Equity markets are slow to price in the implications of change. This creates opportunities for dynamic, style-agnostic investors to take advantage, argue Caroline Galligan and David Cumming.
The coronavirus pandemic has roiled markets, disrupted supply chains and transformed business models. Companies are racing to adapt to shifts in government policy and emerging consumer trends.
In such an unpredictable environment, it has never been more important for investors to understand the nature of change. And yet a growing body of academic research indicates stock markets are slow to incorporate price-relevant information about how change affects companies and the environment in which they operate.1
Our dynamic, change-based investment philosophy aims to exploit the resulting inefficiencies by freeing our fund managers to actively select stocks from a broad range of opportunities, supported by a global research model that is set up to capture insights about the effects of change across regions, industries and sectors. In this paper, we delve a little deeper into the key elements of our approach.
Bias and inattention
Start with the inefficiencies. There are three main reasons markets are slow to react to change. The first is a psychological bias known as “anchoring”. Behavioural economists have observed that investors tend to anchor their view of a company based on its historic performance. This can leave them slow to recognise scenarios in which the future promises to be unequal to the past – a breakthrough innovation or management change at a company can transform its prospects.
Investors often prefer to wait until the dust settles rather than engage with the dynamics of the situation as it unfolds
Second, human beings are naturally averse to uncertainty. Because uncertainty is psychologically uncomfortable, investors often prefer to wait until the dust settles rather than engage with the dynamics of the situation as it unfolds. As the economists John Kay and Mervyn King wrote in their recent book Radical Uncertainty, investors commonly restrict themselves to their “comfort zone…by trying to limit themselves to a small, stationary world”.2
Third, investors can be bound by analytical constraints. Research shows many equity fund managers are prone to what’s known in financial economics as “inattention”: they fail to notice developments that do not appear immediately and directly relevant to the narrow range of stocks they monitor.3 This inattention is compounded when investors work in teams that are strictly siloed by asset class or sector.
Investing based on a single-style bias, such as growth, quality or momentum, can further restrict the focus of attention. Investors who limit their approach in this way are unlikely to devote resources to in-depth research on companies that fall outside of their style bucket, leaving them ill-equipped to understand the implications of dynamics that affect multiple industries at the same time. This also restricts their ability to switch out of their chosen style bucket if that style becomes overpriced.
Investing on the right side of change
Our style-agnostic approach allows us to cover a broad range of companies to identify price-relevant changes that are being missed by the market, informed by a globally connected research model that shares granular analysis across regional, sectoral and asset-class teams. This provides a view of how the changes we identify will affect other companies along the value chain and across the market-cap spectrum.
Our global sector specialists focus their analysis on two categories of change: internal change and external change
When we use the word “change”, we refer to a set of concrete and quantifiable dynamics affecting companies. Our global sector specialists focus their analysis on two categories of change: Internal change, which includes management change, new product innovation, a new market entry, corporate restructuring or a shift in capital allocation; and external change, which includes changes in the competitive environment, consumer behaviour, new regulation, or technological progress in the industry. Using this framework as a qualitative guide, we can orient our research towards finding companies undergoing change, and, more specifically, cases where the effects are being mispriced.
Mispricing can work in both directions. A company may be either a mispriced beneficiary or casualty of a particular change. Perhaps the market has overestimated the advantages Tesla will gain from the societal shift towards electric vehicles (EVs). Perhaps it has underestimated the adaptability of traditional automakers such as Volkswagen. Or perhaps it has entirely overlooked a potential beneficiary in a different part of the world or another part of the value chain, such as a mid-cap Korean company that specialises in making components for batteries used in EVs.
Once we have identified a salient change, we examine the implications for the share price in a peer-reviewed research note. This piece of analysis zeroes in on the fundamental indicators, sentiment factors and valuation metrics that drive the company’s share price and seeks to quantify how these will be affected by the internal or external change. We compare our view with that of the wider market, based on both sell-side forecasts and the buy-side consensus (as inferred from valuation multiples). If the company is already being given the benefit of the doubt by broker analysts, or by investors willing to pay generous valuation multiples, we are likely to conclude that we don’t have a non-consensus view and move on to other opportunities.
We corroborate the change thesis by leveraging our research to gain a holistic view of the company’s prospects
If the idea is taken forward, we corroborate the change thesis by leveraging our research to gain a holistic view of the company’s prospects. Through in-depth analysis of the firm’s peers, suppliers and customers, we aim to confirm or disprove the thesis and investigate the wider market implications.
We also conduct a robust risk assessment with a focus on business, macro, regulatory and environmental, social and governance (ESG) hazards. For example, we are currently undertaking detailed analysis of the supply chains of Brazilian protein companies to assess their role in the growing problem of illegal deforestation.
We pay special attention to context-specific financial factors relevant to the company’s exposure to the change we have identified. For instance, we may take the view that a particular airline stands to gain from an uptick in tourism once international travel resumes in the wake of the coronavirus pandemic – but if the company has a weak balance sheet, it may not survive long enough to reap the benefits.
One key advantage of investing in this style-agnostic fashion, searching for stocks where the implications of change are being overlooked by the market consensus, is that it enables us to improve the diversification of our portfolios and generate returns without relying on the success of a certain factor.
Note that some of the change-driven stocks we select may fit into what is generally known as a “growth” bracket, such as companies that stand to gain from a new technological innovation. Others, such as firms undergoing management changes that promise to yield improvements in efficiency or corporate governance, would fall under the “value” spectrum or would not fit neatly into any style category at all. At a time when global stock-market indices are being driven by the outperformance of a small clutch of growth-focused tech companies, this approach helps us build balanced portfolios with a range of performance drivers.
Our bottom-up research is directed towards discovering companies whose shares will be influenced by change in specific ways that the market doesn’t fully appreciate
Note also that this process is not “thematic” in the usual sense of the word. We do not start with a top-down idea and then put together a basket of stocks that stand to gain from the trend. Rather, our bottom-up research is directed towards discovering companies whose shares will be influenced by change in specific ways that the market doesn’t fully appreciate.
Consider an example. The rising demand for renewable energy is no secret; there is a powerful environmental and social case to increase the proportion of the energy mix derived from wind, solar and hydropower as part of societies’ wider decarbonisation efforts. What is less widely acknowledged are the positive implications for sub-industries such as electricity transmission and distribution. These implications emerged from our granular analysis of firms involved in these areas.
Shifting the power-generation mix away from large, single-unit power stations towards renewables necessitates a more-distributed network, because renewable facilities such as wind turbines tend to be located offshore or on rural hillsides, far away from the cities that account for most energy consumption. This means more transmission cables will be required in the network, along with batteries and gas-fired engines to plug the occasional gaps in an intermittent supply.
We identified an Italian manufacturer of high-voltage electric cables as a clear beneficiary of this ongoing shift in demand. This idea went against the consensus, as indicated by the stock’s relatively low forward price-to-earnings ratio at the time, which we were confident would see subsequent re-rating as the benefits of the change become better understood. Before investing, we tested our thesis through meetings with the company’s suppliers, competitors, customers and industry peers, which bolstered our view that the change was material, sustainable and mispriced.
History doesn’t repeat – but it rhymes
By applying our change-focused approach in a rigorous and disciplined way across different markets and sectors, we can identify recurring patterns of change in new contexts. Change never happens precisely the same way twice, but by drawing on our experience of these patterns to inform our analysis, we can further refine our ideas and quickly home in on new opportunities.
We have observed that highly competitive industries sometimes undergo a process known as oligopolisation
For example, we have observed that highly competitive industries sometimes undergo a process known as oligopolisation, whereby a single company or small group of companies emerge as dominant while retaining the strong price discipline they were forced to adopt early on to muscle out their rivals. This dynamic has been evident in trade finance in the Asia-Pacific region, where Standard Chartered and HSBC have effectively emerged as a duopoly over the last decade, and, more recently, in the US airlines industry. A similar pattern now looks to be playing out in the global semiconductor industry, with positive implications for the leading firms.
Another example is what we call the “back book versus front book” dynamic. Investors are traditionally slow to notice cases where a troubled company starts to develop a new, more profitable, business line. This was evident in the wake of the global financial crisis, where the market continued to punish banks long after they had started to clean up their balance sheets and land profitable new business.
A similar pattern now appears to be playing out in India, where the multinational conglomerate Reliance Industries is productively shifting its capital allocation away from petrochemicals towards more profitable, high-growth businesses, such as e-commerce and telecommunications. The market has yet to fully price in the positive implications of this transition, suggesting investors are anchoring their view of the company on its involvement in threatened industries such as oil refining and overlooking its efforts to refocus on more-sustainable business lines. The market also seems to have missed other pertinent internal changes within the business, including substantial improvements in management quality.
ESG-related changes are often pivotal to the long-term success of a company
As this example suggests, ESG-related changes are often pivotal to the long-term success of a company. Consequently, our change-based approach goes hand-in-hand with our market-leading, cross-sector ESG expertise. Our capability in this area yields valuable insights as to the impact of ESG-related changes, from the potential of new green technology to the upside potential occasioned by improvements in corporate governance. As active investors, we exert our influence to ensure the companies we own are on the right side of these important shifts.
Testing the thesis
Change-based investing is not an exact science, and the changes we identify will not always play out as anticipated. This is why we have a robust process in place for reviewing and challenging each idea, based on three tests:
- Is the investment case realised?
- Is the investment case invalidated?
- Has the investment case been overwhelmed by exogenous risk factors?
These challenges to the case are routinely and rigorously applied at our periodic sector reviews and ongoing event-driven investment forums. Perhaps the market has belatedly caught on to the change we identified, meaning it is no longer runs counter to the consensus; perhaps the change did not pan out as expected; or perhaps an unforeseen external development introduces new and unacceptable risks.
We identify stocks that stand to benefit from the dynamics that remake and reshape markets and the wider world
Adopting this rigorous and value-disciplined approach gives us the confidence that we are continuing to identify stocks that stand to benefit from the dynamics that remake and reshape markets and the wider world. In doing so, we can build truly balanced and diversified portfolios. Too many investors shy away from change; we embrace it.