High Quality: A Growth Story
P&I: Tell us about Vontobel's overall investment approach and philosophy.
Matthew Benkendorf: We are high-quality, long-term growth investors. Our philosophy and bottom-up approach is based on buying great businesses and letting them do the heavy lifting for us. We believe philosophically that the sustainability of earnings growth is correlated to stock price appreciation over time. We believe—and history has proven—that the market will get that relationship right. And valuation plays into the equation. We want to make sure we pay the proper price for that business, and when we own a business we apply a sell discipline, because owning an appropriately valued high-quality business is a less risky proposition versus holding an overvalued high-quality business. But both styles, growth and value, are interdependent.
P&I: It seems more and more managers are adopting a high-quality investment style. What makes Vontobel different?
Matthew Benkendorf: That's true, but how each investment manager defines high quality can be quite different. For us, there are a number of hurdles that must be reached in order to qualify for our high-quality company universe. There are the usual financial metrics: certainly solid business economics, high returns on equity, high returns on invested capital and stable operating margins. But we take that a few steps further. Textbook measurements are important, but we want to dig deep and understand the fundamentals of this particular company and how it operates within its ecosystem. We are looking for consistency and market strength, and want to pinpoint exactly why this business will continue to stand out from the crowd. We routinely ask ourselves, 'What makes this business model sustainable over time and gives it enduring market power?' All that is tied into intimately knowing the fundamentals of the business, how it builds on its brand, its market position, its relationship to its customers, and so on.
Also, our definition of high quality includes predictability. We favor businesses that are annuity-like in nature with a repeatable quality to what they're doing—say, selling essential equipment that requires consistent consumable replenishments, or locking customers into long-term contracts. So our universe of high quality is a well-defined group of companies, and as a result we fish in a much smaller pond than many other managers.
Also, you need to be consistent and stick to the style for it to work properly. Our style doesn't do well when there's a much higher market appetite for more operationally geared or financially levered businesses. But that's something we're willing to accept because we have a high conviction that over the full market cycle the process works. Because of this, we are benchmark unconstrained. We're willing to be quite meaningfully over- and underweight certain sectors of the S&P 500 consistently over time. We seek to generate consistent high single-digit, low double-digit compounding of capital with better capital preservation in down markets. The expected by-product of sticking to our guns is beating the respective index. Another key distinction is that what fits our definition of quality evolves over time. While these changes aren't radical, it's clear our portfolio composition is not static, even with a style that is as disciplined as ours. It's essential not only to ensure that what we own continues to qualify as quality, but also that we identify new opportunities moving into the quality space. We don't want to be too dogmatic, and we need to constantly evaluate when this evolution is occurring. It's a critical balancing act that we need to manage in order to deliver repeatable results.
P&I: Take us through the steps of your investment process.
Matthew Benkendorf: Our investment process starts with a screen, which acts to eliminate most of the businesses out there. We look for companies with stable earnings and predictability. We screen on return on equity, operating margins, relative balance sheet strength, and other quantitative criteria, like a low standard deviation of earnings over time. We're picky, and those attributes aren't all present in most companies. It's not highly complicated; we look for different iterations of those qualities to point us towards businesses with a richer set of opportunities. Once we have those names, that's when the rigorous analysis and hard work begins. We set about to prove or understand that the performance can be repeated. We are essentially trying to match the mechanics of the business with its numbers and make sure that the results aren't some kind of financial illusion. Perhaps the most difficult part is trying to look ahead and test the thesis that this is indeed a sustainable model. Can they keep delivering? The probing is built around building a fortress of confidence that allows us to better answer that question quantifiably. There's a marriage, you see, between the financial metrics and the intelligence gathering around the stability of the business.
Each sector is represented to some degree after the screening process, but there are consistent patterns. Over time, this philosophy, approach and screening criteria identifies more consumer staples and fewer basic materials and commodity-driven businesses. Highly cyclical businesses don't make it through the screening process. Financials vary over time, depending on their fundamentals at relative points in the cycle.
P&I: What about portfolio construction and risk management?
Matthew Benkendorf: First and foremost, we like to allocate more capital towards the best businesses. We're comfortable taking large positions in the best businesses we can find. We also expect that our investment returns will mirror the underlying compounded earnings in our portfolio, so we allocate more capital towards the faster growing businesses that drive that potential higher. That's a variable we believe is more in our power to control and optimize.
The other factor is reasonable risk diversification. We're different from other managers here, too. Our risk management approach is based on a common-sense view that, ultimately, risk is in the underlying businesses. For example, we have about 27 percent of the portfolio in consumer staples right now—our exposure has been as high as 40 percent—which could signal a lot of operational risk. But not all consumer staple companies do the same thing: we have tobacco companies that sell cigarettes; we have food companies that sell food and beverages; we have a food retailer. All consumer staples, but each engaged in a different operational business with different competitive risk dynamics.
We think you need to peel the onion back a few more layers if you properly want to address risk management. What does a business we own do, what are the underlying operational risks around what it does, and what is the risk of the future not looking like the past? That's what we focus on so that we're comfortable that there is not something in the world that can go wrong and affect a disproportionate share of our businesses.
P&I: How does being part of a global team support your investment strategy?
Matthew Benkendorf: We operate as a boutique in New York, but we have the unwavering support of our parent, a large Swiss bank. Our strength is that under this structure, we are free to apply and execute our distinct investment philosophy and approach. High quality equity investing is all that we do at Vontobel in New York. Led by Rajiv Jain, who was named Morningstar's 2012 International-Stock Fund Manager of the Year, our team is global in nature, and all of us, portfolio managers included, are analysts. We work together on all six products, ranging from this U.S. equity product to our emerging markets equity product, as one team. As analysts, we are organized by sectors, with a global perspective, and are not segregated by geographies. In addition, each of us has multiple sector responsibilities. Our objective is to identify the best businesses globally, not the best relative opportunities in any single sector or country in isolation.
P&I: Quality stocks are expensive right now. How are you still finding opportunities?
Matthew Benkendorf: As the old adage says, 'You get what you pay for.' So if you have to pay slightly more for a higher quality business, you often get higher growth rates that compound over a longer period of time. There is a perception that high-quality stocks are expensive right now. They aren't as cheap as they were five years ago, but we're not near any bubble-type valuations, either. It's also important to ask, 'What are you paying for low quality?' Over the past year we've had a strong rally in the lower-quality areas of the marketplace and the value gap between low and high quality has collapsed rather sharply. So today, there is more risk in the overvaluation of low quality versus high quality, in our opinion. Prospective returns today going forward are going to be much more predicated on earnings growth than any multiple expansion. Well, that's fine, because that's the core of our long-term philosophy. That's all we're ever looking to achieve.
P&I: What is your outlook currently on the U.S. as an investment opportunity?
Matthew Benkendorf: Broadly, we've seen five-plus years of positive equity market returns—everywhere, not just in the U.S. So how do you still find opportunity?
The good news is that opportunity evolves. The U.S. is still a very deep, very broad market with phenomenal companies. A lot of attention is paid—and rightly so—to the bright story of investment opportunity outside the U.S. But the U.S. has the most world class, strong, high-quality franchises of anywhere in the world. We think there is still a lot of good incremental work you can do on U.S.-listed companies and find a lot of undiscovered or less appreciated names into which you can put money to work.
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