Better Hold a Handful of Winners than the Market Right Now

Not Out of the Woods on Inflation – and Interest Rates

“The key unknown, and it’s an unknown that even the Federal Reserve has admitted to, is that we don’t know how bad inflation will be. Therefore we don’t know if monetary policy will have to be tightened further,” says Hughes, adding that markets may be forgetting that the world has already gone through an environment of quantitative easing and extremely low interest rates to one where rates have risen somewhat in a heavily indebted world.

“The rule of thumb is that it takes about 18 months for monetary policy to have any impact on inflation. Essentially, the global economy has not yet experienced the impact of tighter money and won’t do so for a while. There is a danger of news flow worsening and that’s being reflected in further market declines,” says Hughes, a 30-year industry veteran who joined GuardCap in 2014 after working for such firms as Trinity Street Asset Management and being responsible for the management of $72 billion in European equity assets for JP Morgan Asset Management, in London.

The BMO fund is replicated in 47 different portfolios managed for institutional and retail investors in Britain, U.S. and Canada. In total, the GuardCap team oversees $17 billion of assets that rely on the concentrated strategy which focuses on a select group of companies and holds them for many years.

Hatches Already Battened

Making market predictions are not something Hughes’s firm spends a lot of time on. Instead, they focus on managing a portfolio that is geared to deal with bear market conditions. “If markets are pricing in a worsening level of economic activity, our strategy performs very strongly in comparison to the market,” says Hughes, noting that the strategy, has not had a negative year since 2008. In contrast, global markets suffered losses in 2011, 2015 and 2018 (in US dollar terms). “We run a strategy expecting bad times. Indeed, we are ready for bad times,” says Hughes, “That doesn’t mean you might miss out on the upside. But historically you have been well-protected against the downside.”

Year-to-date (August 18) BMO Concentrated Global Equity F (which was launched in May 2018) returned -13.29%, versus -11.44% for the Global Equity category. Hughes attributes the lagging short-term performance largely to the fact that markets have been focusing on cyclical companies in which the fund does not invest. On a three-year basis, the fund returned an annualized 8.25% versus 7.61% for the category.

Have Conviction in Your Defense   

In light of the falling share prices in the first half of the year, Hughes notes that the fund managers have not made any tactical shifts and taken advantage of lower stock prices. “We invest in 25 companies which as a whole work well in a bull market but have tended to significantly better when markets are falling. We don’t need to adjust the portfolio in the light of changing market conditions,” says Hughes, noting that the fund’s turnover is 15%. “As a general rule, if your fund manager is reacting to changed market conditions it’s almost certainly too late anyway.”

The last major changes Warren and Boyd executed were in the first quarter of 2021, says Hughes, adding that they reduced or sold holdings that were regarded as less attractively valued and took new positions known for their resilience. These new holdings include Danish food ingredient supplier Christian Hansen Holding A/S (CHR), US-based decision systems support provider Verisk Analytics Inc. (VRSK) and Coloplast A/S (COLO), a Danish medical components supplier.

Long Term Value at Heart

“They are engaged in areas such as the food and medical industries and have strong recurring earnings and revenues and a history of being able to grow even in periods of economic difficulty,” observes Hughes. “And it’s not because our managers predicted a market downturn. It was simply because those companies looked to be better value from a long-term view,” says Hughes, adding that the fund tends to be fully invested at all times and the average holding period for stocks is about nine years.

Given the emphasis on stock-picking, the geographic and sector weightings are a by-product of the stock selection process. Currently, about 62% of the stocks are held in the U.S. and the rest are in international names. From a sector perspective, consumer discretionary is the largest sector at 20%, followed by 17.8% information technology, 16.8% healthcare, 15% consumer staples and 12.3% financial services.

The managers reduce the risk of over-concentration by taking several measures. “We don’t think that where a company is listed matters. What we do worry about is to make sure we are not exposed to any geographical market in terms of where our companies as a whole are doing business,” says Hughes, adding that the team tends to avoid industries such as oil, raw materials and banks because their earnings are hard to predict. “We want to make sure that we don’t get over-exposed to a single market or set of markets. For example, we ensure that no more than 50% of the portfolio’s sales go to the U.S. If it exceeds that then you start to be affected by the US dollar.” He adds that the fund’s standard deviation is 13.4% and below that of the benchmark MSCI World Index, which is 17.6%. “The world index has 1600 companies. Our strategy has only 25 companies and yet it is less risky.”

Recipe for Risk Management and Growth

In scanning the stock universe, the managers seek three main attributes:

First, stocks must be in secular growth industries: “If the economy is doing well, and markets are doing well, you can do well. But if the economy turns down and markets do the same then usually these companies tend to outperform. If every single company in the portfolio is in a secular growth trend that means your portfolio as a whole can perform like the markets, when they are rising, and tend to perform much better when markets are falling.”

The second attribute is a sustainable competitive advantage. In short, it means that the company is an industry leader and benefits from a competitive “moat”, in the form of economies of scale or technological advantages, that puts its ahead of competitors. “This allows you to look into the future of the company and determine its growth rate and market share in five years' time, and do projections on its earnings so that you can value the company.”

The third attribute is quality in the form of a mature business that has low leverage and generates a lot of cash. “These characteristics are always in the portfolio. And they protect you when markets go down.”

Top Stock Picks

By way of example, Hughes cites EssilorLuxottica SA (EL), a French-Italian leading provider of ophthalmic equipment and sunglasses such as the Ray-Ban brand. “The secular trend is an aging population. As you get older, you need new glasses more frequently. The demand for vision correction lenses will keep rising for many years to come,” says Hughes, adding that the firm enjoys a competitive advantage because in 2021 the firm accounted for more R & D expenditure than the rest of the entire industry. “You can’t compete with it because of the quality and range of its products. Because it is expected to grow for many years, the stock is under-valued in relation to its long-term growth,” says Hughes, adding that the firm is capable of delivering returns in excess of 10% a year. The stock, which pays a 1.55% dividend, is trading at 40.5 times earnings, according to consensus estimates.

Another top holding is Novo Nordisk A/S (NOVO), a Danish multi-national pharmaceutical firm that specializes in treatments for diabetes that affects an estimated 450 million people around the world. “Within the sector that seeks solutions for diabetes, the firm has been at the forefront in protein engineering and research for over 90 years so it has some advantages in terms of the quality of its products. It is in the forefront of the next wave of treatments for people who suffer from diabetes and other illnesses,” says Hughes, adding that Novo Nordisk benefits from economies of scale and a deep understanding of the disease. A holding since 2010 in the overall strategy, Hughes estimates that the firm may potentially generate compound earnings per share growth of 12.7% for the next five years. In contrast, the broader equity market is expected to grow only 7% a year.