insightpaper
THEMATIC INVESTING
Applications for alpha
This is the second paper in our series on thematic
investing. In the first paper we looked at some of
the limitations of investing in benchmarks, and
discussed why a thematic approach to creating an
investment universe may be better suited to some
investors.
In this paper, we describe how thematic investing
may be applied to help meet long-term investment
objectives. In a returns constrained world, there
is no doubt that generating alpha is to become
increasingly valuable as individuals and corporations
strive to meet their funding needs for retirement. We
outline how thematic investing may provide one of
the solutions to help meet this challenge.
NOVEMBER 2014
IN THIS PAPER WE DISCUSS…
>> How the market typically undervalues secular growth.
>> How the market frequently fails to give due
recognition to attractively valued quality companies
and management teams that can use that growth
opportunity and create additional value.
>> By combining these two opportunities, investors
may be able to generate higher risk adjusted
returns through the cycle with lower beta and lower
correlation than most traditional strategies managed
relative to a benchmark.
ANDY GARDNER
Fundamental Equities
About the author
Andy joined AMP Capital in February 2012 as a Portfolio Manager/
Analyst within the Fundamental Equities team, and has more than
12 years’ investment experience in Europe and Asia Pacific as a
senior buy and sell side equity analyst and strategist. Andy holds
a Bachelor of Science in Economics (first class honours) from Kings
College London, and is a CFA charterholder.
LIVING IN A RETURNS CONSTRAINED WORLD
The predicted outcome from our strategic asset allocation (SAA)
process is that, unfortunately, the medium-term return for most
asset classes is likely to be constrained. To explain why, Dr Shane
Oliver, Head of Investment Strategy and Chief Economist at AMP
Capital, wrote a paper describing one of the methodologies he
and his team use to estimate the future returns from an asset
class (The medium term return potential for major assets - still
constrained; 6 August 2014).
For equities, Dr Oliver finds that a simple model of adding dividend
yield to trend nominal gross domestic product (GDP) growth has
done well at predicting equity returns for over 100 years. GDP is
used as a proxy for earnings and capital growth.
From the perspective of an equity investor, Dr Oliver’s framework
has a number of attractions because it is simple and intuitive, has
a good long-term track record, and exemplifies how the two main
components of stock analysis interact: the top-down (economic
growth) with the bottom-up (valuation).
As you can see from the left-hand chart (on the next page), longterm equity returns in the US have declined from nearly 20% in
the early 1990s and are likely to head back towards 5% over the
next 10 years. Using the same methodology for global equities, he
predicts a return slowing to around 7-8%. These will be the lowest
projected rates of return for equities seen since the early 1970s and
1940s. As such, they present huge challenges for the current and
next generation of retirees.
TOP-DOWN
BOTTOM-UP
Trend nominal
GDP growth
Dividend yield
Long-term
equity market
returns
1
US EQUITIES:
GLOBAL EQUITIES:
Projected returns falling to around 5-6%
Projected returns falling to around 7-8%
25
25
10 yr trailing
equity return
Percent, pa
20
20
15
15
10
10
5
5
0
-5
1920
0
Projected return = dividend yld +
growth, advanced 10 years
1930
1940
1950
1960
1970
1980
1990
2000
2010
2020
10 yr trailing equity
return
Percent, pa
Projected return = dividend yld +
growth, advanced 10 years
-5
1930
1940
1950
1960
1970
1980
1990
2000
2010
2020
2030
Source: Thomson Reuters, Global Financial Data, Credit Suisse Quantitative Research, AMP Capital.
MEETING THE CHALLENGE BY APPLYING THEMATIC INVESTING
In a returns constrained world, generating alpha is to become increasingly valuable as individuals and corporations strive to meet their
funding needs for retirement. We believe that thematic investment may be part of the solution.
To better understand how thematic investing can be applied, we first need to break down Dr Oliver’s model into its two component parts,
the ‘top-down’ and the ‘bottom-up’. We can then use a four-step process to create an optimised model that helps us to generate improved
risk adjusted returns, or alpha.
1
TOP-DOWN
Identify secular themes which
grow at multiples faster than trend
nominal GDP growth.
TOP-DOWN
BOTTOM-UP
4
Trend nominal
GDP growth
Dividend yield
Long-term
equity market
returns
2
BOTTOM-UP
When managing a portflio for
alpha, it is equally important to
focus on the risk as well as the
reward, and to protect capital.
3
TOP-DOWN
Group stocks which are highly
exposed to those themes to
create an investment universe.
BOTTOM-UP
Select quality companies from that
universe which offer attractive value
and growth attributes to create a
concentrated portfolio
TOP-DOWN
Secular themes
2
BOTTOM-UP
Quality stocks
Capital
protection
Long-term
equity alpha
TOP-DOWN: STEPS 1 AND 2
Identify secular themes and create an investment universe of stocks
>> Examples of our preferred themes (which exhibit high exposure
to our five secular investment drivers) that we believe provide
some of the best opportunities for investors over the long-term:
education; energy revolution; ageing demographics; obesity,
health and wellness; technology change; and urbanisation.
In our first paper we explored:
>> How most benchmarks are capitalisation weighted and arbitrarily
constructed. This can create limitations for generating alpha.
>> Why an alternative approach to filtering for investment
opportunities may be to identify stocks which are highly exposed
to secular investment drivers (demographics, productivity,
environmental, social and governance).
Application
To approximate for the high long-term growth rates that our
portfolio of secular themes should exhibit, we carried out a simple
process. Firstly, we identified a varied selection of sectors over
different time periods which demonstrated very high 10 year
revenue growth. Consumer Staples (revenue grew 190% from
1999-2009); Healthcare (revenue grew 380% from 1992-2002);
Energy (revenue grew 580% from 1998-2008); Telecoms (revenue
grew 270% from 1993-2003); Financials (revenue grew 240%
from 1997-2007). We then combined these five sectors to create a
hypothetical thematic portfolio.
>> How secular changes in demographics and productivity can create
huge long-term opportunities and challenges.
>> The ‘reward’ to an investor lies in being able to identify which
specific companies will benefit most by taking advantage of the
opportunity or providing a solution to the challenge.
>> Why thematic investing is well suited to investors seeking exposure
to an international portfolio of stocks, and those with a longer-term
time horizon. It may provide an alternative solution for investors
currently seeking growth through emerging markets and small caps.
Hypothetical thematic portfolio
12
Cumulative Performance
1. THEMATIC SELECTION ALPHA
10
Sectors which experienced sustained periods of
revenue growth outperformed the market over the
medium to long term
8
> Secular growth is under valued by the market
6
MSCI
World AC
4
2
0
0
12
24
36
48
60
72
84
Time (months)
Sector
MSCI AC World
96
108
120
Total Return
89%
341%
Annual Return
6.5%
15.8%
Annual Vol
6.7%
7.6%
Sharpe Ratio
0.97
2.08
Annual Active Return
9.1%
Annual Active Risk
5.2%
Information Ratio
Correlation
Source: Macquarie Quantitative Research, AMP Capital.
Sector
Beta
1.75
76.0%
0.8
Thematic selection alpha
The results show that sectors which experienced sustained periods
of revenue growth outperformed the market over the medium to
long-term. Annual returns were more than double the benchmark
(MSCI World All Countries). Furthermore, by investing in a diversified
mix of themes which are unrelated to each other (e.g. energy and
telecoms), the process can deliver a lower beta (~0.8x) and lower
correlation (76%) than most traditional strategies managed relative
to a benchmark. Whilst there is marginally higher annualised
volatility than the benchmark (7.6% versus 6.7%) this is more than
compensated for by the annualised return (15.8% versus 6.5%),
which when combined delivers a much improved Sharpe ratio (2.08x
versus 0.97x) and high information ratio (1.75). The average number
of stocks held in the hypothetical thematic portfolio was 149 versus
2,200 for the MSCI World All Countries index.
The results provide evidence to support our theory that the market
typically undervalues secular growth. This is because the market’s
attention is mostly focused on short-term cyclical economic data
and beating a benchmark. Humans also exhibit a general tendency
to underestimate long-term impacts and overestimate short-term
impacts on asset markets and economies. Hence, we have found
that the market typically undercapitalises secular growth by not
focusing on the power of compounding at rates in excess of the
average over the medium to long-term.
3
BOTTOM-UP: STEP 3
Select quality companies which offer attractive value and growth attributes to create a concentrated portfolio
We also believe there is the ability for some companies to use that growth opportunity and generate additional value. At the same time,
some companies can destroy value by overinvesting typically when management has poor capital discipline. So, how do we go about
choosing the best companies from our investment universe of stocks? We can screen our universe to search for attractive growth and value
factors before applying fundamental analysis to assess the sustainability of those factors.
Hypothetical thematic portfolio
12
Cumulative Performance
10
1. THEMATIC SELECTION ALPHA
Sectors which experienced sustained periods of
revenue growth outperformed the market over the
medium to long term
8
6
> Secular growth is under valued by the market
2. STOCK SELECTION ALPHA
4
Stocks which ranked highest for earnings, FCF, and
dividend yields performed consistently well in all
sectors and time periods
2
0
0
12
36
24
60
48
72
84
96
108
120
> Opportunities in combining value and quality attributes and management teams that can use that
growth opportunity and create additional value on
top through return on capital and return of capital
Time (months)
ROIC
FCF Yield
Dividend Yield
MSCI
World AC
Sector
Sector
ROIC
Earnings Yield
Earnings
Yield
MSCI AC World
Dividend FCF
Yield
Yield
OUTCOME
HIGH SHARPE & INFORMATION RATIOS
Total Return
89%
341%
392%
633%
876%
615%
LOW CORRELATION
Annual Return
6.5%
15.8%
17.1%
21.8%
25.3%
21.5%
LOW BETA
Annual Vol
6.7%
7.6%
8.3%
10.3%
9.3%
8.2%
Sharpe Ratio
0.97
2.08
2.06
2.13
2.71
2.62
Annual Active Return
9.1%
10.6%
15.6%
18.0%
14.4%
Annual Active Risk
5.2%
6.7%
8.2%
7.4%
6.8%
Information Ratio
1.75
1.58
1.90
2.45
2.11
76.0%
63.8%
61.1%
63.8%
63.7%
0.8
0.8
0.9
0.8
0.8
Correlation
Beta
Source: Macquarie Quantitative Research, AMP Capital.
Stock selection alpha
The results show that companies that ranked highly on free
cashflow yield, dividend yield, and earnings yield factors performed
consistently well in all sectors and all time periods. Annual returns
were more than three times the benchmark (MSCI World All
Countries index). The average number of stocks held in our factor
tests was only 30, versus 149 in our first test and versus 2,200
for the MSCI World All Countries index. This added concentration
reduced the correlation to the index to less than 65%, whilst
maintaining a low beta of around ~0.85x.
While our factor portfolios exhibited slightly higher annualised
volatility than the benchmark (8-10% versus 6.7%) this is more
than compensated for by the annualised return (over 20% versus
6.5%), which when combined delivers a high Sharpe ratio (~2.5x
versus 0.97x), and higher information ratio (1.90-2.45).
The results provide evidence to support our theory that companies
which can generate high and sustainable earnings, cashflow,
dividends yields and re-invest above their cost of capital for many
years will be able to deliver strong investment performance over
the medium to long-term. Like with our secular growth themes,
the market may undervalue the power of compounding – in this
case, the power of compounding return on capital (e.g. high and
sustainable earnings and free cashflow yield) and return of capital
(e.g. high and sustainable dividend yield).
The hidden power of thematic investing is that it capitalises on
the key advantage of equities - their time horizon. In the third
paper in our ‘Thematic investing’ series we outline why alpha is
more obtainable when investing over the medium to long-term,
and explain the best bottom-up factors to use in order to capture
it. These include the importance of valuation, particularly when
combined with quality, capital discipline, and dividends.
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BOTTOM-UP: STEP 4
Protect your portfolio
In the same way we use certain factors to help inform our
buy decisions, we can also use them to guide us when to sell.
Protecting capital against downside risks is just as important as
identifying the upside. For example, if your portfolio of $100 falls
by 50% to $50, it would need to rise by 100% just to get back to
where you started. Investors can look to protect their investments
in three ways:
1.Use value as a guide. Stocks exposed to secular investment
drivers will have high growth prospects, but investors should not
buy at any price. James Montier at GMO fleshes this out in great
detail in his golden rule of investing1, “No asset (or strategy) is
so good that you should invest irrespective of the price paid”.
Similarly, if a stock becomes expensive, investors should sell. A
disciplined approach to valuation provides a counterbalancing
mechanism for how short-term market fluctuations can
negatively affect the forecasted investment returns of our
secular themes. Similarly, we have found that occasionally
themes can become overhyped, pushing valuations to dizzy
heights. A value approach provides sell discipline, and enables
investors to take advantage of contrarian opportunities - or
as Warren Buffet wisely espoused “be fearful when others are
greedy and greedy when others are fearful”. Whilst mentioning
Buffett, we should at this point state that we also consider
ourselves style agnostic and that we consider both growth and
value to represent two sides of the same coin.
“Most analysts feel they must choose between two
approaches customarily thought to be in opposition:
‘value’ and ‘growth’. Indeed, many investment
professionals see any mixing of the two terms as a
form of intellectual cross-dressing. In our opinion,
the two approaches are joined at the hip. Growth is
always a component in the calculation of value.”
~Warren Buffett
1 James Montier “No Silver Bullets in Investing” December 2013
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2.Identify and protect against negatively impacted sectors. Once
a new secular theme is underway, it can be very disruptive to
the status quo. Recent examples include how online classifieds
(such as carsales.com and seek.com) have superseded traditional
advertising channels and the bricks-and-mortar travel industry,
or how mobile phones have displaced landlines. Therefore,
professional investors may look to protect their portfolio by
taking a short position in negatively impacted sectors via an
ETF, a basket of stocks, or even single stocks where gross capital
misallocation (typically overinvestment) has occurred.
3.Financial cycles are here to stay. No matter how defensive your
stock portfolio is, your wealth is always at risk of being exposed
to financial cycles. Our research suggests that these occur in a
secular fashion and their amplitudes are becoming greater as
the global economy becomes ever more reliant on credit and
asset prices to drive growth. At AMP Capital we use the insights
of our Macro Markets team (led by Ilan Dekell) and Dynamic
Markets team (led by Nader Naeimi) to identify when financial
risks are building, and invest in products that should help protect
capital. These may simply include the ability to hold high cash
balances or near cash proxies such as high quality bonds or gold.
The financial and business cycle in the US
20%
a
Banking
strains
15%
10%
Financial crisis
iFirst oil crisis
Dotcom crash
5%
0%
-5%
Second oil
d
crisis
Black Monday
-10%
-15%
1970
1980
Financial Cycle
1990
2000
Business Cycle
2010
2020
Recessions
Source: Bank International Settlements, Credit Suisse Quantitative Research, AMP Capital.
KEY TAKE-AWAYS
>> We began by using Dr Shane Oliver’s model for predicting future
equity market returns, and explained that by breaking his
model down into its component parts, we are able to propose
enhancements which may help increase chances of delivering
superior investment performance over the long-term.
>> While the global economy is looking better than it has for years,
relatively low investment returns from most major asset classes
mean the medium-term return outlook remains constrained
compared to the long-term bull market in equities and bonds
that started in the 1980s. In a world where returns are becoming
increasingly scarce, investors may look to identify themes which
will grow at rates many times faster than GDP. They may do this
by considering their exposure to five secular investment drivers:
demographics, productivity, environmental, social, governance.
We believe the following themes (which exhibit high exposure
to our five secular investment drivers) provide some of the
best opportunities for investors over the long-term: education;
energy revolution; ageing demographics; obesity, health and
wellness; technology change; and urbanisation.
>> While many themes are already playing out in the market, the
market’s attention is mostly focused on short-term cyclical
economic data and beating a benchmark. Humans exhibit
a general tendency to underestimate long-term impacts
and overestimate short-term impacts on asset markets and
economies. We have, therefore, found that the market typically
undervalues secular growth by not focusing on the power of
compounding growth at rates in excess of the average over the
long-term.
>> The market also fails to give due recognition to those companies
that can use that growth opportunity and create additional
value by generating high returns and continue re-investing those
returns above their cost of capital for many years.
>> These are the two major opportunities for investors with a
longer-term horizon. By taking advantage of these opportunities,
investors may be able to generate higher risk adjusted returns
through the cycle with lower beta and lower correlation than
most traditional strategies managed relative to a benchmark.
>> Finally, investors should consider ways to protect their capital
against the risks of permanent capital loss by avoiding expensive
stocks, decaying trends, and secular financial cycles.
Contact us
If you would like to know more about how AMP Capital can help you, please visit ampcapital.com
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warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This
document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor
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