With around US$33 trillion in assets under management, global fund managers are a principal determinant in every company’s share price around the world. Whether ‘real money’ funds (managing pension and insurance money predominantly) or ‘hedge’ funds (managing money for high net worth individuals and institutional investors), all of them seek to maximise rewards from their investments while minimising risks, utilising investment criteria that comprise a different mix of macro- and micro-factors. In broad terms, global fund managers take either a ‘top-down’ or ‘bottom-up’ approach, or a combination of the two, to identify companies to buy, ignore, or sell.
The top-down approach was most famously employed by the original partners of Quantum Fund – the legendary George Soros and Jim Rogers – and involves looking
at the three following areas in order: the overall picture of an economy to ascertain where it is in the business cycle; at different business sectors to select those that are likely to do particularly well in that cycle; and then at specific companies that appear best positioned to outperform the country’s benchmark stock market.
While there are extremely long-term business cycles in the global economy of between 45 and 60 years – defined as the ‘Kondratieff Wave’ by investment professionals – within these there are other shorter time cycles followed by many top-down fund managers. “Every one of these cycles has four distinct phases: full-scale recession, early recovery, late recovery and early recession,” explains Christopher Cruden, CEO of Insch Capital Management hedge fund in Lugano, Switzerland.
In the full-scale recession phase, he adds, sectors that do well tend to be cyclicals (such as retail stores, auto manufacturers, building firms), as well as transport, technology and industrial companies. In the early recovery stage, fund managers tend to favour industrials, the basic materials sector and energy firms, while in late recovery, firms in the energy, staples and services sectors are preferred. The final phase – early recession – will see top-down fund managers looking to buy companies in the services, utilities, cyclicals and transport sectors.
Virtuous circle firms
For the bottom-up style of investment, fund managers most commonly favour ‘growth stocks’ characterised by rapidly growing company earnings rather than ‘recovery stocks’ that are out of favour for one reason or another (including cyclical stocks that are at the low end of their business cycle). “If a company has got a sufficiently differentiated product or service that creates real value for the customer, then that customer is likely to come back with repeat business. All sorts of good things can happen to the metrics of that company and its share price as a result of this virtuous circle,” says Steve Clayton, fund manager for Hargreaves Lansdown’s Select UK Growth Shares Fund in Bristol, UK.
Fidessa is a good example, providing value-added software and services to customers in the financial services sector, he says. “This also allows for the generation of much greater free cashflow [!operating!], which allows investment in the next leg of growth, be that new products or new regions to operate in,” he highlights.
On the other side of the balance sheet, fund managers pay very close attention to the level of debt that a company carries. “It doesn’t matter how well a company is operating; the higher the level of debt it has on its books, the more vulnerable it becomes to tougher business conditions; and if it is a cyclical stock, the pressures of debt can quickly become acute,” Clayton says.
Very bad or very good
For fund managers of any style, the management of companies is an important factor, but mainly only to ascertain whether it is especially good or especially bad. “A talented CEO can add value to a good business and can even turn around a failing one, while a talentless one can wreck anything, which is why generally you want something in between if you’re looking at a long-term investment,” says Sam Barden, CEO of SBI Markets hedge fund in Dubai.
A case in point of a good CEO was Sir Terry Leahy of supermarket chain Tesco. Leahy transformed Tesco over the
10 years under his charge into the number one supermarket in the UK, and the third-biggest in the world. Since he left in 2011, though, Tesco’s standing in both the UK and the world has slipped; it suffered a major accounting scandal, and its share price has more than halved.
Conversely, Gerald Ratner destroyed his eponymous British High Street retail chain overnight when, in 1991, he joked – in a speech to the historically well-media-covered Institute of Directors get-together – that one of his firm’s products was “total crap”, and boasted that some of its earrings were “cheaper than a prawn sandwich”.
Four factors to attract fund managers
A unique brand, product or service, or IP.
Positioning in a business sector
That allows a company to add dollar revenue per cent of investment.
A healthy price/earnings ratio
Is often seen as a prime indicator of company health, but when P/Es become very high, they can indicate a bubble is growing, such as happened in the case of the dot.com bubble (when the arithmetic mean average global P/E for such firms was 32, against an average P/E for US equities from 1,900 to 2,007 of 16).
Solid dividend payments
Are regarded as a reflection of the confidence that a company’s management has in the firm.