Investing in the US Part 3

Elisa Trovato: What exposure to US equities do you recommend to clients?

Lance Peltz: We have been overweight equities. We did not time or trade the market to dip earlier this year, which – luck or judgment – was right, but we have actually been selling the US to close the underweight in Europe. That is as much a short-term trade valuation opportunity reduction in risk premium as a longer-term fundamental view.

Stefano Spurio: A lot of investors have used the US dollar and US equity market as a natural hedge this year in their allocation to get out of Europe, for example. We did the same and we continue to do so. We thought that, to get out of Europe, a natural hedge was the US dollar for the currency, for the sustainability, for the homogenous government policy and the quick impact from the decision makers into the economy from QE1, QE2 and QE3 (so unlike what happened in the eurozone). The US is a better and safer place to be in. That was what was probably driving a big chunk of the performance of the US market this year.

Oliver Gregson: If clients have exposure to US equities we recommend they obtain protection, either in buying some out of the money puts, or looking to get some exposure to volatility increasing in the portfolio. The cost (or premium) to buy this hedge is relatively cheap now. Given that it has been a bumpy journey, and we have seen some pretty decent gains on equity markets in that country, we think this is a sensible strategy, especially as I think the future political drivers of volatility remain elevated.

Elisa Trovato: Grant, how do you manage volatility in your equity funds?

Grant Bughman: From our clients’ perspectives, often it is the idea of having your cake and eating it too. They want the high returns from equities but they want to do it with as little risk as possible.  In reality, that is somewhat difficult. We are traditional long-only managers, we are fully invested. We do not have more than 5 per cent cash in our portfolio. We try to manage volatility for our clients by having a disciplined valuation approach, in which we buy different types of complementary business models – what we call classic, elite and cyclical growth.

Cyclical businesses are very closely tied to the economic cycles, so, today, we do not have a lot of exposure to those. We are underweight industrials and financials; we do not own any banks; we are underweight materials. That helps us to mitigate volatility due to macro swings.

In terms of classic growth, companies that have 4-5 per cent revenue growth and slightly higher earnings per share are good businesses that generate a lot of free cash flow, pay dividends and act as a stabiliser. It is a way for us to buy companies when there is noise and when we think the downside is limited, and then, essentially, a barbell with what we think are higher-growth-rate types of companies in a secular industry – for instance, ecommerce – that we think can take share for years.

Lars Kalbrier: What is the rationale behind your decision not to own any bank at all?

Grant Bughman: First of all, for growth managers, banks in general are a small percentage of our index. If you think about the return on equity banks are likely to earn in the next few years, it is exceedingly low and we do not see many drivers for revenue growth in the near future. Net interest margins are coming down, and so traditional lending for banks is not as attractive as it has been historically. In this environment, then, coupled with the fact that Dodd-Frank and the regulatory environment is still very uncertain, it is likely going to be an environment where banks will continue to underperform.

Regional banks are a little different. They are not a main focus of ours because they tend to be smaller in terms of market cap, and we are large-cap managers. You can, however, certainly make the case that regional banks, because of increased mortgage-lending in particular, have some pretty decent prospects in front of them. My comments are about financials in general, particularly larger banks. We own financial-like companies, such as Visa and MasterCard in particular. They do not have any credit risk; they are essentially a toll-taker on commerce. They are excluded from my comments regarding financials because they are included in the technology sector. Technology in the US market is looked at as a core strength of the US economy and it continues to be.

Oliver Gregson: On the banks argument, we have a slightly different view in terms of some of our portfolios.  Maybe we are playing that more as a theme than on a sector basis. For us, someone like Wells Fargo looks quite interesting, with a market-leading position in mortgages, more than a one‑third market share, and some synergies still to be gained from Wachovia.  Looking at the housing theme that we mentioned, that becomes an interesting proxy, especially given the classic way in which homebuilders have rallied so strongly this year. As a result, getting in at these levels is a little challenging. 

Grant Bughman: We do not own any homebuilders. We own one company related to housing, which is Sherwin-Williams, which makes paint. They have a tremendous business model that is vertically integrated. They bought back a third of the company over the last decade in terms of share buybacks. It is a much better way for us to play a housing recovery than banks or homebuilders.

Bill McQuaker: Going back to Grant’s point on volatility, everyone would love to have a nice, safe, high-yielding asset that does not have a volatile price, and it does not exist. The result is that people are having to buy areas of the market, equity and high-yield, to get that yield. They do it uncomfortably in some instances and they stop doing it whenever there is heightened uncertainty about the economic outlook.

For as long as the world’s policymakers and central banks keep this cycle running, however, I think there will be a tendency for people to buy those safe risky assets: dividend-paying equities, or maybe shorter-duration, higher-quality, high-yield bonds. That is what people are drawn to because they cannot get a decent level of income from deposit accounts or from what they perceive to be safe, high-quality government bonds.

Claudia Panseri: The problem is that, when you have safe assets they are expensive, and they get volatile in the case of consolidation as all people are invested in. Think about defensive equities with high yields when the dividend is cut.

Mouhammed Choukeir: The other thing is that stock-pickers have a really tough time. You have a really hard job because, essentially, what we have seen since the crisis broke out is the increase in correlations, not just at the stock level, but at the sector level and at the country level. This year, we can talk about high‑performing versus low-performing regions, but compare that to pre-2007, where you had that divergence and you could be selective to manage your risk and make those kind of allocations. You increasingly have the challenge now of either being risk-on or risk-off.

What we have seen in the past few months is that correlations in equity markets have started to turn a bit lower, but they are still quite elevated. The trend is still quite high and it is very difficult to create alpha or additional returns over and above the US market.

Grant Bughman: Yes, you are absolutely right: correlations have risen. I think that is why, if you look at active management in general, in an environment that has been very difficult, active investors have underperformed broader benchmarks. I think that is mainly because people have thought that this is a normal environment, and correlations will eventually become lower.

What we have tried to do is take advantage of that, because what we know is that this is probably here to stay and, every six months, it seems that our favourite business models are thrown out because of high volatility and high correlations.

As recently as the second quarter, then, the same companies that were up 40 per cent January through March were down 20 per cent, for no reason or change in their fundamentals, but because the perceived level of risk had changed. That is why we have this barbell type of approach in our portfolio, because it allows us to take advantage of the volatility that is presented to us.