Matthew Sutherland is a die-hard equity analyst. In his own words, he has been in research “all his life”. His career as an equity analyst began in 1983 in the U.K. and 10 years later he moved to Asia. His role all along was to primarily manage teams on the sell side.
In March 2006, he joined Fidelity International as head of equity research for Asia, ex-Japan. Based in Hong Kong, he broadly oversees all the analysts in Mumbai, Hong Kong, Singapore, Seoul and Sydney.
In an organisation where analysts are trained over the years to eventually don the mantle of a portfolio manager, he confesses that he has “absolutely no ambition to become a fund manager or manage money”. Equity analysis remains his first love.
Here he speaks to Larissa Fernand on the research process at Fidelity Mutual Fund and why that sets it apart from its competitors.
Fidelity often portrays the impression that its fund managers have a sound background in equity analysis. Can you tell us specifically how the fund managers at Fidelity stand out?
Fidelity does boast of strong fund managers who are very experienced individuals.
Our fund managers start off as analysts. The role of an analyst in Fidelity is to first and foremost, provide our portfolio managers with great ideas on which stocks to buy. They attempt to get great ideas into our funds to help them outperform.
But the second, and equally important, role is that this is a training ground for future fund managers. Typically, the average career of an analyst at Fidelity is around 7½ years, before he gets promoted to being a portfolio manager. During this period as an analyst, he will do different assignments. For instance, for 2½ years he would cover financials, for the next 2½ years he would cover cyclicals and for the same time frame also cover the consumer sector. So during his entire career as an analyst, he would have seen three very different parts of the market and roughly an entire economic cycle.
All our existing fund managers have been through this programme in the past. By the time an analyst gets promoted to the role of fund manager, he has years of experience in analysis under his belt. Any mistakes made would be during this training period before they begin to handle client money.
We also have analysts who are country specific as well as sector specific on a regional level. For instance, we have five analysts in Australia who cover just the Australian market. In India we have five analysts who cover only India and in S. Korea, three to cover that country. In Hong Kong we have eight country focussed analysts who cover Greater China —Hong Kong, Taiwan and mainland China. And in Singapore, we have three who are focussed on the ASEAN region which comprises the South East Asian countries.
But in Hong Kong and Singapore, we also have pan-regional sector analysts who look at sectors across the entire region.
What is the logic of some stocks being analysed on a country focussed basis and some on a regional basis?
Technology, utilities, gaming, mining, oil, steel and transport are the sectors we cover more or less on a pan-regional basis. In other words, we pretty much have one or two analysts who cover the sector across the entire region. The reason being we believe that the drivers for such sectors are global or regional in nature.
But typically the drivers for other sectors like financials or consumers are much more local and single country — such as the monetary policy of that country.
With such a great emphasis on in-house research, how much of flexibility do your fund managers have?
One hundred per cent flexibility.
There is no pool of accepted stocks that the fund managers have to pick from. And every fund manager has total freedom in deciding which stocks should be included in his portfolio.
Neither is the fund manager obliged to only go by the recommendations of the analysts. Frequently they do, but not always.
The average portfolio manager at Fidelity uses our in-house research as well as other sources of research. Here too they have the flexibility to use it in varying degrees according to their comfort level.
Every portfolio manager and analyst at Fidelity is responsible for his own individual performance. The analysts are individually responsible for the success of their recommendations. And every portfolio manager is responsible for the performance of his fund. So the entire process of fund management is a combined effort between the analyst and the fund manager where everyone is individually accountable.
Portfolio managers are also totally free to come up with their own macro framework for what is happening across the globe. We have no imposed top-down view such as exchange rates are going to be ‘X’, interest rates are going to be ‘Y’, and GDP growth is going to be ‘Z’. They are free to make up their own minds and they do so. So each portfolio manager can have his own world view. And we see this as quite constructive because if you have a focussed centrally imposed macro view, your portfolio manager will have to force himself to comply with it. If that views turns out to be wrong, the entire family of funds will take a hit. Of course, the reverse too can take place. But there is a risk when everything is going the same way. We think it is wiser to leave each portfolio manager to make up his own mind and be individually responsible for his performance. This will give a better spread of results across funds and neither will we have capacity issues of all portfolio managers rushing into the same stock at the same time.
You mentioned that the task of the analyst is to get great ideas into the funds. How do they go about that?
We look for mispriced stocks where we feel that we have an edge in differing from consensus. In order to differ from consensus, we have to understand what the consensus is. So we rely on sell side research as an input into the process. We see what their forecasts, recommendations and earnings estimates are. Then we can disagree, or agree, because of particular reasons. We would also like to have an edge that makes us confident in being different from the street.
Where does the edge come from?
A number of factors actually.
For one, Fidelity is a big company. So we have sufficient cash flows internally to fund our analysts to enable them to do what it takes to come up with intensive research. So if an Australian analyst says to me that he needs to go to China to get a first-hand feel of Chinese demand for iron ore, to help him analyse an Australian iron ore company better, we have the ability to allow our analysts to travel.
Being a large fund house, every single listed company is keen to talk to us. So corporate access is not an issue.
I earlier mentioned how an analyst is rotated between sectors during his career. So we ensure that we have a fresh pair of eyes on the sector every so often. Now this is opposite to what is commonly followed. The trend is to leave one analyst in a sector for, say, seven or eight years so that they become incredibly well versed with the sector. But you could also argue that chances are they would become stale because they are looking at the same stuff for an extended period of time and they would stop questioning how the sector works. We live in a dynamic world where things change frequently so having a fresh pair of eyes look at the sector every 2½ years and question all the previously assumed drivers is very beneficial.
Naturally, this process creates a huge internal pool of accumulated knowledge. Let’s say we have an incoming regional transportation analyst. Within the Fidelity network, he can track the work of all the analysts who preceded him. He can access such information not only within his region but across the globe, whether it’s Asia, Japan, Europe or the U.S. That would amount to looking at the inputs of a great many analysts across the world who are experts in the industry. Not only can he dig out old research but he even has access to them should he need to talk.
Unlike teams which are purely single country oriented, we have the benefit of an international slant since we are present in all major economies of the world. The first thing I tell my analysts who are being rotated on to a new sector for the very first time is to contact their internal counterparts before they talk to anyone else — a sell side broker or a listed corporate. So they will talk to the analysts who are covering the sector in London, Boston, Seoul, Sydney and anywhere else. So they immediately get a grip of what has been going on in that sector across the globe. So if margins of, say, construction companies are falling in Europe they should be aware of why it is happening and if it could well result in the same happening in their country.
So when you look at all these factors in combination, we certainly have an edge. And typically the fund managers themselves have been trained as analysts so they too would have knowledge on the industry.
How important is it in the entire research process to actually meet up with the management of the company?
It is very critical to the research process. Meeting up with the management of the companies is very core to the investment process at Fidelity. But that does not mean we slavishly follow what the company management tells us. We feel it is very important to hear directly from the company how they perceive situations, but we do question what we hear from them. Sometimes company managements can be behind the curve in what is going on in the world and often we are ahead of the game as we are looking at sectors globally. The economic turning point at the end of 2007 is a case in point.
But to come back to the importance of meeting with management, in 2008, we had 4,300 company meetings across Asia. If we only look at the statistics for India, we had 435 meetings with corporates, 6 overseas meetings, 137 conference calls and 221 meetings and conferences. So that is a lot of corporate contact.
Where do your analysts look when coming up with a research recommendation?
Like I mentioned earlier, the first step is for the analyst to talk to his counterparts and tap into Fidelity’s internal resources.
The next step would be to talk to company managements as well as look at sell side research.
But we are increasingly looking at independent research houses — other sources of research who are not brokers. The reason being that what a broker says is accessible to everyone. And we want to dig deeper to find information that the street does not have. One of the best ways to do it is to go to independent providers of research — expert networks, for example. These are companies who maintain a network of experts. So let’s say you have a question: What is happening in the pharma industry in China at the moment? Is the government looking at introducing a social welfare support system that could change the way pharma companies in China are paid? So we go to an expert network in China which will tap into experts and individuals in the industry, in the government, in agencies, in hospitals, unlisted providers of healthcare, doctors and other professionals in the industry and give us an answer in the form of a detailed report.
We also do surveys on retail trends so we know who is buying what and where. So now around 10 per cent of our research budget goes towards providers of third party research.
In your opinion, what is the best way to understand a company’s fundamental strength? For instance, is it to understand the rates of return that the company earns on the capital that it invests in its business?
This is my personal answer and not Fidelity’s methodology because everyone will have their own personal investing style. If you distil it down to just one thing, then what you mentioned is absolutely critical. You need to understand whether or not a company is capable of generating a sustained return on capital that beats their cost of capital and the potential threats to that. So we would have to look closely at the competitive landscape in that sector to see if there are any new practices coming up or new products being developed that could threaten the company or can it strongly defend its position for a long period of time and maintain a high return on capital.
But on top of that, you would need to layer all sorts of other stuff. Is the management trustworthy? What’s the corporate governance like? What’s the capital management of the business like? It’s all very well a company having a sustainable high return on equity, but if they never give their shareholders any of that return but instead invest it into lousy businesses, it will end up diluting returns going forward.
Each individual portfolio manager will have a different way of encapsulating that. Some are more tilted towards growth and momentum, others prefer a value slant. But at the end of the day, it boils down to one factor — a company cannot generate growth unless it is generating a premium return on capital.
Does Fidelity not tilt towards value picks?
I don’t think it does. My impression of Fidelity Asia, ex-Japan, is that we have more of a reputation of being ‘growth at a reasonable price’ house rather than a value house. You don’t come to Asia for value, you come here for growth. You don’t look for dividend paying companies in India and China. You are here because there are a billion people who are going to be spending over the next 25 years and you want to tap into that. Having said that, Fidelity International’s wide range of funds covers both value and growth.
When you pick up a stock, what are the valuation parameters that you consider?
There is no hard answer to this question. We look at a number of different parameters depending on where we are in the cycle. It also depends on the sector or stock we are looking at.
Right now, for example, we are steering very heavily away from anything that has ‘E’ in it, because we do not know what ‘E’ is going to be. So we have stopped looking at PEs to the same degree that we used to and are now looking more at ‘B’. At this point of time, book value is more reliable. Of course, it is not necessarily written in stone but at this stage of the economic cycle it is more reliable than earnings rated valuation methodology.
Other than PB, at this stage of the economic cycle what is relevant is EV to sales, EV/EBITDA, or anything to do with the replacement cost of assets.
We all struggle at these turning points and what cyclical analysts in particular have been struggling with at this point of the cycle is: At what point does the fact that my stock is trading at .3x price to book take over as a driver of the share price from the fact that it’s got declining earnings for the next three years and probably makes a loss for the next three years? Around the region there are plenty of cyclical stocks in that camp. A lot of such stocks did bounce off at .3x or .4x price to book but subsequently rebounded dramatically and are now much closer to 1x price to book. Personally, I do not believe value is the key driver but risk appetite is. So if you are too obsessed with value, you miss the big picture of what’s happening in the world which is that people are getting more optimistic about life and that the world economy is not totally going to implode. So in the last two months, risk appetite has returned with a vengeance in markets globally. So I think cyclical stocks bounced back because risk appetite changed.
I tell my analysts not to consider just one ratio but two or three, depending on what is most appropriate for your sector or stock at that particular stage in the economic cycle. And if you get different answers, it will cause you to ask some interesting questions. So if a company has a high PE but low PB, what does that say? Are earnings forecast wrong? Are people worried that the company is going bankrupt?
With all the emphasis that Fidelity puts on bottom-up stock picking, how do you balance a top-down view?
Again, my advice to my analysts is that it depends where you are in the economic cycle and what sector you are looking at. There would be times when you are totally convinced that the entire sector is going to underperform or outperform the market. For instance, in a strong secular bull run, it’s quite obvious that cyclicals and high beta sectors outperform defensives. Turning points are much more difficult where you might want to take a more balanced view.
Let’s say that for a particular sector, currency is very important or the price of a commodity is. We may be pretty agnostic on the direction of the currency or commodity price. But we would be pretty sure that we have picked up the best quality companies within that sector. Looking at a macro view is unpredictable, but sorting the good companies from the bad is more predictable.
Where does technical analysis find a place?
It varies from one portfolio manager to another. Anthony Bolton, who is Fidelity’s International’s most famous portfolio manager, is quite an advocate of technical analysis. He always looks at it when making stock selection decisions. A lot of our fund managers probably use it too. They will look at all the fundamentals of the company but look at the chart to ensure that they are not buying at an all time high or its not 2 standard deviations above the mean or it is not massively overbought on an RSI. It’s probably used as a sanity check and not as a key driver.
You said that your analysts are individually responsible for the success of their recommendations. Yet, the fund manager has total flexibility to accept or reject the recommendations. How does it work in practice?
The analysts are remunerated on a number of different measures. How successfully their stocks outperform the relevant benchmark. How each stock performs relative to their own basket of stocks, since they too have to run model portfolios of their own stock selection. But they are also rewarded on their ability to get their ideas into our funds. There is no point in having a good idea if it does not find its way into the funds to help performance. So the analysts are expected to sell their ideas to the portfolio managers. Whether the recommendation leads to a fund outperforming or underperforming is also considered. Majority of times, it has led to outperformance from following an in-house idea.
But the ultimate call on whether they find their way into the portfolio rests with the fund manager.
At Fidelity, we have quarterly fund reviews (QFRs). At such instances, the fund manager sits with the CIO and one of the aspects looked at is the degree to which the fund manager follows analysts’ recommendations. If there is a huge divergence, the CIO would want to know the reason why. It could be that the portfolio manager is not confident about the analyst or he has very strong views of his own. Then we would try to steer our portfolio manager to use our research as much as possible since our experience shows that our research does deliver superior results.
This interview appeared in the June 2009 issue of Mutual Fund Insight.