The Case for Fundamental Research
The historic changes that Wall Street has undergone over the past several years—consolidation, regulatory reform and a spike in market volatility—have exacted a heavy toll on fundamental investment research. A widely published survey of the period between September 2008 and May 2009 turned up more than 2,200 formal announcements of brokerage and investment-bank analysts dropping company coverage in the U.S. alone. Investment management and mutual fund firms have trimmed their staffs as well, in some cases replacing the painstaking and expensive labor of traditional investment research with statistical modeling and Internet databases.
In our view, this retreat from fundamental research couldn’t come at a worse time. As economic prospects improve, investors need solid research to identify those companies that retained strength during the recession and are poised to take part in the recovery. On-the-ground fact-finding around the world is more important than ever because of our increasingly global marketplace. New opportunities are springing up everywhere from northern China to southern Brazil, even as some old-line European and American companies struggle to regain their footing.
Seeing is believing
Analysts can collect baseline intelligence easily enough by combing through financial statements. But without personally visiting with company management, they can’t gain actionable insight on the opportunities and strategies that make one business stand out from the rest.
Tom Lloyd, an analyst who covers industrial stocks out of our Los Angeles office, sums up the dilemma: “Every year, it seems, companies put out more and more numbers. You can spend your life trying to make sense of them all, but until you go and find out what’s actually behind them, you’ll never be able to pick out the two or three that really count.”
Bill Hurt, chairman of Capital Strategy Research, draws a further distinction between number crunching and genuine insight. “The numbers tell you where a company has been, not where it’s going. People make the future, not numbers,” he says. After six decades of professional investing, Hurt is convinced that a company’s long-term profitability depends on the resourcefulness of the people who run it. “We expect our analysts to get to know the management teams of the companies they cover, not merely hear them address industry events or speak at company-sponsored investor days. We want them to meet with the senior managers personally in their offices.”
Lloyd adds, “CEOs are more expansive on their own turf. They’re more likely to reveal themselves through their body language and by how they relate to their staff.”
The real “G-force”: globalization
Business is going global at an accelerating pace, even if the world’s equity markets have not fully kept up. The capital invested in U.S. stocks today represents a little more than 40% of the world’s total, yet the U.S. contributes barely 20% of global economic output. The emerging markets, by contrast, account for 11% of overall stock market value and nearly 45% of total output. This ongoing shift has entailed massive, if still barely recognized, adjustments in corporate cultures, in patterns of middle-class consumption, in financial and environmental regulation, in resource exploitation and utilization—indeed, in nearly every aspect of economic endeavor. Clearly, an analyst can’t sort through the investment implications of arguably the most transformative economic phenomenon of our time isolated in the air-conditioned comfort of a downtown office tower.
In fact, although the pace of globalization may have picked up, the process itself has been under way for a long time. We know, because we were there at the beginning. We opened our first overseas research office in Switzerland in 1962. Other U.S. financial services firms had set up foreign outposts earlier, to be sure, but we believe ours was the first dedicated to pure research. Even back then, as Europe’s post–World War II boom was just getting started, we recognized that understanding how companies, industries, economies and financial markets fit together and evolve demands a continuous presence.
Our commitment to research has kept pace with globalization’s spread. Analysts are based in 12 locations around the globe. Over the past year we opened offices in Mumbai and Beijing, and we continue to spend significant sums on our research effort.
Formulating a worldview
Dickon Corrado’s outlook typifies this globalist perspective, just as his résumé embodies it. Corrado follows Asian heavy industries. He earned his undergraduate degree in Shanghai and his graduate diploma in Chapel Hill, North Carolina. “It’s one thing to read about China’s growth in magazines and statistical abstracts, and to fly into Shanghai every other year,” he says. “But to really understand the magnitude of China’s accomplishment, you have to go there and watch the economy growing before your eyes.”
If being on the ground in Asia added value before the credit crunch, the ensuing recession has made it crucial. “Going back and visiting businesses and the people who run them last fall and into this spring gave us a ringside seat as the recession played out company by company,” Corrado notes. “We arrived at some really solid investment conclusions that we just couldn’t have gotten staying at home.”
Though deployed all over the world, our analysts are anything but “fixed assets.” Their careers track the changes of the industries they follow. Ernie Nutter offers a case in point. One of Canada’s most veteran mining analysts, he started covering the industry in the 1970s. Back then, the bulk of the world’s industrial ores—bauxite, iron, nickel and the like—came out of Canada, destined for factories in Europe and the U. S. Globalization has changed that. Once-remote deposits in the Southern Hemisphere are just as close or closer to today’s big end users in Asia. The companies that control these deposits call South Africa, Australia and Brazil home. Canada, once the dominant force, has become a relatively minor player. Still based in Toronto, Nutter now applies the knowledge he accumulated in mine shafts under the Arctic Circle to the whole world.
Our analysts collectively follow more than 100 industries from aerospace to deepwater oil drilling on behalf of our clients. Channeling the sheer volume of this effort into actionable investment ideas is no small task. The system we’ve developed over the years functions effectively, as our results demonstrate, but also works somewhat counterintuitively. We don’t edit our research down to an arbitrary few best ideas. We have found that the give-and-take of multiple views produces even better investment recommendations.
Connecting the dots
Our analysts are in continuous dialogue—on the phone and in person, through formal presentations, internal publications and countless e-mails. These discussions are all geared toward a single objective: to turn up the unconventional, the overlooked and the underestimated investment. Long-term success, we have found, comes from going against the market’s herding instincts.
We’ve recently taken a further step to connect the dots by forming eight separate coverage “clusters” to break down the silos between industries. In the consumer cluster, for instance, fixed-income and equity retail analysts compare notes on consumer behavior around the world with their colleagues following entertainment, leisure and packaged goods.
Weekly cluster conference calls serve to alert a disparate group of analysts to distant trends that could impact their immediate coverage. That’s how it played out in early 2009 for the technology cluster, which brings together analysts covering computer hardware, software services and the Internet. At a time when demand looked like it had fallen off a cliff to analysts covering the U.S. market, their counterparts in Asia reported a buoyant outlook among the companies they followed. Such intelligence persuaded the U.S. analysts to make an early call—and enabled some of our portfolio managers to participate in the sector’s spring rally.
The work of investing
We consider it a strength of our process that intelligent professionals working together can draw different conclusions from the same set of findings. Though we actively encourage cooperation, we go to great lengths to discourage the leveling effects of consensus. Compromise usually leads to mediocre investment results. Conviction does not. Varied views form the foundation of our multiple portfolio manager system, which constructs client portfolios not to match some pre-determined benchmark but to capture—one stock at a time—the most deeply held convictions of the firm’s best investment minds as demonstrated in the chart below.
Our analysts bring many different competencies, relentless curiosity and wide-ranging backgrounds to the process. Their convictions result from close inspection, backed by hard data and validated by long experience. They rarely emerge from freshly minted MBAs laboring over spreadsheets. That’s why investment research at our firm constitutes a distinct career track. It’s not a farm system for portfolio managers, a common practice in the rest of the asset management industry.
Our approach lends continuity to our research. By following a single set of companies over the years, our analysts develop a deep knowledge base and an intuitive feel for their industries. “We have long relationships with the companies we follow,” Aline Avzaradel, an insurance analyst based in San Francisco, points out. “We understand our industries and each competitor’s advantages. That helped us dodge some of the worst of the broad decline, and it’s helping us to spot opportunities now.”
The most important job
Research remains the essence of our investment process. Our only business is managing financial assets. We do not engage in any activity that would compromise our independent judgment of the companies we follow. Our research is not for sale; we use it exclusively for the benefit of our clients. We cultivate conviction by giving our analysts a direct stake in the success of their recommendations. They have no incentive to modify their assessments to coincide with conventional wisdom. On the contrary, they invest in stocks within their coverage area alongside portfolio managers. Their research portfolios work both ways. Bonuses are based on the success of recommendations, but analysts are also rewarded for holding cash if none of the companies they cover warrants owning. The point of the research portfolio, after all, is not simply to invest but to do the right thing for our clients.
Our process has never depended on sophisticated mathematics, detailed technical analysis or any of the investing fads that seem to rise and fall along with the mood of the market. It relies on dispassionate, painstaking research by intelligent and dedicated professionals. Over the long run, this has proven to be the surest way to protect and prudently grow financial assets. In an economy that has forced firm after firm to cut back on research, we remain steadfast in our commitment. If anything, as alternative sources of intelligence grow scarcer, we believe intensive and independent research has greater value now more than ever before.