Martin Currie is new to the Future Generation Global (ASX: FGG) stable of pro bono fund managers. Can you tell us a bit about your investment style?
We focus on sustainable, quality growth investment ideas. We’re unconstrained, which means we focus on the very best ideas in the market. We’re highly concentrated so, typically, we hold 20-30 positions. The way we find these companies is through good old fundamental analysis, which we do in a very detailed manner, and we have a strong focus on environmental, social and governance (ESG) factors as part of that.
Is this the way you have always invested or has your style evolved over time?
Throughout my investment career, I’ve always focused on quality growth. When I was at BlackRock, I managed the Blackrock European Unconstrained Equity Funds, which were very similar in style. They concentrated on around 20 stocks, so that investors were exposed solely to the best ideas. It’s a tried and tested approach.
With high conviction funds, if you pick correctly, you can hit the ball out of the park. But the opposite is also true. So how risky is a concentrated approach – and what can you do to mitigate that risk?
That’s a good question. What I’ve seen throughout my career is that fund managers might have 50 positions in their portfolio for diversification purposes– but they actually only strongly believe in 20-30 of those ideas. Typically, in a 50 stock-portfolio, there are 10-20 stocks which are getting close to the price target and therefore by definition are not going to give you the alpha [the excess return of an investment relative to the return of a benchmark index] you might expect. Why hold on to stocks that aren’t going to give you much upside? Then there tend to be 10-20 stocks – the “tail”, as we call it – where you don’t have a clear conviction on whether they’re going up or down. They are just fillers for the purposes of risk management. The concept of high conviction, unconstrained investing is to cut the “tail” and get rid of the companies that are close to price target, so that you can focus solely on the 20-30 stocks that you believe have strong upside potential. We believe this is a superior approach to a diversified one because there is greater opportunity for alpha generation.
That said, risk mitigation is absolutely a relevant issue to tackle. When you have 20- 30 stocks, it is more difficult to diversify. It takes time and focus, but you can still do it. The way we have done it is by having a clear understanding of the types of businesses we’re invested in – whether that’s geographically, in terms of exposure of revenue, profits and production bases; whether it’s in terms of end user markets; or whether it’s in terms of thematic exposure. It’s really important to have an accurate assessment of exposures because that leads to more efficient diversification.
Does a high conviction fund mean you have more turnover in your portfolio?
We’ve actually got low turnover. Our time horizon is 5-10 years, so we’re long-term, unconstrained investors. This means our de facto turnover tends to be around 10%- 20% each year. But if you take last year, as an example, it was actually closer to 5%.
But I believe your question relates more to taking quick action when a stock goes wrong. And you’re absolutely right. When you’re holding 20 to 30 high conviction stocks, it’s important to make sure that all stocks are firing on all cylinders. For us, that means identifying early when we’re losing conviction on a stock or a stock investment thesis is broken, then taking action to protect the assets from further negative alpha.
Your investment process is, as you said, extremely rigorous. So how do you take the entire investable universe and whittle it down to 20-30 companies?
It’s a daunting task! By way of background, we have three steps to our investment process. Step 1 is the idea generation stage and that’s where we screen for quality growth. Step 2 involves in-depth fundamental research on the most interesting ideas that come out of Step 1. It’s a long process but at the end of Step 2, we have a good sense of the company’s fair value and a good understanding of the risks that the company brings. We then move to Step 3, which is the actual portfolio construction, and that is just as important to us as Steps 1 and 2. In this process, we try to build portfolios of high conviction ideas, but which, at the same time, are diversified and don’t have any unintended risk exposures. I think, however, that your question relates chiefly to Step 1. In this process, we start with a universe of 2800 stocks and we narrow that down to 500 stocks, using a few filters. One of them is on the quality growth side. We define quality growth companies as having a high return on invested capital (ROIC) and attractive growth prospects. So, unlike some growth managers that might be focused on early-stage growth companies that are unprofitable and burning through cash, we tend to want companies that have reasonable growth and a high return on invested capital.
Secondly, we look for companies with solid balance sheets. We like companies that grow organically, rather than through acquisitions, so we focus on goodwill on the balance sheet. If there’s a lot of goodwill, it tells us the company has been very acquisitive. We then assess whether those acquisitions have destroyed or created value, which tells us whether management is able to deploy capital efficiently. As an aside, our ROIC calculations include goodwill, meaning we penalise companies that are acquisitive. So, we’re very conservative.
The final filter is companies with a market capitalisation of more than US$3 billion. So all of that together enables us to narrow the universe down to 500 stocks. But that is still too many. So, what we then do is we segment those stocks into four verticals: technology, media and telecoms; consumer; healthcare; and industrials, financials, materials and energy. We have two analysts per vertical and those analysts use their sector knowledge and expertise to further narrow down the stocks before we move into Step 2, the phase of in-depth research. Ideally, we end up with companies in sectors with high barriers to entry, which have dominant market position, strong pricing power, low risk of disruption, strong structural growth prospects, high returns on invested capital, strong cash flows, solid balance sheets, quality management, good corporate culture and sustainable business models. Above all else, they also have attractive valuations.
We’ve gone through a tough period for growth stocks, so how has your fund performed over the past 12 months-18 months – and what has been driving that performance?
We are focused on quality growth stocks; we have no value exposure. So, over the past 18 months, we have faced a lot of headwinds as the market has been selling out of growth and going into value. That shift into value was, of course, predominantly triggered by the change in monetary policy expectations as the market realised that the US Federal Reserve (the Fed), and other central banks were going to have to tackle elevated inflation levels. Over the past 14 months, we’ve had over 500 basis points of rate hikes by the Fed. That triggered a rotation into value away from growth because growth companies tend to be long duration stocks and so are more sensitive to shifts in interest rates.
Adding to this, we’ve had the tragic invasion by Russia of Ukraine, which also triggered a sharp increase in commodities and energy prices. The energy sector is a value sector, which we have no exposure to.
Finally, we have had headwinds in the form of the Chinese economy being in lockdown. Our investment strategy has various direct and indirect thematic exposures to China, such as the emerging market middle class, and some of the industrial companies we hold are exposed to the China cycle. However, over the past six months, our performance has improved very strongly – for the same reasons we faced headwinds. Firstly, China reopened unexpectedly and sharply at the back end of last year. Secondly, as interest rate expectations have stabilised, there’s been a return towards quality growth companies, notably in the tech space which we are highly exposed to. Thirdly – but still attached to the second point – is the excitement around AI (artificial intelligence). This has triggered a very strong focus on a few companies, such as Nvidia (NASDAQ: NVDA), which is our biggest holding, as well as AI-exposed or semiconductor-exposed companies like Microsoft (NASDAQ: MSFT) and ASML Holding (NASDAQ: ASML), which we also hold.
So, in a nutshell, our performance has been very strong over the past six months. These are unaudited numbers– so treat them carefully – but the fund ex Australia is up 27.9% for the six months to June 30, in a market that’s up 16.3 per cent. That gives you an 11.6% excess return over the benchmark. As a result, over one year, the fund has been up 30.5% in a market that was up 20.5%. So, that’s 10 percentage points excess return.
That’s pretty impressive.
Yes, it’s particularly pleasing that during that period of sizeable underperformance – while the market was digesting the rapid shift in interest rate expectations – we held on to our high conviction stocks. We didn’t change our investment approach or investment philosophy; we stuck to our guns. And those stocks have really come through for us. This, to me, highlights the importance of long-term investing and focusing on businesses that on a 5-10 year basis are well-positioned and will outperform because they’re grossly undervalued in terms of their fundamental potential.
How difficult is to hold your nerve when the market suggests you are getting things wrong?
That’s a good question because it’s not easy. You need the experience of many market cycles. I’ve got 25 years’ experience in financial markets, of which 20 years have been on the buy side and 18 years have been spent managing funds. Some of those funds, as I said earlier, have been high conviction, concentrated funds and there have been periods of very sizable underperformance. So, having experience is the first aspect that helps manage the pressure. If you lack that experience, it can be difficult to cope.
Secondly, you need to have a strong belief that the in-depth fundamental research you are doing is indeed leading you to the right conclusions. At times, that’s not going to be apparent from the performance. But you need to stay focused on your fundamental research and believe that it will lead you to an accurate assessment of whether a stock is undervalued or not.
That said – and this is the third aspect – we are always testing ourselves to ensure that we’re not burying our head in the sand. We are prepared to sanitise the portfolio if we feel there are any inherent biases, such as affinity bias to stocks that we hold, or confirmation bias, or just overconfidence. We need to be able to confidently say that even if the market goes against us, we will be able to outperform the market on a five-year rolling basis. So that’s really the way we are able to hold our nerve. We have experience, we have a strong, structured and consistent investment process, and we are constantly ensuring that the companies in our portfolio will help us through periods of underperformance.
Looking at the stocks you hold, what would your top two stock tips be?
It’s almost a cruel question in a portfolio where all our stocks are high conviction! So maybe instead of giving you two stocks, I’ll give you a stock tip per sector. In technology, we think Nvidia is in a similar position to where ASML was 10 years ago. Its dominance and strong leadership in AI gives it a 5-7 year lead on any competitor. So, we think it remains well-positioned for that long-term structural growth both of semiconductors and of AI.
In luxury goods, we would highlight Moncler (BIT: MONC). It’s a brand that remains very creative, very current and very dynamic in a segment of the market that is also highly dynamic – the younger cohort. It is a brand that is still under-exposed, meaning there is a lot of growth potential. And the Creative Director and CEO have been very careful about managing its inventories so that they don’t discount much. This leads to high returns on invested capital.
In consumer staples, we would highlight L’Oreal (EPA: OR). When you compare L’Oreal’s performance to that of its key competitor, Estee Lauder (NSYE: EL) the difference is stark. Estee Lauder has had two significant profit warnings over the past 12 months, while L’Oreal has had positive upside surprises compared to consensus estimates. That shows you the importance of navigating challenges such as China, where Estee Lauder has had issues. We believe that L’Oreal has demonstrated an ability to be well-positioned; to have good pricing architecture to capture consumers at different price points; and to utilise and leverage its R&D (research and development) to make innovative products to drive demand.
In the auto segment, our pick is Ferrari (BIT: RACE). The pricing power that that company has is staggering. It is able to launch limited edition products at prices of between $1 million-$2 million per unit – and these models sell out before production commences. So, while the mainstream models have some cyclicality attached to them, anytime there is a drop in demand, the company can just start delivering limited edition models to its customers. Production lines continue to be full and because these products cost $1 million-$2 million, revenues are actually enhanced and it’s accretive to the company’s profitability. So, in periods of slowdown or recession, Ferrari can just pull on that lever.
Apart from Nvidia, how exposed are you to AI and what’s your outlook for the market?
We are big holders of Microsoft, which is exposed to AI through CLI (the Azure Command-Line Interface) and its ownership of OpenAI, the author of ChatGPT. We also hold ASML, a leader in semiconductors. And then, arguably, we are exposed to the AI market through Atlas Copco because a quarter of the company’s sales are vacuum technologies, which you need in order to keep semiconductor rooms clean of any dust. These companies have all had very strong tailwinds from the semiconductor supercycle.
As for the AI market, we think there will be an explosion in AI spend by corporates as they realise it is critical to becoming more competitive. There is a lot of anecdotal evidence at the moment that corporates are asking engineers to – quote, unquote – “experiment with AI”. We believe these teams will report back to their executives with recommendations to increase investment in AI. Nvidia is almost uniquely positioned to capture this demand through the competitive advantages it has gained over time, its R&D superiority and its scale. When you look at Nvidia’s Q1 results, which came out in May, it significantly beat expectation for both revenue and profits. The results meant analysts increased their consensus full year revenue estimates by 40% and their full year earnings estimates by 100%.
Do you believe investors are still underestimating the AI market?
Yes, at this stage, we think they are. It’s difficult, it has to be acknowledged, to have a clear view of the take-up or size of the opportunity. For example, when Nvidia presented at an investor event in March 2022, they estimated the market opportunity at US$300 billion. In March this year, they came in and upgraded that estimate to US$1 trillion. That’s more than three times the previous year! What that shows you is how difficult it is to forecast the market, given that it’s a nascent opportunity. But it gives you an idea of how sizeable the market could be.
Are you concerned the theme could become frothy given it’s so difficult to predict the size of the market?
Yes. To put it crudely, Nvidia’s shares went up 25% on the day of its results, plus another 10% in the following 3-4 weeks. So, the stock has gone up 35% on a 100% upgrade in earnings. That actually tells you that the multiple has contracted. So, there will be a healthy debate on whether some of these AI-exposed names are overvalued and whether the theme is frothy. It does highlight the importance of valuation discipline which, for us, is always critical. As I said earlier, we don’t just invest in attractive themes, we invest in attractively priced, attractive themes. The same holds true for stocks. We don’t just invest in stocks that we think are well-positioned and have attractive characteristics. We always go back to them having an attractive valuation. That is the most important thing.
We recently had indications of a slight slowdown in Inflation in the US. Going forward, what do you expect in terms of inflation and interest rates?
We think inflation is going to be stickier and longer lasting than people are expecting. We think there is a risk of inflation turning more structural in the US, where wage inflation has accelerated and the labour market is very tight. Things are starting to ease, which is encouraging, but we still believe it is premature to think about central banks pivoting in the second half of this year. About a month ago, that’s what the market was expecting. In the past few weeks, the market has adjusted its expectations – and we welcome that adjustment. For us, a pivot is not going to happen before sometime in 2024.
As a result, you might have a bit of a healthy bull-bear debate. The bulls will insist that monetary policies are either close to peaking or have peaked already. The bears will focus on the fact that inflation remains elevated, so central banks will continue to hike – and that increases the risk of recession. That debate is valid.
In our outlook for 2023, we did actually highlight that this is a year with the most forecast risk that we’ve seen in a long time. That’s because of all the elevated uncertainties – whether that’s around inflation, monetary policies, the macroeconomic cycle, the corporate earnings cycle, or geopolitics. On the macroeconomic cycle, we have a view, which goes against consensus, that we will avoid a recession in 2023. We put the probability of a recession at 30%- 35%, both for the US and for global markets. Our core scenario – with a probability of 60%- 65% – is one of a sharp slowdown at the US and global level. We believe we can avoid a recession because China has reopened. China is the second largest economy globally so its sudden reopening has contributed supportive momentum to the global economic cycle. Yes, there have been concerns about some of that momentum in China petering out, but we believe that this is partly due to the difficulty of forecasting an economy as huge as China coming out of lockdown. So, we’re still in the camp of no recession.
You’ve spoken about the support that the Chinese economy offers the global economy, but what about China itself? Is it still investable?
Well, that’s where it nicely ties in with the risks I’ve been highlighting, such as monetary policy risks, fiscal policy risks, persistence of inflation, pandemic relapse risk that could disrupt supply chains, regulatory risks and finally geopolitical flare up risks. Indeed, for us, the largest geopolitical risk is related to China, Taiwan and the US. So your question is absolutely valid.
It’s very difficult to quantify that overall risk, especially when there’s such a lack of predictability in China related to regulatory risk. As a result, we’ve been steadily reducing our exposure to direct China. A couple of years ago, we sold out of Alibaba. Last year, we sold out of Tencent. We prefer our exposure to China to be indirect, through the Chinese consumer. Typically about 50% of luxury goods consumption globally comes from the Chinese consumer. We believe there is a good tailwind coming over the next 12-18 months because the Chinese consumer will gradually return to travelling internationally.
So how do you think that’ll play out on markets?
Well, global markets never like uncertainty, especially geopolitical uncertainty. Some commentators are saying that tensions between China and the rest of the world are taking a worrying turning point. We are not taking a strong view on that at this stage. But it’s important to keep an eye on things because these kinds of tensions rattle markets.
You mentioned ESG earlier. Can you tell me how you incorporate ESG into your investment decisions?
ESG is fully integrated into our fundamental research approach. It is carried out by our fundamental analysts. Unlike some other fund managers, where you might have an ESG team that does that, we do the ESG analysis as part of our fundamental assessment.
In Step 2 of our investment process, we assess risks across four areas: industry risks, company risks, ESG risks, and portfolio risks. Behind that ESG risk assessment is a more detailed assessment. We have 52 parameters, which includes things like board management, remuneration and culture; environmental and social risks; whether sustainability is integrated into company targets and ambitions and so on. We also assess each company across five common factors: climate change, cybersecurity, human capital, customer trust and taxation. By doing that, we have a very good understanding of where the governance and sustainability risks lie. That’s where we engage with management, to understand better how they manage those risks, and we aim to drive positive change in those areas.
Finally, you recently joined Future Generation Global as a pro bono fund manager and we’re incredibly grateful for your generosity. Why did you agree to do this?
We feel that we are very much aligned with Future Generation. We like the ethos, we like the focus. For us, governance and sustainability are so important. We believe that when you focus on businesses which are sustainable and which reduce the risk of societal exploitation, you end up with a better outcome. Future Generation is well aligned with that. So we were actually very excited to be asked to pitch for exposure to Future Generation and to have been appointed.
Going forward, we’re looking forward to working together to develop Future Generation and to get the right outcome in terms of alpha and returns for your shareholders. It’s very important that we do that, but at the same time continue our efforts for a more sustainable world.