REAL VALUE FOR REAL INVESTORS

Transcription

1 with independent analysis from REAL VALUE FOR REAL INVESTORS Deutsche Asset & Wealth Management presents its CROCI philosophy and strategies range, headed by Francesco Curto December 2014

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3 Introduction Welcome to Source, a publication that shines the spotlight on particular funds and their managers. This time, Deutsche Asset & Wealth Management presents its CROCI philosophy and strategies range, with an in-depth profile and Q&A with product head Francesco Curto, plus supporting analysis from Citywire. Investment profile Analysis Q&A Contents December

4 4 December 2014 Investment profile with Francesco Curto, head of CROCI investment strategy & valuation group at Deutsche Asset & Wealth Management

5 Investment marketing teams around the world are keen to position their products as guardians of the real investor, but few can claim to have created a new way of valuing stocks towards that goal. With its CROCI process, Deutsche Bank has done exactly that, and is celebrating the 10th anniversary of the first funds launched in line with the philosophy. CROCI which stands for cash return on capital invested was first developed back in the mid-1990s by analyst Pascal Costantini. Current head of CROCI Francesco Curto says the philosophy is rooted in the North American tradition of value investing, espoused by famous names, such as Benjamin Graham and, more recently, Warren Buffett. At the core, their investment philosophy is about choosing equities based on value, and CROCI came out of a desire to bring that to Europe, he adds. The problem when trying to judge value on a global scale is that accounting standards are different across countries, so a like-for-like comparison between Total, ENI and Royal Dutch Shell is difficult. CROCI creates a level playing field by assigning an economic valuation to each stock, enabling better comparisons across a broad range of industries and countries. CROCI is an extremely labour-intensive philosophy to implement and there is currently a team of 60 analysts covering a global universe of 830 stocks. To give an idea of the work involved, three analysts will typically work on a stock for around a month before it gains admission to the universe and a place in the CROCI book, a huge tome including masses of data on every company analysed. Over the years, we have industrialised the process, so our research does not depend on just a few individuals, says Curto. A final part of the CROCI philosophy ties it back into the value idea, with existing funds focusing on the cheapest stocks meeting the criteria. According to Curto, the process is entirely rulesbased and, with the current value focus, he defines the range as offering systematic active alpha. CROCI aims to help investors avoid the most expensive stocks on an economic valuation basis, which will tend to mean revert in the future, and focus on the cheaper names with greater The problem when trying to judge value on a global scale is that accounting standards are different across countries, so a likefor-like comparison is difficult Francesco Curto December

6 potential for positive performance, he says. Writing about CROCI back in the late 1990s, Costantini said the following: Price to book and return on equity work well in a world where financial gearing does not exist, where there is one single accounting standard, where goodwill is not written off against reserves, where it is appropriate to depreciate assets in a linear way, where no asset revaluation occurs, where intangible assets are immaterial and where there is no inflation. Of course, that is not the world we live in and the CROCI team adjusts corporate data to transform from accounting view to economic reality. Curto uses the example of buying a house: When buying a home, would you trust the estate agent entirely, who is ultimately paid by the seller, or do your own due diligence? With equity investing, the estate agents are effectively the accountants and the company management, and using CROCI is essentially due diligence, to determine a company s real value and true level of profitability. After all, corporate accounting policies are rarely designed for the benefit of equity investors. Many investors talk about being longterm like Buffett, but they are also desperate to know what is happening in the markets day to day. Our whole focus is on determining the real value of companies and, for us, the rest is just noise Francesco Curto Ultimately, the real value, or economic price-earnings ratio (P/E) rather than the traditional accounting P/E of a stock depends on three pieces of data, namely enterprise value, net capital invested and, finally, CROCI itself: cash return on capital invested. Combining them effectively creates a universal method of valuation and allows investors to compare stocks globally in a meaningful way. Finding real value will typically include a number of adjustments to a stock valuation, including taking factors like intangible assets, liability and the actual depreciation of assets into account (for a detailed explanation of the CROCI process see the Q&A). Critics might question how far these 6 December 2014

7 adjustments can alter a stock s valuation the answer is: substantially. Curto gives the example of American Airlines: back in 2007, the stock was trading on an accounting P/E of 11.4 times and therefore looked cheap against the market on 16.2 times. CROCI, however, gave the stock an economic P/E of over 25 times, taking the company s huge leasing and pension obligations into account, changing the valuation from cheap to expensive. Deutsche s initial three funds based on the value end of the market focusing on the US, Europe and Japan have just reached their 10th anniversary and the range has expanded to incorporate a range of country, regional, global and style-based strategies over the subsequent decade. While performance has been strong, Curto says this is a by-product of the process. He is critical of the market s increasingly short-termist focus on returns. Ultimately, if people are obsessed with performance, they should buy a tracker, he says. CROCI is a philosophy that removes the emotion from investing. Staying true to a value style can sometimes lead to periods of underperformance, but ultimately if you buy cheap stocks and do enough due diligence not to buy value traps many academic studies have shown you will be rewarded in the end. Value is rarely pretty, but while the market is inefficient, as we believe, it is not crazy and good cheap stocks will eventually mean revert. Curto is also critical of marketeers selling funds based on performance and, again, stresses the importance of the CROCI philosophy above all else. If people buy CROCI funds just on performance, there is a chance they will sell if returns dip, so our sales focus has always been on process and philosophy, he says. Many investors talk about being long-term like Buffett, but they are also desperate to know what is happening in the markets day to day. Our whole focus is on determining the real value of companies and, for us, the rest is just noise. In our minds, the definition of a speculator is trying to buy low and sell high. The definition of an investor is someone who does the due diligence, tries to work out the real value and profitability of a company, and then buys if the stock is cheap. Looking to the future, the next step for CROCI is to extend the product beyond its current systematic alpha slant. As outlined, the current range has a value skew, so the US strategy, for example, buys the 40 cheapest stocks in the S&P 500, based on CROCI criteria. Curto says the plan is to introduce index replacement offerings in due course, essentially offering CROCI portfolios without the value slant. CROCI has traditionally been all about systemic alpha, taking big views on the market and selecting 40 stocks out of 300 in the US, for example. Some investors cannot afford to take those kinds of bets if their mandate is about tracking the market, for example. So we are looking to add this beta replacement element to the range next year, using CROCI factors to weight stocks. For now however, there are 10 CROCI funds available for investors across Europe in UCITS form: UK, US and Japan on the country side, Eurozone in the regional category, four global offerings World, World ESG, Sectors and Branchen Stars (the latter mirroring the Sectors products for euro investors) as well as US and global dividend vehicles. December

8 INTERROGATING PERFORMANCE Frank Talbot Deputy head of investment research, Citywire Matching and beating the MSCI World DB Platinum CROCI World R1C-E MSCI World Source: Lipper With CROCI designed to allow stock comparisons across sectors and countries across the globe, its World strategy has beaten the MSCI World index since launch. It selects 100 stocks from the 450 largest in the MSCI World and is region neutral against the benchmark. Total returns (%) Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Oct-14 8 December 2014

9 CROCI process also outperforms in sector sphere Source: Lipper Total returns (%) Oct-05 DB Platinum CROCI Branchen Stars R1C Oct-06 Oct-07 Oct-08 MSCI World TR Oct-09 Oct-10 Oct-11 Oct-12 Oct-13 Oct-14 As CROCI is designed to create a level playing field to compare stocks around the world, a sectorbased strategy was an obvious extension of the range. This graph shows the Branchen Stars strategy, which selects 30 stocks from the best valued global sectors, including Eurozone, US and Japanese companies and has beaten the MSCI World index since launch. Branchen Stars is targeted to eurodenominated investors and is eurohedged monthly. The CROCI Sectors fund, another strategy in the CROCI range, is based on a very similar approach, but is not euro-hedged. December

10 Strong track record extends to the Eurozone Source: Lipper Total returns (%) DB Platinum IV CROCI Euro R1C EuroStoxx Large Deutsche launched its first strategies based on the CROCI philosophy back in 2004 US, Euro and Japan and all the strategies invest in the cheapest stocks in their market based on the CROCI criteria. As this graph shows, this value approach has paid off, with CROCI Euro offering outperforming over the decade. It selects the 30 cheapest stocks from the EuroStoxx Large index based on CROCI criteria Jun-04 Jun-06 Jun-08 Jun-10 Jun-12 Oct December 2014

11 A decade of beating the world s most efficient market Source: Lipper Total returns (%) DB Platinum IV CROCI US R1C S&P 500 TR Another one of the original trio of CROCI strategies, the CROCI US strategy has outperformed the S&P 500 since launch. -30 Jun-04 Jun-06 Jun-08 Jun-10 Jun-12 Oct-14 Total returns (%) DB Platinum IV CROCI US R1C S&P 500 TR Past performance is not a guide to future performance. December

12 Q&A Francesco Curto answers detailed questions about the CROCI philosophy and process Q What are the issues with using traditional accounting data for stock selection? A Many of the difficulties stem from the fact that accounting data has not been designed with investors in mind: by contrast, our economic price-earnings ratio (P/E) is to serve investors by revealing a company s real value. Published financial statements can also lack consistency between regions and industries, based on different tax or accounting standards, for example. That creates significant challenges for investors trying to find the most attractive global opportunities, with meaningful likefor-like comparisons not possible using traditional valuations. Traditional accounting data can significantly under- or over-represent a company s genuine value, failing to consider factors such as intangible assets and liabilities, and also often depreciating assets in an inconsistent fashion. Q What are the key areas where the CROCI corporate economic information diverges from traditional corporate accounts? A A company s assets are where accounting data can diverge from its real value most often. So CROCI focuses on four key elements to identify real value and profitability. First up is intangible assets, which are particularly important when it comes to sectors like pharmaceuticals, where research and development (R&D) are integral. R&D as well as advertising costs are treated as annual expenses in reported accounts, and so their contribution to future profits, in the shape of new products or greater customer awareness, is ignored. In contrast, CROCI treats these as assets, and therefore allows for better comparisons between businesses that are brand or research-heavy and those that are not. CROCI also inflation-adjusts plant and equipment: while traditional accounts tend to value these as their original costs. We work out what they are worth today and 12 December 2014

13 estimate their replacement costs. CROCI also seeks to take both financial and operational liabilities into account, along with equity. Thus, we use enterprise value instead of plain market cap, factoring in such potential liabilities as pension deficits and lease obligations. Using this has helped the team avoid investing in companies that have subsequently filed for bankruptcy. Finally, CROCI depreciates assets based on economic useful life. In traditional accounting, depreciation expense can vary significantly, even within the same industry, so applying a consistent process gets past that. Q Why is the CROCI process difficult to apply to financial stocks? Could excluding such a large part of the market have a potentially detrimental impact on performance? A Essentially, investors want to know they can trust the numbers. Within CROCI, our due diligence is considerable and it can take a month to add a single name to the database, even with three analysts working on it full time. At the end of this process we know the real value of a company, but when it comes to financials, we feel the accounting does not serve the end investor well. Assessing and comparing the valuation of financials is difficult as a result of different sets of accounts prepared for different purposes as well as sometimes ambiguous accounting practices. CROCI does not just exclude financials it excludes any companies where we cannot get confident on the real value. Financials may be a large part of the market, but if you look at the MSCI World, including and excluding financials going back to the mid-1990s, the difference in performance has been negligible. There have been periods when excluding financials has been positive and times when it has been negative for performance, but these have tended to offset each other over time. Q Could you outline some examples of how CROCI has identified over- or undervalued stocks? A Japanese utilities are a good example. They have shown how stocks can be mispriced for a long period of time too expensive in this case before something finally happens to change the situation. In Japan, because bond yields and interest costs were low, and therefore debt was cheap, utilities accumulated a lot of borrowing on their balance sheets from the 1990s. As supposed safe havens, it was easy for these companies to access credit markets. As investors, you have to consider debt. Our focus on enterprise value gave us a very different view of the sector. So much debt in these companies raised a red flag on CROCI, which meant our Japan fund was underweight utilities for many years. In contrast, utilities is typically seen as a key value sector and many other funds were fully weighted or even overweight. When the tsunami happened in 2011, we had a situation where these debt-laden stocks lost 70% or 80% of their market value in a few months. CROCI Japan only held one utility that was fairly debt free. Our structural underweight therefore led December

14 to very strong outperformance in a short period of time. Q Do the CROCI criteria skew the funds towards certain sectors of the market? The exclusion of financials is one area, but are there sectors where the process will typically highlight a lot of opportunities? A A key part of CROCI is taking the emotion out of picking stocks, and the CROCI process is not biased towards a particular type of company. On most of our strategies, the portfolio consists of 30 to 50 of a specific market s stocks, filtered by the CROCI criteria. With the value tilt in place, there will be times when certain parts of the market are on or off our radar: in 2000, for example, we had nothing in technology, whereas today, the sector is among our major overweight positions. The analysis of the stocks has remained the same but the value they offer is clearly very different. Q With so much work going into stock analysis, how does sell discipline work on the funds following CROCI strategies? A Sell discipline is very straightforward, given how much work we do before the stocks come into our database. In basic terms, on the CROCI US strategy for example, the fund will own the 40 cheapest US stocks out of the CROCI coverage. We review every quarter and if any fund constituents have become significantly more expensive, they are replaced with cheaper companies. Q A How has CROCI evolved since it launched in 1996? The process has continued to evolve over the years, but the basic philosophy remains the same and our confidence in it has continued to grow. We launched the CROCI US fund as one of the first products in 2004, for example, and in, perhaps, the world s most efficient market, it has gone on to outperform 90% of its peers in this space. On the product side, we initially started with regional offerings, but as CROCI can enable cross-sector and country comparisons, we followed up with global and sector-focused offerings as well as thematic strategies. At the sector level, CROCI has helped us to avoid the traditional skews, which have led to sectors like energy dominating value portfolios. If you have an energy stock priced at 100p, and with earnings of 10p, and a pharma stock at 100p and earnings of 5p, the former trading 10 times earnings looks more like a value name. But what CROCI shows is that perhaps the 10p energy earnings are not real and the 5p for pharma should be higher and actually allows a proper comparison. This Deutsche Bank AG sponsored advertisement has been prepared solely for information purposes and does not constitute an offer or a recommendation to enter into any transaction. This marketing material has been approved by Deutsche Bank AG, London Branch. Deutsche Bank AG is authorised under German Banking Law (competent authority: BaFin Federal Financial Supervising Authority) and is regulated by the Financial Conduct Authority for the conduct of investment business in the United Kingdom. The registered address of Deutsche Bank AG, London Branch, is Winchester House, 1 Great Winchester Street, London EC2N 2DB Deutsche Bank AG. 14 December 2014

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16 Deutsche Asset & Wealth Management Believing in a long-term equity investment philosophy CROCI. Engineered by Deutsche Asset & Wealth Management Are you looking for established high-quality global, regional, national, sector, sustainable and dividend equity solutions then discover the world of CROCI today. Since Funds 4 x Morningstar 5-Star Ratings Assets under Management 11 bn Euro in CROCI strategies Past performance is not a reliable indicator of future results. Important Information: This advertisement has been issued and approved by Deutsche Bank AG, London Branch. It has been prepared solely for information purposes and does not constitute an offer or a recommendation to enter into any transaction. Investments in funds involve numerous risks including, among others, general market risks, credit risks, foreign exchange risks, interest rate risks and liquidity risks. The value of an investment in a fund may go down as well as up. Investments in a fund can result in losses, up to and including a total loss of the amount initially invested. Please refer to the relevant fund s full prospectus and any relevant Key Investor Information Document for more information on Deutsche Bank funds. These documents are available on or can be obtained free of charge from Deutsche Bank, London Branch. Deutsche Bank AG is authorised under German Banking Law (competent authority: BaFin Federal Financial Supervising Authority) and is regulated by the Financial Conduct Authority for the conduct of investment business in the United Kingdom. The registered address of Deutsche Bank AG, London Branch, is Winchester House, 1 Great Winchester Street, London EC2N 2DB. Any direct or indirect distribution of this document into the United States, Canada or Japan, or to U.S. persons or U.S. residents, is prohibited Deutsche Bank AG. All rights reserved. Copyright Morningstar, Inc. All rights reserved. The information contained herein: (a) is proprietary to Morningstar and/or its content providers; (b) may not be copied or distributed; and (c) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Deutsche Bank takes no responsibility for the Morningstar rating. Past performance is no guarantee of future results.