/ SPW Global Equity - investment philosophy This document is for authorised intermediaries and professional investors only and not for distribution to retail clients The overarching investment approach employed is one of high conviction stock selection for constructing an actively managed global equity portfolio within a risk controlled framework. Our three key investment principles The investment philosophy is grounded in three main principles. Principle 1: a strong focus owning quality companies The first principle forms the bedrock of our investment philosophy and is founded on the concept that holding a portfolio of quality businesses for the long-term has historically produced superior shareholder returns. In addition, the data indicates that quality stocks provide relative sanctuary in periods of economic uncertainty and increasing market volatility. Whilst using one of Warren Buffett s tenets, the underlying concept behind economic moats is imperative to our first principle of owning quality businesses. We believe that sustainable economic value (or profit) is created from both competitive forces and how long a company can earn significant excess returns over its cost of capital. A company must be able to earn an economic return higher than the average of its competitors in order for it realise a sustainable competitive advantage. Our analysis aims to look at industry and company specific advantages in order to gain a thorough understanding of the overall profitability of a company over a full business cycle. We believe that this is necessary to find a good business that is able to sustain high performance over the medium to long-term. Broadly speaking, stable industries are more likely to realise sustainable economic value. In the report, Measuring the Moat, by Michael Mauboussin (213), the author encapsulates our perspective when stating that companies try to understand the industry and competitive landscape in their product markets so as to allocate resources in a way that maximises long-term economic profit. Investors seek to understand whether today s price properly reflects the future and whether expectations are likely to be revised up or down. In conclusion, we aim to forecast the future cash flow a business can generate over a normal cycle in order to achieve sustainable economic value over the long-term. Some of the factors that we consider are the company s historic growth rate, industry trends, realistic terminal growth rates and conservative forecasted estimates. Whilst this is not an exact science, it does provide a sense of the margin of safety between the present market and intrinsic values. Principle 2: capital allocation is fundamental to the creation of longterm shareholder value Capital allocation is fundamental to our process and is aligned to our first investment principle, in order to produce sustainable economic value. We invest in attractive companies that have low capital requirements and seek to achieve appealing returns on capital through rational strategies that enable them to maintain or expand their economic moats. This can be accomplished either organically or inorganically and on the basis that the company can earn attractive returns on capital that exceed the cost of capital. Capital allocation is not about assessing and approving projects. It is about supporting the overriding strategy of the business and identifying the sources of competitive advantages and their durability. A company s capital allocation decisions are invariably concentrated on mergers and acquisitions, capital expenditures and research and development. Academic research has shown that a business that seeks to rapidly www.privatewealth.sanlam.co.uk
grow its assets produces meagre total shareholder returns. This is in contrast with divestitures, which generally create value, as invariably the buyer tends to lose value compared to the price paid, and synergies can be difficult to fully realise. A strong balance sheet is not necessarily the secret to success, but a weak balance sheet can quickly cause a good company to become a vulnerable business. Our companies tend to be self funding and have the ability to generate free cash flow in significant sums. This gives them the flexibility to take on more leverage. To quote Benjamin Graham, Evidently stockholders have forgotten more than to look at balance sheets. They have forgotten also that they are owners of a business and not merely owners of a quotation on the stock market. It is time, and high time, that the millions of shareholders turned their eyes from the daily market reports long enough to give some attention to the enterprises themselves of which they are the proprietors, and which exist for their benefit and at their pleasure. The key is to understand the rationale and motivation for the decisions management make and whether they are consistent with the principles of building shareholder value. Understanding incentives for management provides an indicator of how committed they are to allocating capital in order to produce long-term value. Principle 3: the power of compounding forms the basis for achieving sustainable and consistent outperformance Our long-term investment horizon and focus on quality leads us to selecting stocks that compound returns by returning excess cash flow to shareholders through dividends and share repurchases. The important element is the snowballing effect of compound earnings on reinvested earnings which is a very powerful contributor to total returns. An investor not only receives capital appreciation, but also any dividends that accumulate and the potential significant impact from net share repurchases over time. Whilst we acknowledge the power of compounding earnings over time, ultimately the ability of a business to generate sustainable free cash flow is a key driver of longterm returns. Over time, capital appreciation becomes a less important component of total shareholder returns as an investor accumulates excess cash flow through dividends and share repurchases. 45 Procter & Gamble vs Alcoa total return 4 35 Rebased = 1 3 25 2 15 1 5 1986 1988 199 1992 1994 1996 1998 2 22 24 26 Procter & Gamble 28 21 212 214 215 Alcoa Price returns in USD: Performance calculated from 1996 Sources: Bloomberg, SPW UK
Long-term investment horizon Active management Holding periods for stocks are close to record lows, with the majority of professional investment managers taking a short-term view when investing in businesses as opposed to acting as shareholders intent on holding positions for the long term (five years or more). This trend has been magnified by sell-side research increasingly focusing on quarterly or near-term earnings rather than longer-term sustainable growth. Average holding period in years 9 8 7 6 5 4 3 2 1 Long-term investment horizon 196 1965 197 1975 198 1985 199 1995 2 25 21 215 Sources: Marathon, NYSE, Bloomberg, SG Cross Asset Research Mature markets are not perfectly efficient, creating opportunities for skilful active managers to add value to returns. The concept that it is impossible to systematically and consistently generate alpha is based on two main cases. Firstly, that markets are efficient and fully reflect all information and knowledge on individual companies, and this was discredited in the last bear market and subsequent rebound in risk assets. Secondly, the fact that the average active manager has not beaten the benchmark index for the most recent one-year period. Active managers should be judged over longer term time periods of five years or more. There is plenty of evidence that active managers have indeed exceeded their benchmarks over these time periods and outperformed across market caps and these funds have held up well under periods of market stress. We acknowledge that whilst market inefficiencies create opportunities for active managers to exploit, the ability to capture superior returns is formed from a robust investment process. Conviction Framed in this context, there is an arbitrage opportunity for investors with a long-term time horizon to exploit. However, this is without being trading orientated. We are experiencing an investment environment where the market s spotlight is on each earnings season, resulting in a tendency to overreact to short-term events or news flow, which creates mispricing of assets. We believe that the inclusion of a stock into the portfolio should be based on the underlying fundamental investment thesis and held for the long-term. We define long-term as three to five years, but remain comfortable holding an individual stock for much longer time periods and have historically done so. We are not alone, with many other investors concurring with this perspective. For example, one of California Public Employees Retirement System s (CalPERS) ten investment beliefs is a long time investment horizon is a responsibility and an advantage. To quote Warren Buffett time is the friend of investors in a business with a sustainable competitive advantage and we force ourselves to spend little time on shortterm news flow and noise. Furthermore, only buy something that you d be perfectly happy to hold if the market shut down for ten years. We believe that skilled active managers that focus on quality and bottom-up stock selection to construct a portfolio held for the long-term should be able to generate consistent and sustainable alpha. Understanding the durability of a company s competitive advantages is an important consideration and a key element we focus on. This differentiated approach allows us to take advantage of the inherent short-termism in markets where an asset s value may be temporarily depressed. In an academic study, Best Ideas, the authors Choen, Polk, and Silli (21) found that portfolios best ideas not only generated statistically and economically significant risk-adjusted returns over time but they also systematically outperformed the rest of the position managers portfolio. Furthermore, the authors go on to state that we show under realistic assumptions, investors can gain substantially if managers choose less-diversified portfolios that tilt more towards their best ideas. Whilst diversification plays an important role across all investments in a portfolio, our objective is to produce positive risk-adjusted returns and achieve a higher Sharpe ratio than the benchmark.
Merits of our style An actively managed, unconstrained fund with a long-term investment horizon where the manager seeks the best growth opportunities available in global equities. The strategy has historically, and should in the future, participate in the upside returns when markets rise, yet produce lower downside risk. Ultimately, investors are not always rewarded for taking on risk. To outperform in falling and volatile markets, active managers must have a differentiated approach and choose to own higher quality, lower volatility stocks rather than chase short-term performance from high beta risk stocks. Moreover, the manager can choose to avoid taking on full market risk in uncertain times where risk is overpriced by the market. There is plenty of historical evidence to support the belief that focusing on quality has produced superior returns. This leads the manager towards selecting stocks that compound returns by returning excess cash flow to shareholders through dividends and share repurchases. Historic data supports the concept that over time capital appreciation becomes a less important component of total returns. Investors are increasingly focusing on risk budgeting and seeking a favourable risk/return profile that performs in a variety of market conditions. The manager takes a holistic approach, viewing risk as the permanent loss of capital. Our approach is enshrined in the concept that we do not focus on the shortterm movements in a stock price. A high conviction, unconstrained portfolio construction and bottom-up stock selection process which is agnostic to the country listing of the underlying stock. Since the Global Financial Crisis, markets have experienced an unprecedented amount of monetary stimulus. As Quantitative Easing comes to an end and we move to a more normalised environment, specific fundamental research will become a focus for returns. This will lead to a greater emphasis on active management rather than taking on full market risk. Skilled active management that focuses on quality and bottom-up stock selection to construct a portfolio held for the long-term should be able to generate consistent and sustainable alpha. Quality has historically outperformed the market: 7 6 5 Rebased = 1 4 3 2 1 1995 1996 1997 1998 1999 2 21 21 23 24 25 26 27 28 29 21 211 212 213 214 215 MSCI World Total Return Index MSCI World Consumer Staples Index Total returns in USD: Performance calculated from the 3.9.1995 Sources: Bloomberg, SPW UK
/ SPW Global Equity - investment philosophy Important information Investing involves risk. The value of investments, and the income from them, may fall as well as rise. Investors may not get back the original amount invested Issued by Sanlam Private Wealth, which is a trading name of Sanlam Private Investments (UK) Ltd which is authorised and regulated by the Financial Conduct Authority Registration No. 122588 The value of investments in overseas securities may rise and fall in sterling terms purely as a result of exchange rate fluctuations Contact us: Corporate T +44 () 2 728 87 E enquiries@privatewealth.sanlam.co.uk Bath T 1225 461 Harrogate T 1423 718 Kirkby Lonsdale T 15242 72941 London T 2 728 87 Marlow T 1628 473298 Newcastle T 191 3 9242 Sevenoaks T 1732 747 Teesside T 1642 9312 Registered office 16 South Park Sevenoaks Kent TN13 1AN Important information This document is not for general distribution outside the UK. The Sanlam Group does not accept any liability for any claims, loss or damage, as a result of reliance placed on the information in this presentation, or in respect of the use of this presentation, in the form provided, or otherwise Investments in emerging markets are likely to be more volatile and carry more risks than investments in developed markets Investments in smaller companies can be more volatile and less liquid than those in larger company shares Sanlam Private Wealth is a trading name of Sanlam Private Investments (UK) Ltd which is authorised and regulated by the Financial Conduct Authority. Registered in England and Wales 241819. is11-1115 Piet van Heerden (1917-1991), Boland Mountains, oil on board, Sanlam Art Collection. Sanlam Private Wealth (UK) @sanlamspw www.privatewealth.sanlam.co.uk