The Hermes US All Cap Strategy has generated 1.5%* net annualised outperformance during its first two years. With US interest rates rising – providing opportunities for patient stock pickers – and the market continuing to assess companies on a short-term basis, we believe that our focus on enduring quality across sectors will continue to benefit investors.
Figure 1. Net performance of Hermes US All Cap Strategy, since inception
Source: Hermes as at 31 May 2017. Performance shown is the Hermes US All Cap Strategy in USD, net of all costs and a 50bps management fee, since its inception on 31 May 2015. The benchmark is the Russell 3000 Index. Past performance is not a reliable indicator of future performance.
With the Strategy establishing a consistent performance track record, we are introducing a founder share class for the Fund, which will be managed simultaneously. As the Fund enters its third year, investors whose allocations comprise the first £100m in commitments will benefit from a halving of the management fee to 25bps. In addition, in the coming months we will cap the ongoing fund charge at 45bps in an effort to enhance returns for all investors.
Fundamentals reward long-term investors
In recent years, many commentators have questioned the value of active management, arguing that it is difficult to outperform in the US large cap market given the number of skilled investors in this sector. Indeed, in aggregate active managers have not been as successful in recent years as they have in the past (see figures 2 and 3).
Figure 2. The asset-weighted alpha of active US equity funds versus comparable ETFs
Source: Morningstar Direct, Deutsche Bank as at 31 May 2017
Figure 3. The proportion of active US funds outperforming comparable ETFs
Source: Morningstar Direct, Deutsche Bank as at 31 May 2017
That is not to say that an active manager cannot consistently outperform. For instance, the market often takes a short-term view of companies, allowing investors with time horizons of three years or more to buy attractive, under-priced stocks and then benefit from superior returns.
Hermes US All Cap applies the successful bottom-up process established by the Hermes US SMID team but extends this throughout the capitalisation spectrum. In practice, we look for businesses with sustainable competitive advantages, known as moats, and invest when they are trading at discounts to their intrinsic value.
For example, one year ago we purchased shares in Charles Schwab, a leading broker, at $30 each. At the time, the benchmark US interest rate was 0.5% and consensus earnings for the business were about $1 per share. With an increase in interest rates, the company’s earnings power could rise to $3 and it could be valued on a multiple of 20 times, making each share worth $60.
Emerging opportunities for active managers
Over the last 50 years, the underperformance of active managers against the US market has been cyclical, with the current cycle seeming to have recently peaked (see figure 4). Some believe the recent outperformance by the market has been supported by the low-interest-rate environment, which has reduced volatility and increased stock correlations, making active investing more difficult.
Figure 4. The cyclicality of outperformance by US active managers in aggregate
Source: Nomura Instinet as at 31 December 2016
But as benchmark US interest rates rise, stock-price dispersion should increase as weaker companies find it more expensive to access capital, enabling stronger peers to take market share. Further growth and inflation should result in monetary-policy normalisation, causing a higher cost of capital that should reward investors which have diligently picked better stocks.
Quality: taking a broader view
Many quality funds invest in a narrow part of the market, focusing on sectors like consumer staples. By default, this results in a top-down bet against cyclicals and restricts the universe of high-quality companies available to them. Our measure of quality – the strength of a company’s moats – allows us to buy cyclical companies in addition to traditional quality stocks. The result is a sector-neutral portfolio, with a combination of cyclical and defensive stocks, whose performance is driven by stock selection.
We look for business models that have defensive characteristics like recurring revenues, good profitability and cash flows, low debt and management teams with long track records of allocating capital. A great example here is Equifax, one of three US credit bureaus. The company receives contributing data from financial institutions, which means that its cost of goods is effectively zero. Its management team has increased growth by combining data sets, and entering new lines of business and regions.
Quality is one of the largest factor exposures for Hermes US All Cap, which should support relative performance during market downturns. Analysis by Style Research shows that the portfolio is tilted towards growth and quality factors like low gearing (see figure 5).
Figure 5. Portfolio Style SkylineTM for Hermes US All Cap
Source: Style Research as at 31 May 2017
ESG integration and engagement
ESG analysis and engagement are embedded in our investment process. When researching companies, we look for sustainable business models and industries that have lower obsolescence risk and will stand the test of time. We consider how industries might change in the coming decade, and whether a company’s moat is likely to widen or narrow.
We examine corporate fundamentals, looking for hidden assets that benefit from creative destruction. One of our largest holdings, Analogue Devices, produces integrated circuits for hybrid and electric cars. Given their ability to save fuel and lower emissions, electric cars are expected to represent 30% of the European fleet by 2025 (see figure 6), making the company well-positioned for future growth. In addition, peer company NXP forecasts the cost of the content comprising circuits to increase from $100 to $500-$600 per car as society adopts autonomous driving.
Figure 6. Charging: electric vehicles’ share of new car sales, by region (%)
Source: UBS as at 23 May 2017
We aim to avoid industries characterised by unsustainable business models. For example, we have no exposure to coal-mining companies, due to their high level of carbon emissions and potential for their reserves to become stranded assets; nor tobacco, given the detrimental health effects on smokers; or gambling stocks, since the odds are stacked against consumers, many of which are addicted to betting. The portfolio’s carbon footprint, as measured by emissions per millions of dollars invested, is 47% lower than the benchmark’s.
Our focus on running high-active-share, low-turnover portfolios is well suited to engaging with companies. The stewardship specialists in Hermes EOS engage with 57% of the AUM in the portfolio. We consult them during the fundamental research and monitoring of companies, which informed our investment in Delta Airlines.
We identified low fuel efficiency at the airline relative to its peers, which incurs both economic and environmental costs. At Delta’s Atlanta headquarters, we asked how the company intends to achieve the company’s fuel-efficiency goal. They said they plan to retire all McDonnell Douglas MD-88 planes in its fleet and replace them with Airbus A321 or Boeing 777 aircrafts over the next five years. We have factored higher capital-expenditure requirements and savings from greater fuel efficiency going forward into our model.
Two years strong, focused on the long term
We believe that Hermes US All Cap is well positioned to exploit the short-term nature of the US market and build on its 1.5%* net annualised outperformance since inception. As the Strategy enters its third year, we believe our sector-neutral approach to investing in high-quality companies combined with value-adding ESG integration should continue to deliver attractive long-term returns for investors.
*Source: Hermes as at 31 May 2017. Performance shown is the Hermes US All Cap Strategy in USD, net of all costs and a 50bps management fee, since its inception on 31 May 2015. The benchmark is the Russell 3000 Index. Past performance is not a reliable indicator of future performance.