A justified approach?

Investing offshore for sustained quality returns

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Selecting an offshore equity manager is daunting and the apparent simplicity of a passive strategy often seduces investors. Getting broad exposure to difficult-to-outperform global equity indices at low cost is often used to justify the allocation. We argue that a long-term active approach, with low portfolio turnover to minimise transaction costs, has clear benefits for investors.

A 2014 paper by Cremers & Pareek, entitled ‘Patient Capital Outperformance’ sets this out compellingly. Their analysis of retail and institutional equity fund performance in the US between 1986 and 2013 revealed that only those active managers who trade infrequently outperform indices on average. According to their results, stocks held by patient, active institutions outperform by 2.2% p.a., with outperformance driven by ‘picking safe, value and quality stocks and holding on to those over relatively long periods.’

Long-term active investing has wider benefits as well.

As Andrew Haldane, Executive Director of Financial Stability at the Bank of England, argued in his speech on ‘The Age of Asset Management?’ in 2014, shorter-term mandates and passive investing have been proven to increase asset correlations and amplify pro-cyclical swings, reducing risk-taking detrimentally.

The perpetual nature of equity should make it an ideal source of long-term financing to households, companies and governments. When executed effectively, a long-term active approach can play a key stabilising, counter-cyclical role in stressed economic and market conditions. In other words, long-term active investment can be beneficial not just for shareholders, but for the wider economy and society as well.

For South African investors, the selection of an appropriate actively managed global equity strategy is crucial. We are a small, cyclical emerging market largely dependent on exporting commodities, which in turn rely on the strength of global economic growth cycles. It is imperative to use your offshore investment to complement your domestic assets and elevate risk-adjusted returns.

The benefits of a quality approach

In assessing the ability of active quality investing to deliver long-term sustainable returns, we have studied how companies with a high return on invested capital (ROIC) mean revert. We found quality companies are not only more profitable, generating a higher ROIC, but are also less prone to mean reversion (a downward move towards the long-term average, with negative consequences for share prices) or a decay (a long-term fall) in those returns over time. These companies typically utilise capital-light business models, and have enduring competitive advantages, in the form of intangible assets such as brands, copyrights, licences and distribution networks.

These competitive advantages create barriers to entry that protect quality companies from competitive threats and are typically found in the consumer staples, health care and technology sectors. Crucially, the local domestic equity market provides investors with limited exposure to these quality sectors. Our research shows that investing in companies with sustainable top quartile ROIC is most likely to deliver strong long-term shareholder returns. Over the analysis period, 58% of companies that started with top quartile ROIC were able to maintain that over a rolling five-year period. These quality companies delivered outperformance of 5.4% p.a. on average versus the market.

The importance of in-depth active research

Whilst the quantitative analysis shows that a quality approach works, active qualitative research is essential to fully assess the sustainability of a company’s business model and competitive advantage, and therefore a company’s ability to sustain a high ROIC.

A few headline quality metrics provide misleading results. These commonplace metrics may not necessarily show, for example, how strong a company’s competitive positioning and market share actually is, the impact of short-term currency movements, a firm’s dependence on the economic cycle, relationships with key stakeholders, or business tail risks such as regulatory risk or over-reliance on a single product or market.

Aggressive accounting and financial engineering can distort earnings-based metrics, giving a false picture of the actual health of a company, and even fairly reported figures can be misleading. For example, high margins may reflect under-investment rather than pricing power or cost efficiency.

Overall, different levels of disclosure, accounting treatments and calculation methodologies, as well as corporate activity leading to one-off gains or losses, all make cross-company comparisons difficult using solely a passive or quantitative based approach. An active approach also benefits from engagement with company management. Engagement helps to assess, and raise if appropriate, governance issues such as risk management, board balance, audit, remuneration and the rights of shareholders and other key stakeholders.

As well as ensuring that capital allocation is fully aligned with stakeholders’ long-term interests, it can also provide deeper insight into a company’s suppliers, customers and competitors, which in turn can help to generate new investment ideas. While a passive global equity strategy might be the easiest solution, investors need to approach their offshore allocation with care.

Clyde Rossouw and Neil Finlay, Investec Asset Management

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