Defence stocks have recently benefited from the first upsurge in spending since the end of the Cold War. Identifying themes like these is more effective than investing on a regional or sector basis
The ongoing turmoil in financial markets has raised many questions about the fund management industry and the products it provides to its customers. Specifically, the three years of decline in equity markets has increased focus on the risks being taken by fund managers in their efforts to provide superior returns for their clients.
In their search for lower-risk products that provide greater returns, investors are increasingly turning towards global equity funds and those with longer-term horizons. A variety of styles, however, proliferate.
Fund management houses are traditionally organised in a way that promotes investment on a country-by-country basis. The investment process will typically involve asset allocation committees that take decisions on which countries are likely to provide the best returns, then allocate funds accordingly. The fund managers responsible for that country then invest the funds with the intention of outperforming the local index. The implication of this is that the country of origin is the most important factor in the returns from equities.
This process ignores a number of problems and issues that arise through investing by country. By increasing the allocation of equities to a particular region, the implication is the fund manager should be investing in companies exposed to that region. But what of the companies in which the fund ultimately invests? What are the most important factors determining the fortunes of the companies in the index? For instance, Coca Cola is quoted in the US yet only 32% of sales are based in that country. Do US domestic sales drive the company or is it the growth of sales outside the US?
An even more extreme example would be Nokia, which is quoted in Finland but generates only 1.2% of sales in that country. This implies an enormous amount of exposure to foreign markets, which must be taken into account when the fund manager is deciding whether or not to invest in that stock. It begs the question of why funds should be allocated by regional index when significant portions of the index are being driven by the performance of other regions.
Using sectors as a tool to pick stocks also causes difficulties. Firstly, many companies may be made up of different divisions that would themselves be allocated to different industrial sectors. GE is a classic example. Is it a financial company or an industrial company? Financial services accounted for 39% of sales last year and, if analyst forecasts are to be believed, will account for nearly 50% of earnings in 2003.
The next biggest division is power systems, which accounted for 15% of sales. GE is classified as an industrial conglomerate in the S&P 500 and accounts for 75% of that sub-sector. This is an extreme example but it does highlight the problem of whether sector classifications allow the fund manager to invest in the most relevant companies or whether there should be more flexibility.
Another problem is that although sectors such as energy and technology are genuinely global in nature, other sectors such as retail and utilities are most certainly not. These businesses are inherently regional, with relatively little cross-border currency risk to worry about, hence the importance of getting the country decision right in certain cases. This contradicts the reasoning for investing by global sectors in the first place.
The question ultimately comes down to efficient portfolio construction. Which investment process offers the best return for the lowest risk?
To answer this, you first need to decide which factors are the most significant in determining stock returns. The country factor has been diminishing over the past few decades as the companies in the regional indices have been growing turnover outside their home markets. This will continue as companies continue to try and improve returns for their shareholders by focusing on faster growth areas, placing less emphasis on their own, more mature markets. The efforts of WTO and the member governments to reduce trade barriers and make it easier for companies to conduct cross-border trade will allow this trend to continue.
If geography is declining in significance as a tool for global diversification and industry diversification is patchy on a global basis, fund managers must find an alternative driver for their investment process. One solution increasingly being adopted is the use of themes. These enable a fund manager to target the attributes that are expected to lead to enhanced long-term performance, irrespective of a company's domicile or the sector allocation it is given.
Over the long term, returns on invested capital are critical to share price performance. Good companies will be able to grow their returns over time. This will be achieved through growth in sales and efficient management of the assets needed to enable the sales growth, whether they be factories, shops, websites, personnel or whatever.
Technology was an attractive investment in the 1990s because it generated more productivity. In a highly competitive industry, this can be a significant advantage for the right company. Businesses that were able to effectively use technology in this way were able to grow returns on capital. The change was not that technology had suddenly become more powerful but that companies had more capital to spend on technology.
Many other industries will experience the same phenomenon of a period starved of capital, followed by a period in which capital returns to the industry. An example of an industry suffering an under-allocation of capital is defence following the end of the Cold War. Spend is now recovering sharply as the equipment needs replacing and upgrading.
Flow of foreign capital into China has shown how much need there is for capital there to fund infrastructure spend, as well as build an export hub for multinational companies. Beneficiaries of this investment vary widely from Japanese food manufacturing companies to US technology companies to domestic Chinese manufacturers that ally themselves with foreign companies.
The other facet of improving returns is sales growth. High-quality companies with strong management will seek out and find new opportunities to grow their business. The Japanese auto companies, notably Honda and Toyota, have done a tremendous job growing their market share in the US. Even as industry forecasts show flat to falling unit demand for US autos in 2003, so the Japanese companies still expect to grow units and sales at the expense of their main US competitors.
As multinationals and cross-border transactions increasingly drive the world economy, investors will demand global and long-term investment solutions. The most pragmatic approach for investors to fully benefit from secular trends is not to restrict investment to countries or to sectors but to invest in the most significant themes that are driving the improved outlooks for certain companies.
Such an approach makes use of the same analysis of macro and micro data that asset allocation committees undertake but makes more efficient use of the conclusions to choose the most important investment themes and stocks. From a portfolio construction point of view, the fund manager can then avoid filling the fund with the inevitable ballast that many choose. The number of stocks in the portfolio can then be reduced to the amount needed to efficiently diversify risk without reducing the expected return from the fund.
Investment on a truly global basis allows fund managers to invest in the real underlying drivers of stock performance while properly controlling the risks they are taking.
Investment houses often invest on a country-by-country basis indicating they see country of origin as the most important factor in returns from equities.
This ignores the fact that many companies have the majority of their exposure outside their own country.
Using sectors as a tool is also misleading as many companies straddle different parts of the economy.
Themes enable managers to target the attributes that are expected to lead to long-term performance irrespective of territory or sector.
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