Global equities: Maybe you can have your cake and eat it
Laura Blows speaks to Colin McQueen, head of global equities at Sanlam FOUR
Colin, you have had a long career in investment management, spanning 20 years. You worked at UBS and Morgan Stanley before coming to Sanlam FOUR in 2010. I’m sure you’ve seen a lot occur in the equities markets during that time. How would you describe the current climate?
I think the current economic climate is particularly murky, at present the outlook is very clouded. On the one hand we have a number of factors that are being a drag on economic growth. China is slowing down after a 20 year investment boom, we see high debt levels around the world, continued austerity in parts of the eurozone and weakness in commodity prices. Unfortunately the list goes on and on.
However on the other side to that we see a relatively normal economic recovery developing in places like the US and UK. There is falling employment and rising consumer confidence, and on top of all of that we have pretty unprecedented levels of monetary stimulus from central banks around the world, which we have never faced before. I think given all of those conditions it’s hard to really predict what is going to happen. You could plausibly argue for quite a wide range of outcomes. That’s why we think one of the strengths of our investment approach is to try to drive our investment strategy with a view that it can cope across all of these different conditions.
Obviously, no company is ever quite immune to the macro economy, but we concentrate on companies that will tend to have limited economic sensitivity and can do better across the wide range of possible outcomes, as opposed to trying to predict what will happen in the immediate future.
I’d be interested to find out more about how you apply this specifically to your Stable Global Equity Fund? I believe it has just had its three-year track record and it did very well, beating its benchmark and its peer group. By why should investors be interested in this going forward?
Fundamentally going forward we think the fund offers an attractive and differentiated investment strategy, particularly for pension funds. We have designed and targeted the strategy to try to deliver active real returns first and foremost. So we target a return level of CPI plus 6 per cent and we try to deliver that with as much reliability and consistency as possible as our first objective. Second behind that we have a resilient portfolio, so we want to be able to protect value and be able to come through tough times intact. The third priority is to take whatever opportunities we can to give ourselves optionality for better returns. We think that sort of risk/reward structure is highly attractive for pension funds. It is probably closer to their liabilities than the traditional equity approach of market returns or market returns plus a bit.
You mentioned about quite a different risk/reward mix, which would be very suitable for pension funds. How is it that you can achieve this risk reward?
Certainly, we do that via a concentrated portfolio, around 25 stocks. We look for all of these companies to meet very exacting criteria in terms of business quality and in terms of valuations. So, on the business quality side we look for companies that can achieve and sustain very high returns on equity over time. We look for consistent cash generation right the way through the economic cycle. We want companies that can compound and grow cash over time rather than see their earnings ride up and down on the rollercoaster with economies. That is why we call the fund the Stable Global Equity Fund. Having said that, we approach that universe of high quality companies with a value investor’s head on. We think it is critical, no matter how good the company, not to overpay for it. You’ll dilute both your returns and you’ll expose yourself to downside risk if valuations become unsustainable. So we typically look to buy companies when they are a little bit out of favour in the market, and we look to buy them when their share prices is discounting really minimal discount growth from here on in.
You highlighted getting value from stocks and the focus is clearly on high-quality stocks. However they have done very well in recent years. Are you not concerned at all that they may still be overvalued?
I think typically when people hear the phrase high quality stocks, most investors’ minds tend to go immediately to consumer staples companies, those like Nestle, like Coca Cola, and whilst for us they tick all the boxes in terms of the quality and sustainability we are looking for, as you point out, the share prices have re-rated, and the valuations have become much harder to justify. So we hold comparatively few of these stocks in our portfolio.
However, we find that if you cast the net a little bit wider you can find similar companies operating in other parts of the market, in areas like healthcare, technology and business services, which have similar characteristics in terms of high returns, the cash generation, and the recurring revenue streams. And so we concentrate our investments more heavily on these parts of the markets.
If you look, on average, the companies in our portfolio have a 28 per cent return on equity at present. Way above the market averages. If we look at what the credit market thinks of them, we do a weighted average of the CDS spreads for the portfolio, which comes to 45 basis points, a similar level to Australian government bonds. So they are getting a big thumbs up in terms of quality.
But despite these quality strengths, the valuation of the portfolio, in price to earnings terms, is actually below market averages. So we’re not paying up to buy those companies. More fundamentally from an absolute valuation perspective we have a free cash yield of 6.5 per cent. If you think about what that translates to, to hit our target returns of CPI plus 6 per cent, all the companies need to do is grow in line with inflation. Whereas historically over the past five years they have grown 6-7 per cent faster than inflation. So we don’t think that’s overvalued by any means.
So how do you find those potential investments and then actually filter them through to your final holdings?
Within our investment process we have a separate idea generation procedure. We rank companies quantitatively on a huge variety of measures, capturing their business strength and valuation characteristics and typically we will look for share prices that may have fallen out of favour. So we look for companies that tick all of those boxes and concentrate our research efforts on those.
We will then seek to understand the medium-term characteristics and strengths of the business model. We want to understand what it is that’s allowed a company to generate higher returns in the past and whether that can carry forward and be sustained into the future.
We typically don’t spend very much time at all trying to outguess the market regarding next quarter’s earnings expectations. It’s incredibly crowded and hard to add value that way. But we use our research into the medium-term business strengths to drive an estimate of the intrinsic value of the company and in turn that intrinsic value drives our buy and sell decisions.
We look for companies that have consistently in the past generated returns on equity into the high twenties, much higher than average. We look for those companies to be in non-cyclical industries that have high recurring revenues and to generate consistent, free cash.
In addition to that criteria we are extremely strict about the valuation levels that we are prepared to pay. So we will typically be buying companies when the share price discounts very little earnings growth into the future and once we start to narrow it down onto that we come to a much shorter list of companies that really fit the bill for us.
Please could you tell me a bit more about Sanlam FOUR itself?
Sanlam FOUR is a boutique investment company. We were founded in 2006, and we currently manage £4.9 billion for investors.
Sanlam is probably not a household name for many people in the UK, but it is one of the largest financial services companies in South Africa. It has a market cap of over £6 billion and a AA-credit rating. It is a very strong, stable parent with financial security and the infrastructure strengths that people are looking for.