Positioning a portfolio for today’s market conditions
Brad Kinkelaar is Senior Managing Director and Lead Portfolio Manager for the Barrow Hanley Global Share Fund. Barrow Hanley Global Investors was founded in 1979 in Dallas, USA, and is now part of Perpetual Asset Management International.
Q: In the last two years, your Global Share Fund is well ahead of its benchmark. What have been the big calls and what are the major themes for the future?
BK: Value stocks have seen a resurgence in outperformance this year-to-date on the back of multiple compressions in the higher growth areas of the market, and it’s important for managers to perform in line with their style as part of a client’s broader asset allocation.
We would not attribute this performance to ‘big calls,’ as our process looks to find dislocations in the market through a bottom-up, fundamental process. Our holdings in the Industrials and Consumer Discretionary sectors have been strong contributors but for different reasons. Within Industrials, we saw European defence companies offering compelling valuations post the strong run up in cyclical stocks in the latter half of 2020 and early 2021. These stocks have done well on the back of markets that have shunned cyclical stocks. They’ve also benefitted from the Ukraine war causing European governments to recommit to their defence spending targets and even pull those forward.
Within Consumer Discretionary, it has been a mix where during the Covid-19 crisis cyclical stocks came under meaningful pressure. Further, our underweight to the Financials, Consumer Staples, and Industrials sectors, combined with an underweight to the Information Technology and Communication Services sectors, were further sources of positive relative returns.
Although we do not invest on a thematic basis, the portfolio is broadly tilted more towards defensive and compounding stocks versus cyclical stocks. Defensive stocks have held up well, but we are starting to see more cyclical opportunities. The Fund is overweight the Consumer Staples, Industrials, and Materials sectors, with a large underweight to the Information Technology sector.
Q: You look to exploit market inefficiencies and find mispriced companies. Why do these discounts occur?
BK: Markets will tend to trade on short-term news and extrapolate that information into the future, whether positive or negative. For a patient long-term investor, this will always provide opportunities to exploit short-term inefficiencies. Our process takes us to areas of the markets where there are controversies, such as missed earnings, supply chain disruptions, changing macro environment, management missteps, etc. But if we can see a resolution to these controversies over the next three to five years, this allows us to buy companies that are trading at a meaningful discount to our estimate of intrinsic value.
Q: As a value investor and stock picker, to what extent do major macro themes play into your company investment decisions?
BK: Our investment process is macro aware but not macro driven. We are cognisant of broader macro indicators such as changes in currency rates, PMIs, unemployment rates, interest rates, etc., and will take these factors into account as part of our portfolio construction process and, just as importantly, as part of our bottom-up, fundamental company analysis. We regularly review our investment screens, which tend to act as indicators of dislocations in the market.
Q: Do you expect to hold some of the stocks in your portfolio for say 10 years?
BK: Where we see a company continuing to compound value greater than what the market is willing to account for, we will be long-term holders. We would expect this to occur more often in the more stable areas of the market such as the Utilities, Health Care, or Consumer Staples sectors. However, we sometimes see this in the more cyclical areas of the market such as Energy. If the company we own continues to compound its earnings power without a commensurate re-rating of the valuation by the market in recognizing that higher earnings power.
Q: In your analysis, you look for “downside protection if company fundamentals fail to improve.” Can you give examples of such protection?
BK: We spend as much time on what could go wrong with our investment as what could go right. This is instrumental in assessing not only the risk/reward potential of the company but also in establishing the weighting of the security in the portfolio. During the COVID crisis we undertook a full reassessment of every name in the portfolio to confirm that our downside estimates were reasonable and that the companies we owned could survive economic lockdowns. One company was closely tied to consumer spending but it had the cash on the balance sheet and length of cash burn before needing to tap the bond or equity markets. We were patient during this period in not selling or adding to the position until we could see improvement or deterioration. Company management was able to obtain favourable financing in the debt market without diluting existing shareholder equity. With a stronger balance sheet, we added to our position and and the stock meaningfully rerated higher.
Q: Have you sold a stock recently that did not work out as well as expected and taught you something about your investment process?
BK: We have recently sold a position where our original thesis centred on the company having undergone a series of divestitures and restructuring initiatives, leaving the company primarily focused on its healthcare business while completely exiting its consumer electronics businesses. We believe this transition was not fully appreciated by the market. However, the company is currently involved in a product recall of one of its healthcare devices and the risk of high recall costs and costly potential litigation have caused the stock price to meaningfully underperform. Accordingly, the investment thesis has transitioned from business fundamentals to product recall and litigation and is something we are no longer willing to bet on. Our experiences with these problems have taught us that the market can extend the duration and magnitude of these losses.
Q: How do you decide if a company has a quality management team when many CEOs are skilled presenters and talkers?
BK: The risk when talking with management is getting caught up in a good story or relying on promises when management cannot deliver. Investors cannot rely fully on company management plans, projections, etc, exclusively as part of the analysis. We do additional channel checking with either customers, suppliers, competitors, industry sources, and so one, and we have a long history in these industries or with these company management teams. It’s important to be objective in assessing results.
Q: What gives you confidence that the value market we have seen of late will not be short lived as we have seen over the last 10+ years?
BK: If you look back over the last 10+ years, there was little change in the overall economic backdrop, with low interest rates, low inflation and below-trend economic growth, all of which favoured growth stocks which are seen as long duration assets. This pushed the multiples of these growth companies to historic levels and caused indexes to become concentrated in just a few names – not that much different from the late 1990s.
However, the recent economic challenges with inflation mean central banks will need to lift interest rates to substantially higher levels than seen in decades. This puts meaningful pressure on growth stocks. Further, there will come a point at which economies will begin to recover, recognising they may experience more pain, and value stocks will do well going into that recovery. The set-up for value stocks appears good and we expect this value cycle will be longer in duration than what we have seen over the last several years, although we recognise that there will be pauses along the way.