a very broad investment universe. The portfolio managers have a great deal of flexibility to go where they feel the most significant opportunities reside and when investing, they do so with conviction.

Emerging markets investing is considered by many to be an area where active management is a better choice than passive. It is true that emerging market countries have always faced greater challenges than their developed market counterparts. The usual suspects are sensitivity to the value of the USD, volatile international capital flows, declining commodity prices, and fiscal deficits. In 2020, many are also facing additional headwinds of limitations in healthcare resources and government policy tools. This does not mean that emerging markets are to be avoided, but investors do need to recognize the additional risks. Also, the emerging market classification covers a wide spectrum of distinct countries at different stages of development and consequently, these “typical” risks do not impact all equally and may not even apply. The emerging markets manager we use is specialized in this area. The firm offers only emerging markets strategies and has been doing so since the early 1990s. Their resources are extensive, and they have a physical presence in many emerging market countries. Altogether, they are well placed to evaluate the dynamics at play.

The team starts ‘top down’ by determining where the most attractive opportunities are likely to be found at the level of countries and industries. For example, they will assess policy stance, the trajectory of macroeconomic data, the impact of commodities, and currency implications. Their stock investment universe is reduced by focusing only on highly liquid companies that reflect their most positive ‘top down’ areas of conviction. The team will then carry out extensive fundamental research on these companies to ultimately choose around 25-40 for portfolio inclusion. This stock research will assess the business model, industry dynamics, ESG risks, and catalysts and concludes with scenario analysis (incorporating the ‘top down’ view) and valuation appraisal. This is only a brief summary, but what is important is the rigour and consistency behind the process, together with its identification that both ‘top down’ and ‘bottom up’ factors are important drivers of emerging markets price and volatility. We feel that their approach is smart way to invest in these markets.

The first quarter of 2020 has been turbulent and emerging markets were hit particularly hard. The fund was negatively affected by investors rushing for liquidity and disproportionately selling the highly liquid companies in which the fund is invested, regardless of fundamentals. Performance was helped by a decision in early February to reduce energy exposure. At the time, Covid-19 was not yet a pandemic, but the portfolio managers recognized that the Chinese economy was under pressure given efforts to tackle the virus, which could result in a decrease in global energy demand. Given this and the discord amongst OPEC members, they deemed energy companies vulnerable to meaningful earnings downgrades. Of course, there was nowhere to hide amongst the indiscriminate selling which occurred, but the energy sector suffered the most. During the first quarter, the team built up exposure to those ‘top down’ areas (countries/industries) who were the first to be impacted by the virus and would likely be the first to begin normalization. At a company level, they moved towards those who should be the major beneficiaries of government stimulus policies and the accelerated structural trend towards digitalization. They are confident that the emerging markets in which they invest have the necessary ability (policy tools, financial strength and infrastructure) and willingness (proactive policy stance) to recover strongly from the crisis and re-embark on solid growth trajectories.

Since investing with this manager, we have been impressed by their discipline, in-depth research, and insightful outlooks. We continue to believe that emerging markets are an important investment space and that their global importance will escalate over the coming decade.

The developed market is where most of Blue Bridge’s portfolios are invested. Although we have several managers with specific exposures, we do include a global manager who can invest anywhere in developed markets. These markets are often considered too efficient for active managers to add value. This strategy has contradicted this idea by adding tremendous value over the past twenty years. It is run by an investment team who believes that markets are generally efficient over the long-term, but in the short-term they can misjudge the long-term growth prospects of companies due to reliance on short-term data. This creates inefficiencies and therefore opportunities for the fund managers who base their assessments on long-term considerations.

The team builds their portfolio with 20-25 high quality companies whose growth is supported by long-term structural trends and who have low sensitivity to economic cycles. Their approach is one of fundamental analysis which incorporates growth (i.e. secular growth tailwind, sustainable competitive advantage, etc.), quality (i.e. low debt, high free cash flow), and valuation criteria. The design of their process imposes a high level of discipline, is repeatable, and maximizes objectivity to eliminate bias. This process and the significant efforts directed towards understanding secular trends have set this manager apart.

Their portfolio offers a defensive approach to investing in growth companies. This was particularly evident over the past three months when they significantly outperformed their global benchmark. The results were not due to intentional market timing, but rather due to process. For example, the most economically sensitive industries like energy, banks, mines, etc. have never been included in the portfolio. These tend to be amongst the worst performers during market downturns, which proved true this year. Secondly, their focus on companies with high quality balance sheets means that they are well-placed to face the challenges of 2020.  The team has reviewed all portfolio holdings to ensure that none are at risk of balance sheet deterioration and that the portfolio is aligned with major trends such as digitalization, health care, shortening of supply chains, the onshoring and automation of manufacturing, amongst others. Given that long-term structural trends are a key component of the investment process, the portfolio was already largely exposed to these themes and few changes have been required.

Blue Bridge is focused on investing in high-quality companies via managers demonstrating unique approaches as well as protection during down-markets. This manager fits these requirements and has shown that protection does not come at the cost of sacrificing returns during up-markets. Although there is never a guarantee that this will continue, we feel confident that the strategy will continue to benefit our clients.

This rapid review of these two investment strategies is far too brief to convey the high quality of portfolio management; nevertheless, it should be clear that their process provides confidence in navigating these difficult times. It is impossible to know what lies ahead but ensuring that investment managers operate within a sophisticated decision-making structure is surely a critical step in the right direction.

 

 

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By Julia Ainsworth, CFA, M.Sc.

12/05/2020

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