Active Research Drives Active Management

Successful active investing requires exhaustive research and a disciplined process that draws on such research. In fact, active managers backed by strong fundamental research can help investors make risk work for them – be it mitigating risk or adding risk in a portfolio when needed.

Everyone loves a bargain
Research-driven active management typically starts with taking a long-term view of companies and doing in-depth analysis to assign values to each business.

“Our research analysts seek to uncover gaps between a stock’s value and its price. If a stock trades below 70 cents on the dollar, according to our calculations, this margin of safety helps mitigate risk,” says Daniel Nicholas, client portfolio manager at Chicago-based Harris Associates L.P., which is the sub-advisor to the Oakmark Natixis Funds in Canada.

Since many professional investors define risk as an absolute loss of capital – as opposed to tracking error or price volatility – recognizing potential “value traps” is crucial. It’s not enough for a stock to trade at a meaningful discount to perceived value. If the business isn’t growing and specific hurdle rates aren’t being reached, it becomes a value trap rather than minimizing risk through genuine margin of safety.

Get a view from the top
Another critical component of research is meeting with a company’s senior leadership to assess the business and ask important questions:

• Does management run operations efficiently in all economic environments?
• Are they competent stewards of capital?
• Is the business positioned to compete successfully in its industry?
• What’s the free cash flow rate? Is it sustainable or even poised to rise?
• How do credible third parties view these companies? Does this view validate the team’s thesis?

The answers will help a research team assign target multiples to the business and determine a reasonable stock valuation.

“Once we’ve conducted our due diligence, we arrive at an ‘approval list’ of stocks,” says Nicholas. “Then we identify stocks with the most upside potential based on perceived intrinsic value, and buy them when the price meets our target for margin of safety. When the value gap narrows to a certain range, that’s our signal to sell (either trim or exit) and find the next undervalued opportunity.”

The Harris approach to research
While there are common elements of research and risk management, Harris does some things differently. For instance, most analysts specialize in a certain sector or industry, but Harris analysts gain expertise across a number of sectors. “Our research team likes to maintain intellectual curiosity and stretch their knowledge,” says Nicholas. “If anything, team members will specialize by geography so they can understand the economic, political and business forces at play in a given region.”

Also, the team’s research considers certain factors related to environmental, social and governance (ESG) risks and opportunities, as companies committed to ESG are often adept at mitigating risk and creating shareholder value. Businesses with independent boards are highly regarded, as are those who operate without bureaucratic interference (e.g., in China the government imposes many controls on a company’s operations, which increases business risk).

Trust the process … and the research
For a research team to recommend a meaningful equity stake, it must believe in its process, have full conviction in the company and be comfortable taking a contrarian perspective if required. If the research process drives portfolio implementation, portfolio performance becomes a by-product of the research process. For example, after Brexit, a research team may have concluded that U.K. stocks were oversold and that increasing a portfolio’s U.K. weighting would be prudent. If the research is correct, U.K. stocks will outperform.

Similarly, if research reveals certain stocks have moved above their perceived intrinsic value, it may trigger a sale. For instance, yield-seeking investors tend to gravitate to dividend stocks, which end up trading at a premium as demand outstrips supply. Once the stocks become overvalued, the attractive yield is negated by the risk of evaporating margin of safety.

Research in action: General Electric Co. (GE)
Harris recently added significantly to GE in the Oakmark portfolio. The research team has followed GE for many years and believes it is a sound business. Nicholas states “Our research team favours businesses where the initial sale of equipment leads to a 40-year stream of high-margin service revenues, and GE has many of them.” However, concerns existed that GE was risky because it didn’t meet the team’s criteria regarding effective capital allocation. That changed when Jeff Bornstein became GE’s CFO. “Since then,” says Nicholas, “GE’s capital allocation decisions have been impressive and executed as a contrarian value investor would.” With improved stewardship of management, GE finally met Harris’ stringent investment criteria and was added to the Harris approved list in 2014. After GE’s shares recently made 52-week lows and given GE’s advantaged long-term positioning and management changes, Harris believes GE is now a risk worth taking.

Visit the Natixis Canada website to learn about the Oakmark Natixis Funds and how the Harris approach to research can help your clients make risk work for them.

¹ Natixis Global Asset Management’s 2016 Global Survey of Institutional Investors. Survey included 500 institutional investors in 31 countries.

Past performance is no guarantee of future results. Current performance may be lower or higher than the performance data quoted. All returns reflect the reinvestment of dividends and capital gains and the deduction of transaction costs.

The information, data, analyses, and opinions presented herein (including current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) are for informational purposes only and represent the investments and views of the author and Harris Associates L.P. as of the date written and are subject to change without notice. This content is not a recommendation of or an offer to buy or sell a security and is not warranted to be correct, complete or accurate.

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