Continuously rallying markets seem worryingly disconnected from the current geopolitical climate. In this period of uncertainty making correct macro calls is challenging, but complacency is not the solution. Louise Dudley, Global Equities Portfolio Manager at Hermes Investment Management, suggests focussing on company fundamentals and in particular governance to drive outperformance over the long term.
The VIX, the equity volatility index, has hit new record lows recently, while major equity indices have cruised around record highs. These apparently calm market seas have contrasted with a storm of political uncertainty, encompassing EU-threatening elections and Brexit uncertainty, friction between Russia and the West, and the unpredictable actions of Trump. Within this new geopolitical era, the sheer number of geopolitical shocks over the past decade seems to have led to investor complacency.
In this environment of great uncertainty and lack of market leadership, investors acting as macro forecasters must not only be correct about the anticipated event, but also about how the market will react to it – which as we know following the UK’s EU referendum and the extended Trump rally, can be just as unpredictable to commentators. From an investor’s perspective, guessing where the Trump administration will take the economy, for example, is challenging as you must consider the event itself and the market reaction, as well as the visibility and the pricing impact. Our conviction is that if you are able to confidently see this it is likely others can see it as well, and this is therefore already likely to be reflected in securities prices, making it incredibly hard to develop a consistent edge from top-down viewpoints. The fewer bets you take, the more correct you need to be, therefore it is wise to diversify the bets ensuring that all the probable outcomes are evaluated.
Our style of investing has a strong focus on risk management and proprietary tools that we use to ensure that the largest driver of returns is stock-specific risk. This diversification across common-factor risk offers protection in the short-term, which helps the Hermes Global Equity Fund achieve its consistency in relative returns. Our risk management process is forward looking, constantly assessing how the portfolio will respond to varying causes and levels of volatility, and informing our current investment decisions.
A fundamental approach
Having acknowledged the macroeconomic uncertainty that we are facing, what can investors do to protect their performance? One approach is to focus on long-term company fundamentals. We evaluate companies using a broad range of time-tested fundamental factors, looking for stocks with the most attractive combination of these fundamentals, which are trading at appealing valuations. The characteristics we look for include robust financial statements, clear competitive advantage over peers and high-quality management teams.
One factor that has proven to be particularly valuable in our experience is the Corporate Behaviour factor which is effective in both up and down markets. There are a number of metrics captured as part of our assessment of management quality, but one is particularly crucial, and makes up the majority of the contribution of that Corporate Behaviour factor: governance.
Adding alpha by assessing governance
Our research found that poorly governed companies underperform by 30bps per month on average. In recent months, we have found analysing the governance of companies crucial for navigating uncertain markets. The idea that well governed companies outperform irrespective of the market environment is a significant finding.
Figure 1: The most poorly governed companies underperform the average company
Source: Hermes Investment Management as at 30 June 2017
This chart shows the monthly performance by decile of our proprietary governance score over the past eight years, which has helped us to weather this new environment of unknown geopolitical risk.
The most impactful aspect of this result is its negative profile, meaning we achieve positive Alpha not from using the score to highlight the best companies, but by avoiding the most poorly-governed companies. We formed our assessment of governance utilising the expertise of our stewardship team, Hermes EOS. The score is derived from best-of-breed commercially available data sources and crucially the proprietary data from our stewardship team. Within this proxy for good governance, we account for both level and change in governance, acknowledging that not all companies will be perfect right now. Improvement in governance can positively contribute to outperformance.
Company conviction beats market speculation
If you are consistently good at macro decision making, you have the potential to make a lot of money for your clients. Unfortunately this involves being continuously correct and precise, which is extremely challenging and always risky – even more so in this current period of uncertainty.
However, focussing on company fundamentals within your equity decision-making, while ensuring top-down risk is diversified, avoids a reliance on macro predictions. Using this approach increases the chances of delivering consistent outperformance relative to the benchmark. Additionally, avoiding negative surprises through a focus on governance, particularly on the downside, has been an effective form of Alpha protection.
By seeking out a diversified portfolio of companies with strong fundamentals while avoiding the risks of poor governance, investors greatly improve their chances of delivering consistency and being able to weather all storms, irrespective of the way the wind is blowing and the ongoing uncertainty that we will no doubt continue to see.