Thematic thinking enters mainstream

With private banks and asset managers admitting to difficulties in making money for clients through analysing individual stocks in unpredictable, post-crisis markets, thematic investment ideas are once again enjoying a revival.

Investments based around themes – such as ageing populations, the spending power of rising middle classes in emerging economies and development of sustainable energy sources – have been around since the 1980s, with the UK-arm of Swiss bank Sarasin being one of the pioneers in this area.

But under current conditions, thematic investing is increasingly entering mainstream thinking. Indeed thematic ideas are dominating the mindsets of many wealth managers, admits Alan Higgins, chief investment officer at Coutts private bank in London. “Themes have tended to do a lot better than traditional stock and sector selection,” he says.

“With the current political environment, one minute risk is on and cyclical stocks are doing well, while the next, it is all about defensives, as risk is off. Currently, it is much harder to add value in sectors than to identify key themes.”

CURRENT TRENDS

Of the handful of themes currently favoured by Coutts’ investment staff, one of the newest is “oil renaissance”, which identifies huge surpluses of gas produced by shale oil extraction in the US.

This cheap energy source benefits rail and infrastructure companies and others such as aluminium producer Alcoa, which enjoy large international revenue and typically have a high reliance on energy costs.

For clients in the £1m (€1.2m) asset bracket, these themes can be exploited through the purchase of active and exchange traded funds (ETFs), explains Mr Higgins.

Also included in his thinking are export-led businesses, such as Rolls Royce – deriving 45 per cent of revenue from foreign earnings – which can benefit from growth in emerging economies. There is also a flipside to the emerging markets theme, with Asian currencies expected to strengthen against Western counterparts, leading to inevitable investments in Asian assets.

“Despite what the Chinese authorities say, we still see currency appreciation, not just in China, but in Korea and Indonesia,” says Mr Higgins, referring to recent announcements from Beijing claming the renminbi had at last reached a fair value. “This will lead to a consumer-driven model, which will favour exporters.”

There are different avenues to exploit the emerging markets theme, says Mr Higgins, each with strong advocates. “Is it better to be in Caterpillar or Rolls Royce, which are both exposed to emerging markets, or to invest in emerging markets directly?” he asks. “Last year, it was better to be in the exporters.”

Then there is the ‘competitive advantage’ theme, sourcing products that do not need to drive down their selling price in order to remain competitive in tough times. Mr Higgins cites Visa, McDonalds, Apple and cloud technology leader Citrix Systems as examples. The next theme on the Coutts launchpad is likely to be automation, focusing on companies mechanising to mitigate against fast-rising labour costs.

RISK OF OVERCROWDING

The main risk of the thematic model is that of an increasingly “crowded trade”, believes Mr Higgins, with the Swiss private banks and US players like Merrill Lynch also pursuing this course of investment. “Crowded themes tend to be unprofitable, so we are getting a little bit worried,” he says.

However, there is a notion in the wealth world that “quality stories” are powerful, and that even if they are not going to make as much money as other strategies, they can bring in investors through a strong narrative that is difficult to match with traditional pitches about value and price related to stock selection.

Mr Higgins is happy to address this criticism. “Is the theme just a nice way of expressing a romantic view to our clients? Our view is that the theme is more of an expression of a macro-view rather than just a new way of selling on an idea.”

There is also a feeling among some bankers that themes can potentially be marketed as an alternative asset class, not fully correlated with ‘normal’ equities or bonds.

“You can argue to some limited extent that its correlation might be compared to something like an alternative asset class,” says Mr Higgins.

“It is more stable than the market. But themes come in and out of favour and not all of them can perform. Themes are basically beliefs about stocks, which you can pick up and put in portfolios at the right time.”

Although themes do have some defenders in unexpected places, by no means all private client specialists are so enthusiastic. Adam Wethered, founder of private investment office Lord North Street, believes thematic investing often boils down to a series of concepts which are made easily understandable to people outside the industry, with a danger that “illusionary trends” are created to lure them in.

Yet he points out that some of the most important long-term trends in portfolio investing and finance in general – such as the Brics theme of emerging market growth developed by Jim O’Neill at Goldman Sachs 10 years ago – are based on identification of themes.

Mr O’Neill’s classic theme was based on his analysis of demographic factors, with 86 per cent of the world’s population living in developing countries, responsible for around half of global GDP and just 13 per cent of stockmarket capital.

“Jim showed us that the world’s faster-growing economies are hugely under-represented in what investors are buying,” says Mr Wethered, although the developing economies were also home to fewer companies with good corporate governance, many of which were owned by the state, and displayed significant political risks.

“You need to understand what you are buying,” he warns. “But on the equity side, the whole emerging markets theme has been the single most important development.”

STYLE OVER SUBSTANCE

Other commentators believe themes are more of a marketing invention. “Investment banks all use themes as a selling tool,” suggests James Bevan, head of investments at charity specialists CCLA.

The challenge for an active investment manager is to capture mis-valuations, he says, but this is getting more difficult on a sustainable basis. Themes or trends, on the other hand, based on mis-pricing of a whole area of the market, rather than single stocks, can prove a richer, more sustainable source of return. What the private bank or investment fund needs to do, he says, is to identify the common set of risk factors among a group of thematic stocks.

“Philosophically, it is much easier to build a proposition as to how to identify and exploit value anomalies, than to look with a clean sheet of paper at each investment opportunity,” explains Mr Bevan, adding that some financial and structural themes can be quite compelling. It is the nature and intellectual content of some of these propositions of which he is sceptical, however.

“There is a whole basket of things which people regard as themes, which are more to do with marketing and sales than any hard evidence about what correlates to price and income performance,” he suggests.

One of the worst offenders in thematic investing is the ‘changing demographics’ trend, he believes. “I meet a lot of people who say: ‘we should be concerned about a growing or ageing population and here are six stocks to reflect this trend.’ But if we are to conduct a robust analysis of a stock, we need to look at sales, price, earnings and future growth,” ventures Mr Bevan.

“It is very dangerous to describe a company merely by its exposure to a single factor. I am very suspicious of some of these themes as they don’t correlate well with security selection analysis.”

In the current climate, we are also seeing family offices, which may be sceptical of the thematic approach, allocating increasingly to traditional, bottom-up value managers which select stocks in isolation, largely ignoring over-arching political and macro-economic factors.

“Of all the themes you see out there, trying to work out which will be a major driver of stock prices is incredibly difficult to do,” says Timothy Heffer, who runs international business development for Norwegian fund manager Skagen, which oversees assets worth €14bn. Mr Heffer believes stock selection is a much more straightforward discipline than theme identification.

He talks about macro themes which may influence stock behaviour, an obvious one being the weakness of European countries such as Spain, which may need external financial assistance.

“Predicting how and which Eurozone blow-ups will affect asset prices is increasingly difficult to do. On the other hand, we are just trying to identify which companies are cheap against the market over two, three or five years.”

Jim O’Neill’s Bric theme highlighted how just 13 per cent of stockmarket capital is in emerging markets...

...despite them having 86 per cent of the world’s population and being responsible for around half of global GDP