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Investing in a world that isn’t short of anything


Will Kenney from Royal London Asset Management explains how the investment team distils the global equity universe to identify the 20% of stocks that deliver excess return.


The world is awash with excess capacity and the normal dynamics of supply and demand don’t seem to apply. Since the global finan- cial crisis, central banks have pumped capital into a global economy in which there was already plenty of capacity. In addition, technol- ogy has made it possible to buy goods cheaper and faster than ever before, bringing down returns. As a result, investing capital profitably has become much harder. It’s estimated that the companies in the S&P 500 have as much as $2trn of excess capital on their balance sheets. Even the most cele- brated investor of the past 50 years, Warren Buffett, seems to be struggling. His investment company, Berkshire Hathaway, is sit- ting on more than $120bn of capital and he has had to write down the value of his recent investment in Kraft Heinz. Against this, many new businesses are capital light, often using technology to use existing capital more intensively – think Airbnb and Uber. Instead, capital is chasing returns in lots of places, whether it’s coffee shops or even online mattress retailers. The technology sector is also finding it tough to grow as indicated by the lower-than-expected demand for new iPhones. What’s the solution? As investors, how do we sift through this cap- ital excess to identify the stocks that will outperform? The first thing to note is that stock selection really matters. Looking at MSCI World stock returns between 2014 and 2019, the worst performing 80.2% of stocks performed behind the benchmark, with a third losing value in absolute terms, whereas the best performing 19.8% of stocks represented 99% of the excess return (figure 1).


Figure 1: The importance of stock selection MSCI World stock returns (2014-19)


20% 40% 60% 80% 100%


-40% -20% 0%


1


Best performing 19.8% of stocks


delivered all of the outperformance vs the index


Our investment universe comprises around 6,000 stocks. As fun- damental, bottom-up investors, we need a way to understand the world and categorise companies that isn’t rooted in top-down mac- ro-economics. The broad economic environment will have an effect, of course, but we believe that good companies perform well across the economic cycle. What matters more is how the company is using its capital. Through a proprietary algorithm, our Corporate Life Cycle model categorises companies according to their stage of development. Quantitative analysis helps us to identify potential opportunities by scoring stocks across a range of detailed financial factors. We then apply our scoring system to rank characteristics to identify which companies to conduct further fundamental research into for possi- ble inclusion in the portfolio. The Corporate Life Cycle plots economic returns against required returns (that is to say, cost of capital) and describes a typical corpo- rate journey. It describes five distinct phases: accelerating, com- pounding, slowing & maturing, mature and turnaround. These help us to understand where companies are in their journey and how to analyse them to pick the real winners – and, as importantly, avoid the potential losers. After 10 years of excess capacity and cheap money that followed the global financial crisis, there is too much capital chasing invest- ment returns. Given the stock selection data referenced earlier, we believe passionately that active investment is the best way in invest in global equities. The proof is in the pudding. As our performance record shows, our disciplined bottom-up investment process gives us an edge: we have outperformed our benchmark in 15 of the past 17 years.


Will Kenney is a global equities fund manager at Royal London Asset Management.


Worst performing 80.2%


of stocks collectively had relative return of 0%, and 33% of stocks lost value


201 401 601 801 1001 1201 1401 1601 1801 2001


Number of Stocks Source: RLAM and MSCI as at 28 February 2019


For professional clients only, not suitable for retail investors. The views expressed are the author’s own and do not constitute investment advice or recommendations. Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. For more information concerning the funds or the risks of investing, please refer to the factsheets, Prospectus and Key Investor Information Document (KIID), available via the relevant Fund Price page on www.rlam.co.uk. Issued June 2019 by Royal London Asset Management Limited, registered in England and Wales number 2244297; authorised and regulated by the Financial Conduct Authority. Ref: AL RLAM P1 0003.


Issue 85 | June–July 2019 | portfolio institutional | 31


Total Cumulative Return


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