How to find a good manager?

With all the articles in the press and business TV shows pushing the case for low-cost passive investing, we thought it was about time to bring some light to the other side of the story. That being those active managers who have outperformed, and how to find them.

The financial press would have you believe that no fund managers outperform the index, yet there are some prime examples of outperformance over the last 12 months:

  1. The Platinum International Brands Fund, which returned 24.92% for the last 12 months, more than double the index, which returned just 10.7%.
  2. The Antipodes Long Only Global Fund, which returned 17.44%, with the same benchmark.

There were many similar cases in Australia:

  1. The Macquarie High Conviction Fund returned 15.9% compared to the ASX 200 Index of 9.79%; and
  2. The contrarian, Dimensional Australian Value Trust added 17.95% compared to the same benchmark.

What we have found when it comes to the stories on passive investments, is that the analysis used is arbitrary and general gives no consideration to the style and investments that each fund is implementing. That is, there are a substantial amount of funds that simply replicate the index, but due to an arbitrary categorization, they are considered ‘active’ thereby bringing down the average. There are a long list of outperforming funds, both over the short and long-term, so in this short article we seek to provide 5 simple rules to assist readers in finding a good manager.

1. Find a manager that fits your purpose.

By this we mean that investors should not simply think about investing globally as just buying shares or any managed fund; that should consider the sectors, strategies or countries that they expect to perform well and invest accordingly. That is, if you believe Asia or Europe represents the best growth opportunity, then don’t buy a fund (like Magellan) that is more focused on US-based technology companies. If you believe that growth and technology companies have had their run and volatility may lie ahead, then seek a contrarian or value oriented manager. If you think dividends are undervalued, find one that focused on dividends and free cash flow.

2. Demand that management have ‘skin in the game’

As much as we hate this saying, more often than not it holds true. Would you prefer to invest into a fund managed by someone has their own capital invested alongside you and whose personal success and ability to pay their mortgage relies upon the performance of the fund? Or would you prefer to invest into a fund managed by a team of highly paid, salaried managers who are invested the capital of large institutions alongside your own? Our experience has shown that the best returns come in the early days after launching a fund, and you simply don’t get the same returns as AUM grows. There are of course some exceptions, however, in general we believe this holds true.

This is generally due to the fact that in a managers early days, they are striving for every dollar, working hard to maximise your returns. However, once super fund or institutional mandates come in (usually in the billions) these managers are now measured against their benchmarks and the alternatives on offer. If you consider an institution paying a management fee of just .20% of their $1.0bn in assets under management,  that represents an income of $2.0m to the manager. It obviously becomes difficult sticking to one’s convictions when this sort of offer is available; hence the gravitation to index investing in order to minimise ‘underperformance risk’.

3. Minimise exposure to funds who have in excess of $2.0bn under management.

This relates closely to the previous point, in that investors should generally avoid individual funds that have in excess of say $1.0bn to $2.0bn under management. In our experience, this level of capital leads to increasing bureaucracy, longer decision-making processes and generally worse results for investors. More assets under management generally means a manager has several institutional mandates and is now being covered by ‘investment consultants’ who focus solely on their performance against benchmarks. There are generally more meetings, more travel and less time dedicated to digging deeper into investment opportunities. In addition, funds of this size can also find it difficult to identify attractive opportunities particularly where they invest in smaller, less liquid markets.

4. Look for a team, rather than individual based portfolio management process.

By this we mean that investors should be seeking managers who have a process that can be easily replicated and have a succession plan in place. Investing in fund that relies solely on the ideas, analysis and nous of a single portfolio manager puts you at risk of underperformance should that person decide to retire. We recommend investors look to funds that have co-portfolio managers, who make investment decisions as a committee and value the input of every member of their team. Focus on those managers who consider the ideas of every team member and place more value on idea generation than on short-term performance.

5. Understand the risk management process of each manager.

Risk management processes relate to what each manager will or won’t do when things go wrong. If you are worried about protecting your capital make sure you have a manager that implements strict stop losses on positions that go against them. Ensure you have an understanding of how they determine weightings for each investment in the portfolio, the minimum and maximum number of and allocation to each investment and the amount of time they will give to an investment that goes wrong. In this point, you should be looking for managers with expressly stated and implementable capital protection strategies who have the wherewithal to implement them when times get tough. Take for instance, Nick Griffin, of Munro Partners, who was published in the Financial Review this week for indicating that on the first sign of difficultly, he sold out of a major holding to protect investors capital.

It goes without saying that there will always be exceptions to these rules, however, we believe they are a great starting point for investors seeking better returns.

Is BIGGER better?

In our experience there are three areas where any investors tend to make the mistake of ‘going with the herd’ when it comes to their finances – 1. Investing only into so-called ‘blue-chips’, 2. Seeking financial advice from the largest employers in the industry; and 3. Selecting their superannuation or other investment fund based on size alone.

There was an article this week in the Australian Financial Review (available here) which addresses the first issue perfectly. The author makes the point previously raised in our Journal, that the ASX 50 has produced an annualized return of just 0.46% per annum over the last decade. This improves to 4.12% per annum when dividends are reinvested, however we haven’t met many who reinvest all their dividends.  So basically, investors who stuck to the old adage of only investing into ‘blue-chips’ are now staring at a lost decade of investment returns. The influx of exchange traded funds and growing popularity of passive investing is increasingly seeing investment capital directed to the largest businesses, based on market capitalisation. Many investors believe this strategy is lower risk than the alternatives, of say investing into an active fund, unfortunately, the case may be the opposite. Investing into a blue-chip index, or portfolio of Australian stocks actually exposes investors to more risk and offers less diversification by virtue of our heavy weighting to bank and resource companies (which make up 6 of the top 10 on the ASX).

The second issue is all too common and is being brought to light once again with APRA’s investigation into the Commonwealth Bank. As the biggest providers and well-known names, mum and dad investors tend to feel comfortable seeking financial advice from the Big Four Banks or insurance companies. Unfortunately, as many people have experienced over the last decade, the big banks are run solely for the benefit of their shareholders and they have an extensive history of poor outcomes for their clients. Whether this is due to their preference to recommend only their own products, or their focus on providing advice as cheaply and quickly as possible, rather than tailoring it to each individual person; when fees are included they typically leave people worse off than before.

The final issue we raised is the expectation that simply going with the incumbent, or largest superannuation manager in the country is safer than the alternatives. Again, unfortunately, anytime someone makes an investment, you are putting capital at risk, it doesn’t matter who is investing on your behalf, the value of your investment will be different tomorrow. Many people believe investing with the largest provider will guarantee good returns, the only thing it will guarantee however is getting the average return, becoming one of the crowd and receiving no personalized service. This is one of the reasons behind the growing popularity of SMSF’s. Many large investment managers or superannuation providers get caught in the same trap as the large financial institutions, in that they focus on delivering solutions that suit their business and compliance teams, rather than what is best for their investors. They would prefer not to underperform against their peers, and risk losing members, than to take the risk to generate better than average returns. Interestingly, the so called ‘low-risk’ and ‘balanced’ option available may actually be exposing investors to more risk than if they were to do it themselves. This is due to both the index replicating approach as well as the large proportion of interest rate sensitive investments, such as direct property, infrastructure, utilities, telecommunications and other assets they hold in an increasing interest rate environment.

Slick Returns Across The Field by Rudi Filapek-Vandyck

In a reporting season that mostly underwhelmed and failed to excite throughout August, many of the pleasant surprises were delivered by mining companies and oil & gas stocks.
Miners had been tipped by many in advance, given persistently high bulk commodities prices and strong rallies in base metals, but crude oil had largely disappointed in the first half and question marks had been raised about true costs, growth optionalities at lower than projected oil prices, free cash flows and balance sheet vulnerabilities.As it turned out, the oil & gas sector generally delivered a positive outcome, with the following brief assessment of key individual performances:

AWE Ltd (AWE): FY17 performance disappointed all and sundry. Operational costs are a problem and so is a declining production profile. Progress on projects Waitsia and Ande Ande Lumut is necessary to get investors excited again, but the latter, on the company’s own admission, needs crude oil priced above US$50/bbl.

Beach Energy (BPT): delivered a big beat plus larger-than-expected reserve increase. Management is confident in the strong production profile, and total reserve replenishment by 2019. Strong cash flows remain on the horizon. One broker suggested this will become the go to midcap stock for investors seeking sector exposure. Major negative: share price valuation post big jump post FY17 release.

BHP (BHP): operationally couldn’t quite meet market expectations, but the prospect of selling onshore shale operations in the USA and passing on (part of) the proceeds to shareholders has investors excited. The company could be net cash by the end of FY18 and this keeps expectations alive about potential for more capital management.

Oil Search (OSH): delivered an ok interim result, but investor attention goes out to delayed expansion plans due to oversupplied markets. Oil Search remains connected to probably the most exciting expansion potential worldwide, but delays are a disappointment and imply previously assumed benefits will arrive later.

Origin Energy (ORG): delivered a better-than-expected FY17 performance with faster than anticipated debt reduction feeding market hopes dividends for shareholder might make a swift comeback, soon. Lower cost to operate APLNG are another significant positive. Current guidance might prove conservative.

Santos (STO): cost reduction and cash generation surprised friend and foe. The rapid de-gearing of the balance sheet translates into de-risking of the business. Assuming steady progress continues to be made, the share price could make a double-digit percentage catch up, if the oil price and market sentiment further align.

Senex Energy (SXY): FY17 disappointed and sanctioning the Western Surat CSG expansion might imply the stock remains off radar until prospects for FY19 start materialising in a more tangible manner. This probably explains why the share price looks genuinely cheap.

Woodside Petroleum (WPL): stringent cost reduction helped the interim result beat market expectations, including a higher dividend. Delay at Wheatstone was disappointing and question marks remain about true growth potential in case oil prices remain low for longer. However, it goes without saying investors in individual oil and gas companies should always keep one eye out for the broader, macro picture.

It has taken this long, but more and more oil market observers are now succumbing to the realisation that present global oil market dynamics are likely to keep a ceiling on the oil price above US$55/bbl and a bottom below US$45/bbl. As long as OPEC and Russia remain disciplined, and no major supply disruptions or geopolitical tensions occur, these are the levels at which swing producers in the Permian basin in the USA either thrive or perish, adding more supply or less into a well-supplied global market. It is not unthinkable for the global oil market to go through the same scenario over and again: oil price rises, US frackers add more supply; oil price weakens, the highest cost and most price sensitive producers retreat; oil price rises, those swing producers join in again. As long as these dynamics remain in place, and demand stays within reach of supply with and without US marginal producers, it seems the current range can remain in place for a long time.

Early repercussions from what seems like a fairly stringent regime for global oil, are revealing themselves through analyst updates pre-August reporting season. The first seven months of 2017 have seen oil priced below expectations. Thus research updates on the energy sector in July have all led to lowered forecasts, and thus to reduced valuations and price targets. Predictably, this has weighed upon share prices.

Consider, for example, that FNArena’s consensus price target for Woodside has fallen to near $30 from almost $33 in circa two months only. For Oil Search, the consensus target has fallen from $8 to $7.55. BHP ((BHP)) has felt the impact too, with its consensus target falling to $28.

An interesting new dynamic for sector investors in Australia stems from the divergence in USD priced oil and the surging AUD/USD on the misguided belief the RBA is soon to embark on a tightening course. As such, the stronger Aussie dollar has now become yet another valuation headwind for a sector whose main product sells in USD.
Analysts at Credit Suisse put spot oil and AUD/USD through their modeling and resulting valuations for Australia’s main energy producers looked quite sobering, to say the least. On Credit Suisse’s modeling, fair value for Woodside had sunk to $17.50/share (not a typo), for Oil Search it was $4.15, for Santos ((STO)) $1.90 and for Origin Energy ((ORG)) $4.10.
Of course, these numbers are rubbery by nature, and nobody at this stage is expecting oil to remain steady at current level, nor the Australian dollar to remain near 80c against the greenback, but the broader issue here, argues Credit Suisse, is whether investors should now be paying closer attention to the currency and its possible impact on share price valuations?
For good measure: Credit Suisse thinks the answer is “yes”, oil sector investors should be incorporating AUD/USD into their risk and valuation modeling, and accept it as yet another negative (“valuation headwind”) for the sector.

By far the largest threat to energy sector valuations is represented by long term oil price projections used by analysts to make future projections about cash flows, revenues and project returns, combined circling back into contemporary company valuations. Short term oil prices can swing heavily, and they do impact on share prices through short term traders and algorithm robots, but large investors take their cue from longer term projections and assumptions. Were they to give up on the prospect of oil prices to break out of their current range in the foreseeable future, this would have significant impact on valuations for energy producers today. Yet, July has witnessed three teams of sector analysts doing exactly that in Australia.

Worldwide, most sector analysts are working off a long term oil price of US$65/bbl. In July, Citi decided to abandon that anchor and to replace it with a long term oil price forecast of US$55/bbl. Argue the analysts: signs of continuing productivity gains onshore USA have compressed the oil cost-curve. Citi’s research concludes the incentive price to meet future demand has now permanently reduced to US$40-60/bbl. Putting the new long term price forecast through Citi’s models caused valuations in Australia to deflate by between -8-23% while profit forecasts fell by between -12-50%. One day before Citi released its revised energy sector forecasts and valuations, oil sector analysts at JP Morgan/Ord Minnett had come to the same conclusion. Their new long term oil price forecast is also US$55/bbl, down from US$60/bbl prior. In their research update, JP Morgan/Ord Minnett highlighted why these lower price projections are likely to have major impact on the outlook, and thus valuation, of Woodside Petroleum: “sustained low oil prices have had the effect of not only lowering our estimated value for Woodside, but also potentially delaying or deferring the company’s growth projects”. Credit Suisse has since lowered its long term oil price assumption to US$60/bbl from US$65/bbl. To date, most teams of energy sector analysts continue to work off US$65/bbl longer term. At a recent seminar, leading industry consultant Wood Mackenzie reiterated its view a moderate price recovery for oil remains on the agenda by 2020, when US$65/bbl should be back on the agenda. Shorter term, the second half of 2017 should see a bounce in the oil price, while consensus is converging around global over-supply in 2018. The major risk for investors in the sector does not come from marginal surprises in timing and volumes, or from daily volatility which makes perfect timing difficult, but from the fact that more analysts might join the conclusion that US$55/bbl is now likely the new anchor, long term, for a sector already struggling to cope with ever changing dynamics. The importance of all this was once again highlighted in that recent sector update by Citi with the analysts calculating today’s share price of Woodside Petroleum represents an oil price average of US$68/bbl. Same for Oil Search. For Origin Energy and Senex Energy ((SXY)) the price seems to have incorporated US$55/bbl. That drops to US$40/bbl for Santos, but then Santos comes with a sharply higher risk profile and investors have priced in a hefty valuation discount in response.

Bottom line: crude oil prices remaining range-bound for a prolonged time significantly increases the risk profile for investment opportunities in the sector, with capitulation by financial analysts on the long term price average representing a tangible threat. Investors should adjust their strategy and exposure accordingly.

A Report Well Seasoned by Julian Beaumont

Expectations coming into this reporting season evinced more optimism than previous years. Corporate conditions were thought to be seeing some life following a long slug. Indeed, recent business survey data had revealed corporate confidence at its highest levels since 2008. As well, ‘confession season’ was fairly benign with relatively few profit warnings. In this context, the August reporting season was underwhelming.

In aggregate, earnings for the 2017 financial year were about in line with expectations. Optically, earnings growth was stellar, at 17%. However, this was flattered by a dramatic recovery in resource earnings. Ex-resources, earnings growth was a more subdued 4%. What was underwhelming was the outlook for the 2018 financial year. Where companies gave formal earnings guidance or outlook statements were given, they were generally on the weak side. Indeed, the consensus of brokers’ earnings estimates for 2018 reduced over the course of August, from growth of almost 7% to about 5%. This downward trend is not unusual, albeit that there was a sense that this reporting season would be different. The following chart shows how consensus earnings estimates for the market are quite consistently revised down over time for any particular financial year.

Source: BAEP, BAML, as at 24 August 2017

The read-through for the broader Australian economy is that conditions remain sluggish, but benign. Thus, the banking sector, which is quite telling of the broader economy, reported little credit demand growth but a general easing in bad debts. Whilst some pockets of concern remain – the banks continue to call out Western Australia, although other corporates reported stabalising conditions there – things look like they can muddle through. In past years, corporates have dealt with sluggish conditions with a pretty consistent game plan: cut costs; avoid capex/investment; preserve cash; pay down debt; and maximize dividends to shareholders. This has meant lacklustre business investment, remarkably conservative debt levels, and happy shareholders.

Corporates may be starting to invest?
Most corporates continue to run with this game plan. However, in an important trend this reporting season, there are finally signs of some corporates investing for growth. Perhaps this is the business confidence flowing through into action. Examples included CSL Limited (incrementally more spent on R&D and plasma collection centres), Suncorp (an unexpected $100 million on IT and branding for its ‘Marketplace’ investment), Scentre (new shopping mall developments), AGL (on new facilities) and Seek (start-up ventures).

Higher capex, less dividends

This increased business investment comes at a cost, with less able to be returned to shareholders. Partly for this reason, the news was generally treated negatively by investors, who evidently remain focused on dividends. Emblematically, Telstra cut its dividend from 31 cents per share to 22 cents, and the stock fell 11% on what was an otherwise fair result. Forecast expectations for total capex in 2018 were lifted, whilst for dividends they were lowered slightly.

Banks
Commonwealth Bank (CBA) was the only big four bank to report in August. It grew profits by 4.6% to $9.9 billion, and raised its dividend by 2%. Despite a well-received result, CBA shares weakened because of news of the AUSTRAC action. Bendigo & Adelaide Bank reported an inline result but a better-than-expected outlook, owing to a strong net interest margin (NIM) exiting 2017, and a stronger capital position that reduces the likelihood of a capital raise. It was a ‘better than feared’ result that saw its shares rise 7%.The other banks provided trading updates, and expectations for the sector lifted slightly. Whilst lending demand is sluggish, the banks are pricing up rates, especially on investor and interest-only mortgages. This has supported their all-important NIM, and allowed better-than-expected revenue growth. Low bad debts and cost containment mean they can eke out respectable earnings growth. The banks have worked to build up capital, with their positions now sufficient to easily meet APRA’s new ‘unquestionably strong’ capital requirements in time for 2020. Other large sectors of the market – including the insurers, telecoms, healthcare and supermarkets – continue to see meagre growth, despite previous hopes of improvement. The poor showing of these sectors underpins what was generally a weak season for the defensives. As an exception here, utilities and REITs were reliably in line. Otherwise, there was a mix of good, bad and indifferent right across the market.

Insurance
The Insurance sector was the hardest hit over reporting season. QBE, IAG and Suncorp saw share price falls of between 6% and 8%. The expected rise in premium rates for the domestic insurers is coming through, but it was more than offset by claims of cost inflation, with insurance margins consequently undershooting expectations. The example of the domestic insurers’ results illustrates a common lack of genuine pricing power among many Australian corporates, with the insurers’ price rises necessary in passing on higher input costs.

Healthcare
Healthcare results were generally weaker than expected, but for different reasons. Healthscope saw flat earnings growth in the second half of 2017, and guided for more of the same in 2018. This was well below the expectations of the market, which views the hospital sector as offering strong, reliable, long-term growth. Its shares fell 16% on the day, and remain under pressure. Elsewhere, Resmed disappointed with a lower margin outlook; CSL’s result was very strong but its guidance underwhelmed, although noting it seems characteristically conservative; whilst Cochlear impressed with a reliable but inline result, and its share rose 7%.

Retailing
Investors have become increasingly negative on retailers in recent months, owing to concerns of a weak outlook for households as well as the threat of Amazon. Weakness across the broader retail landscape was evident in Scentre’s results, with comparable sales growth across its Westfield shopping centres of just 1.1% for the half year.
However, many listed retailers are executing exceptionally well, and reported very strong results. For example, JB Hi-Fi grew earnings per share by 22%, with same-store-sales at namesake stores up 9%, and it pointed to this momentum continuing into the new financial year. On top of the other sectoral issues, the market also seems concerned with JB’s housing exposure, and its shares weakened slightly on the result. Similarly, Nick Scali reported a strong result but guided down on account of slow housing activity, and its shares fell 10%. On the other hand, others facing the same sectoral issues including Bapcor and Super Retail Group reported good results and saw their shares rise meaningfully. The big retailers, Wesfarmers and Woolworths, are seeing intense, but seemingly rational, competition in their core supermarket businesses. Woolworths has won back momentum, achieving sales growth of 7.2% in the past quarter, compared to Coles’ full year growth of 1.6% and weak near-term outlook. Both are investing more in lower shelf prices, which in turn is affecting profitability. For the year, Woolworths’ supermarket profits fell 2.4% and Coles’ fell 13.5%. Woolworths’ shares have retreated 4% since its result, with large losses at problem-child Big W another big reason. Fortunately for Wesfarmers, some of its other divisions, including Bunnings, helped to ensure a solid result for the company. Other staples, especially those in favourable markets such as Treasury Wine Estates, Costa Group and BWX, posted very strong results, and were ultimately rewarded by the market with higher share prices. Domino’s Pizza Enterprise reported a strong result, with earnings growth of 29%, and guidance for 2018 of another 20%. Both, however, were below even stronger expectations, and the stock price fell around 20%.

Tourism & Travel

Tourism remains strong, as evident in the results of Event Hospitality (hotels), Apollo Tourism (campervans), Skydive the Beach (skydiving), Qantas and Virgin (air flights), and Flight Centre and Helloworld (travel agencies). Flight Centre reported a very strong result, with market share gains, including against online competition, and a new ‘transformation’ program with ambitious medium-term earnings outcomes if executed successfully. Its shares rose 11%.

Housing, building materials & construction

Housing remains strong, based on results from companies such as Mirvac, Lend Lease and Stockland. These companies are guiding to residential development taking a glide down lower, rather than face the cliff that some investors are worried about. Encouragingly, construction is beginning to broaden out. Adelaide Brighton, a building materials supplier, and CIMIC Group (the old Leightons) both presented a strong outlook for infrastructure projects, with a number of large-scale projects in train or about to start up.

Important information
This information is issued by Bennelong Funds Management Limited (ABN 39 111 214 085, AFSL 296806) (BFML) in relation to the Bennelong Australian Equities Fund, the Bennelong Concentrated Australian Equities Fund, the Bennelong ex-20 Australian Equities Fund and the Bennelong Twenty20 Australian Equities Fund. The information in this article is current at 28 August 2017. The information provided is general information only. It does not constitute financial, tax or legal advice or an offer or solicitation to subscribe for units in any fund of which BFML is the Trustee or Responsible Entity (each a Bennelong Fund). This information has been prepared without taking account of your objectives, financial situation or needs. Before acting on the information or deciding whether to acquire or hold a product, you should consider the appropriateness of the information based on your own objectives, financial situation or needs or consult a professional adviser. You should also consider the relevant Product Disclosure Statement (PDS) which is available on the BFML website, bennelongfunds.com, or by phoning 1800 895 388 (AU) or 0800 442 304 (NZ).