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Managers attempt to learn lessons of 2007 as markets turn

JO Hambro’s Ben Leyland sees periods of volatility as an opportunity, while Alex Illingworth of Artemis focuses on expectation management while growing clients’ ‘real wealth’

Managers attempt to learn lessons of 2007 as markets turn

JO Hambro’s Ben Leyland sees periods of volatility as an opportunity, while Alex Illingworth of Artemis focuses on expectation management while growing clients’ ‘real wealth’

As might be expected following a turbulent last quarter of 2018, protecting capital during market downturns and capitalising on volatility were top of the agenda for global equity managers at the New Model Adviser® Conference and Awards earlier this month.

Both Ben Leyland (pictured above), senior fund manager of the JO Hambro Global Opportunities fund, and Alex Illingworth (pictured below), manager of the Artemis Global Select fund, emphasise the relevance of their funds’ ability to offer participation in the upside of global equity markets, while preserving capital through difficult spells.

As Leyland puts it, ‘heads we win, tails we don’t lose too much’. However, the two have adopted slightly different means of achieving that goal.

Management crisis

Leyland says he tries to identify opportunity in periods of volatility. ‘We do not think volatility itself is risk. They’re not the same thing. We think about risk as the permanent impairment of capital. The reason we think about risk in that way is broadly because I came into the industry at the peak of the technology, media and telecommunications [or ‘dotcom’] bubble.’

Leyland joined JO Hambro’s UK Opportunities fund in 2009, just as the global financial crisis was hitting full swing.

Over the past five years, the Global Opportunities fund has returned 67.3%, ranking 61 out of 483 funds in Citywire’s Equity - Global sector. Leyland argues his fund had ‘one hand tied behind our backs’ because it is not designed to perform corporately well in a long bull market. As markets enter more choppy waters, he is hoping the unconstrained fund will come into its own.

‘We think the environment has probably changed for some time, and the volatility is likely to remain high,’ says Leyland. ‘There will be more than our fair share of down months to endure over the next five years, and so a profile like ours has been gaining more and more interest over the past year.’

He suggests this was part of ‘learning the major lessons of 1999 and 2007’. The former lesson was to avoid overvalued assets or compulsion to own stocks in a particular sector, because they represent a large proportion of the index. The latter lesson is to avoid businesses that are overleveraged, and continuing to own stocks out of fear of missing out on a market rally.

‘A lot of the process is about weeding out characteristics of losers, the major causes of capital destruction over a full cycle. The first is poor-quality businesses, with no proven structural advantages, low barriers to entry, poor pricing power and low capital discipline. Generally, those businesses will destroy value over time.

‘The second thing is even good businesses can have too much debt, which creates poor investment returns for the equity side of the business.’

The fund operates in a pool of around 500 to 600 stocks, seeking to invest in companies with sustainable barriers to entry and competitive advantage, which it often finds in intangible assets such as staples and technology, but also identifies in cyclical and capital intensive businesses.

Leyland and his team pick from a representative ‘watchlist’ of around 300 stocks, choosing what they believe are the best investments at particular times on a risk-reward basis. The team monitors these stocks through a cycle, committing capital where it deems valuations attractive.

However, if they see a particular holding as being overvalued, this position will be reduced and ultimately sold to zero. 

Minimising damage

Illingworth employs a similar mantra: to ‘keep up in good times and not mess it up in more difficult times’. But instead of professing to thrive on volatility, the Artemis Global Select fund’s objective is to temper it for investors where possible while growing clients’ ‘real wealth’ by 8% a year. 

The portfolios consist of around 60 stocks, which Illingworth says allows the fund to be as diverse as it can while maintaining focus on areas of secular rather than cyclical growth. He says while investing in global equities was the ‘best way to grow your real wealth over the long run’, volatility was the ‘price you pay’.

Illingworth adds: ‘We choose to give up some of that volatility and build in some capital protection, so you should have an experience that is less volatile through the cycle, but one that outperforms.’

In contrast to Leyland, Illingworth’s fund has made volatility control much more of a priority for investors.

‘We try to grow people’s real wealth 8% a year to give people that less volatile experience through the cycle,’ says Illingworth. ‘We hope one of the periphery benefits of lower volatility is keeping people in at difficult periods, as they will not be as scared by the volatility that equity markets do bring you.’

Now that more volatility has returned to markets, Illingworth hopes stocks with ‘low business model risk’ and ‘proven strong deliverers of cashflow’ will deliver what investors expect.

A fund like this does have other tools at its disposal to help it cope with difficult market environments, but it is chiefly diversification. Illingworth believes having more holdings allows for greater flexibility to access ‘more interesting areas of the market’ such as Japanese robotics and diagnostic testing.

Over five years the fund has returned 60.3%, compared with a sector average of 47.5%, ranking it 102/483 in the global equity sector. The fund is also in the second quartile under the volatility measures.

‘We do quite a lot of things in the portfolio that are very non-benchmark,’ says Illingworth. ‘We do not have very much emerging markets, we don’t have Latin America, no oil, only one bank (Bank of China). Over the years we have had Japan at 5% and 25%, so we are driven by the thematic work we do, looking for areas of secular, not cyclical growth, not driven by what the benchmark tells us to do.’

The fund takes large identifiers, such as demographics, and distils them down to themes that Illingworth and fellow manager Simon Edelsten (pictured above) believe offer a ‘significant amount of stable long-term growth drivers’.

One such theme is healthcare costs, Illingworth explains, adding: ‘To us it’s not enough to say “demographics equals lots of old people — so go and buy pharmaceuticals”, the durable change is the necessity to reduce cost in the provision of healthcare. We know the burden on society from ever-increasing healthcare costs is just too great, especially in America.

‘It really does not matter what [US president] Donald Trump says about his wall, or trade, China, or North Korea. We know this dynamic is going to continue into the future, and when we find a theme like that we get excited, because we can really get an understanding of the cashflows.’

The fund’s positioning as things stand is relatively close to the benchmark, Illingworth explains, though slightly light in emerging markets and with a lot of holdings in North America. The managers do not subscribe to the view of North America being more expensive than the rest of the world, particularly in relation to the quality of companies they are seeking out. 

The 2019 Outlook

At present, Leyland suggests, the JO Hambro Global Opportunities fund watchlist is not demonstrating that now is a ‘compelling time to bang the table and say you have to be invested in equities’, but he does identify some current holdings that are emblematic of this strategy, such as US IT giant Cognizant.

‘As a rule, I think IT services are quite expensive,’ says Leyland. ‘Accenture is beyond what we consider to be appropriately valued, but Cognizant is below 15x P/E, has net cash on the balance sheet, so there are no adjustments to make there, and strong organic growth prospects. We have been using weakness to buy that, and it is now one of the biggest positions in the fund.’

The fund has also invested increasingly in US tobacco company Philip Morris, which Leyland sees as the exception to the rule. Most tobacco companies’ balance sheets are stretched at present due to consolidation.

He adds: ‘It has a strong balance sheet, has the best portfolio of reduced risk products in the world and is trading at less than 14 times earnings. We had been building that position very aggressively during the fourth quarter of last year and using that cash to take advantage of volatility.’

Illingworth reveals the Artemis Global Select fund changed many of its top 10 holdings in December 2018, with approximately six of the 10 now recognisably defensive.

He says: ‘We definitely diversified because we think it is a very difficult time to be 100% sure about where we are going, most particularly because politics is playing a role. But in general, there are some things that are very much 2018 stories, and not 2019. Valuation was excessive last year, and we sought to try and reduce the average multiple of the portfolio throughout the year, but it does feel a bit more like a 2018 story.’

He suggests uncertainty caused by Trump’s trade wars and Brexit was close to a conclusion, and thus the fund’s 2019 outlook is more positive than this time last year.

‘Cashflows have gone up and valuations have gone down,’ says Illingworth. ‘You can only play the team in front of you, and we see the opportunity, we see our companies continue to invest. We talk to them, and they are convinced about the secular growth areas and we don’t find the valuations excessive.’

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