European investors gain access to an american dream

The US stock market is by far the world’s largest. And the choice of the correct US fund supplier and product is just as important for European investors as it is on the other side of the Atlantic.

Even investors with an underweight position in US equities will still have a significant proportion of their portfolio in this stock market.

The importance of the US is reflected in the fact that, according to Feri Trust, three of the biggest selling cross-border equity funds in Europe in June were US equity funds. There was only one other equity fund in the top 10.

Nordea’s North American value fund, which is the largest US equity fund distributed across European borders, attracted net sales of €233.9m, while Fidelity American Growth netted €70m and the US Equity Alpha fund gained garnered €69.2m.

‘As you are not surrounded by the noise of Wall Street all the time, it means when you visit the US you can gain a better perspective’ Louise Keeling, Clerical Medical

‘We believe in buying and holding undervalued stocks and taking very large positions ... to deliver outperformance’ Mary Chris Gay, Legg Mason

Factors to consider

There are a number of factors distributors must consider when selecting any equity fund.

Past performance obviously plays a role by indicating the returns which a fund’s manager had been capable of achieving.

But more important than simply looking at the numbers is analysing the consistency of this performance. Distributors and wealth managers need to determine how the fund has performed in different market conditions, the level of risk taken to achieve these returns and whether the same personnel who were responsible for outperformance remain in place.

Matching portfolio

It is important to look at the style of the fund manager. The fund should complement other funds within an investor’s portfolio and be able to perform well during the market conditions of the next year and not the last year. If a distributor is selecting a fund because of its investment approach, he will not want a manager who has a tendency to undergo style drift.

The concentration of the fund will indicate the level of risk being taken, although it is possible to diversify away returns as well.

The size of the fund is also important. While some investors take comfort from buying a large fund, the smaller and more nimble funds can outperform by avoiding stocks they do not like and reacting faster to opportunities. Again, only by analysing individual funds will it be possible to determine whether they will outperform, whatever their size.

The final factor to consider is the cost of the fund. According to Fitzrovia International, the total expense ratios of the 10 largest cross-border US equity funds vary from 1.31 per cent to 2.07 per cent. Over five years, such differences in cost can have a significant impact on performance. Distributors will often want a significant slice of the management fee in return for selling the fund on to their clients. The manager will need to keep a large enough chunk of the fee in order to keep the funds operation profitable.

Nordea’s American value fund, which runs €2.24bn in assets, has proven that large funds need not underperform. It has also shown US groups that they face major competition from Europe’s domestic banks.

Nordea’s fund has outperformed its peers over three and five years. Only

the Legg Mason Value fund has performed better over one year.

Stress on experience

The management of the Nordea American Value fund is outsourced to Florida-based Private Capital Management (PCM). The co-portfolio managers are Bruce Sherman and Gregg Powers, who have worked together since 1988. PCM stresses the importance of experienced fund managers, with Mr Sherman having worked in the industry since 1969 and Mr Powers since 1986.

PCM has two objectives – to preserve investors’ capital over the long term and to double clients’ assets every five years.

Mr Sherman says: “This is tantamount to a 15 per cent annualised rate of return. Over the long term, achievement of this objective would allow PCM to meaningfully outperform the long-term rate of return of equities and fixed income alternatives while not undertaking the risks and concomitant volatility that accompany a high hurdle rate.”

PCM aims to invest in profitable companies with healthy balance sheets that appear to be undervalued, says Mr Sherman. As a value investor, PCM focuses on the earning power of companies. It seeks companies that can generate excess cash after meeting the costs of production, have sufficient working capital, have serviced their debt, paid taxes and invested in the business.

Stocks analysed

When PCM analyses stocks, says Mr Sherman, it looks at publicly available information and tries to evaluate the “actual enterprise value of a business”. Among the factors PCM looks at are why the business is favourable; its capital requirements; the franchise (in terms of size, durability and profit potential); and the background, philosophy, competence and economic interests of the management. PCM also looks for common interest between shareholders and management.

The fund managers talk to a company’s competitors, customers and suppliers to gain a greater understanding and to cross-reference the management’s comments. Stocks are typically held for three to five years and then sold when fair value is reached.

Bill Miller’s Legg Mason Value fund takes a similar approach by evaluating whether a company’s share price is cheap relative to its intrinsic value.

Mary Chris Gay, senior vice-president of the Value fund, says it does not usually hold its 30 to 50 stocks for less than three years, as it is interested in the long-term value of the company.

Mr Miller holds stocks for such a long time because he does not believe that the S&P 500 index can be outperformed in the short term.

“The stock market is efficient in the short term of up to three years, which is shown by the massive underperformance of fund managers,” says Ms Gay. “We believe in buying and holding undervalued stocks and taking very large positions of an average 2.8 per cent of the portfolio to deliver outperformance.”

Value models

Mr Miller and his team focus on companies with a capitalisation of more than $40bn (€35bn). The first screening of potential stocks is based on an analysis of their cash flow. The team then uses a number of value models to analyse returns on capital and liquidation valuations. The qualitative factors analysed include a company’s position in its market, the alignment of directors’ interests with those of shareholders and the potential to build business value over the next five to 10 years.

Each of the 20-member investment team is given sectors to analyse. A weekly meeting is held to discuss potential acquisitions by the fund, ongoing analysis of companies and new ideas. The final decision lies with Mr Miller.

His near-namesake, Neal Miller, manager of the Fidelity Funds American Growth fund, seeks to identify companies that will benefit from social and economic change.

He says: “Research is undertaken to examine changes or trends in social attitudes, legislative actions, economic activity, product innovation, demographics and other factors. Based on the interpretation of these trends, we try to identify the industries and companies that may benefit and then undertake fundamental research on each potential investment.”

The key, adds Fidelity’s Mr Miller, is to anticipate these trends before they become common knowledge in the market and then invest in the companies that will benefit from them as these will achieve above average profits growth.

Fidelity’s fund also buys companies in industries that are undervalued or out of favour. There is a bias towards small and medium sized companies, which carry more risk than large caps.

In selecting stocks, Miller says the companies favoured are those with a proven management team, a superior future earnings outlook and strong fundamentals.

Fidelity’s fund will sell a stock when the “operating environment is compromised, management fails to execute its projected business strategy, the growth objectives are met or the target price achieved and the stock trades ahead of fundamentals”.

Louise Keeling, manager of CMI GNF US Equity, takes a bottom-up approach to managing the fund. When analysing companies, Ms Keeling looks at what drives a company’s business model, what drives their returns and how they perform in different macroeconomic conditions. As with the other fund managers, Ms Keeling stresses the desire for the interests of management and shareholders to be aligned. While Ms Keeling is a bottom-up stock picker, she does add a macroeconomic overlay to the fund.

She says there are some advantages to her running the US fund from London. “As you are not surrounded by the noise of Wall Street all the time, it means when you visit the US you can gain a better perspective. When I go to the US, I am very focused on the companies I am seeing,” says Ms Keeling. “The other thing is that US companies come through London all the time. I see an average of two companies a week.”

Ms Keeling says she takes a style neutral approach. She argues that this enables her to take advantage when Wall Street under- or over-estimates the growth prospects of companies.

‘Research is undertaken to examine changes or trends in social attitudes, legislative actions, and other factors’ Neal Miller, Fidelity

Strong but undervalued

The Merrill Lynch Basic Value fund, managed by Kevin Rendino, focuses on companies with a market capitalisation of more than $10bn (€8.8bn). Mr Rendino says he looks for established companies with franchises and strong management that the market has undervalued. He takes a bottom-up approach and screens stocks through traditional value measures, such as price to book, price to earnings, price to cashflow and dividend yield.

US equity funds obviously place different emphases on qualitative and quantitative factors in assessing stocks as well as the level of risk they are prepared to take. As well as factors such as performance and costs, choosing a fund ultimately comes down to how well an investor believes the manager and his team are at determining under- and over-valued stocks both when they buy and sell companies.