As thematic investors, we construct concentrated portfolios of stocks from an investment universe delineated by our five mega themes. These stocks have good through-cycle growth potential, are aligned for societal good and usually have a holding period that stretches beyond the next 2-3 years. We invest according to thematic opportunity sets and are not anchored to equity benchmarks.
Proponents of more broadly diversified portfolios believe that concentrated portfolios – usually defined as a portfolio holding under 50 stocks – offer less diversification, and therefore carry more risk.
We believe it is possible to construct concentrated portfolios that can build wealth whilst remaining cognisant of risk. Diversification is more complex than simply the number of stocks that comprise a portfolio. Taken at its simplest level, a portfolio comprised of 80 stocks that are drawn from the same sector or region may appear more diversified but in reality we deem that this introduces significant risk into the portfolio.
How then do we diversify our portfolios while remaining committed to our concentrated approach?
Diversification without dilution
We believe our thematic approach affords us a perspective or insight that is differentiated from the market. Our thematic investment process has three stages: idea generation, stock selection and portfolio construction. At the conclusion of this process we will have built an investment thesis that highlights the stock’s idiosyncratic qualities. This in turn supports the portfolio manager in their conviction to add the stock to their portfolio. The primary way we diversify our portfolios is through our themes and corporate characteristic.
Our five themes – Ageing, Automation, Climate Change, Digitalisation and Evolving Consumption – lead us to look broadly across all sectors and geographies, through differentiated lenses that combine both macro and micro factors to arrive at a select universe of companies in which we could invest. We identify themes from both a top down, or ‘big picture’ perspective, and from our bottom-up fundamental analysis of industries and companies. These themes cut across typical sector and geographic boundaries that are common to indices and benchmarks. In addition, these themes would need to be contributing to societal good – we invest in line with society rather than at its expense.
From these sets of thematic universes of companies we search for stocks worthy of rigorous analysis to determine if they are an attractive investment. We assess the quality, growth and valuation characteristics of each stock using fundamental analysis, and embed environmental, social and governance (ESG) factors in this analysis. At this stage we consider the stage of lifecycle that a company is at and during our research process, will allocate each company a Corporate Characteristic.
Why you should know where a company is in its lifecycle
Identifying where a company is in its lifecycle is especially important when constructing an unconstrained portfolio. It builds a further level of diversification and articulates the likely impact of macroeconomic factors on each company.
We categorise each investment by corporate characteristic, allocating to one of the following five groups:
- Disruptive Growth
- Defensive Franchise
- Cyclical Franchise
- Cash Harvest
- Special Situation
Each of these corporate characteristics has its own quality, growth and valuation dimensions.
Disruptive Growth companies can be enormous creators of shareholder value. They have the ability to attack large entrenched profit pools with a superior product or service. These companies may not generate high returns on capital during their most innovative and disruptive phase because they are investing to drive growth. However, an understanding of the size of the addressable market, potential market share and long-term margin structure can reveal excellent investment opportunities. Our thematic approach is well suited to uncovering these insights. The strongest Disruptive Growth companies evolve into Franchise companies (for example, Amazon) as they reach scale. Valuation is a key risk with Disruptive Growth companies and it is important to maintain perspective and discipline.
Defensive and Cyclical Franchise
We divide the Franchise Corporate Characteristic into two subcategories: Defensive Franchise and Cyclical Franchise.
Defensive Franchise companies tend to consistently earn high returns on invested capital, with limited variability across both economic upturns and downturns possibly aided by a diverse portfolio and/or an expansive global reach – for example utility or consumer staples companies. Cyclical Franchise companies sell products or services where demand is more dependent on where we are in the economic cycle, such as restaurants, hotels or car manufacturers. These companies may have fixed costs and may struggle to maintain profits in economic downturns. Cyclical Franchise companies typically introduce more business risk into the portfolio than Defensive Franchise companies do.
Cash Harvest companies are usually mature and have limited internal need for the excess cash that they generate. As a result, they are likely to return this excess cash to shareholders via dividends or share buybacks. The market can underestimate the duration over which these companies are able to maintain superior and growing cash returns to shareholders even if revenue growth is slowing. Business risk (such as competitive threats from Disruptive Growth companies or management embarking on a questionable acquisition strategy) and financial risk are the more important factors to consider in the Cash Harvest category.
If we categorise a company as a Special Situation, we believe there is a specific and unusual investment case. Examples of a Special Situation might be a corporate restructuring – which may have the potential for a sustained improvement – or a spin-off – when a company decides to split out one part of its business and list it as a separate entity. It may be the case that relinquishing one particular business unit can be an easy way to focus the company on its core strengths.
Companies have different risks depending on their stage in the lifecycle
The style and factor risks in each Corporate Characteristic are typically quite different. For example, Disruptive Growth companies tend to have high valuations and low dividend yield, whereas Cash Harvest companies tend to be more competitively priced and may offer a higher dividend yield. Cyclical Franchise and Defensive Franchise may both offer good return on equity, but Cyclical Franchise companies may demonstrate higher short-term sales and earnings growth. In contrast, Special Situations companies tend not to exhibit any style bias and have a more idiosyncratic risk profile.
By adjusting the weighting in a portfolio between Corporate Characteristics it is possible to ensure a portfolio is tilted correctly for the market environment and to ensure that overall portfolio returns are driven primarily by stock selection. It is a method of diversification which enables unconstrained concentrated portfolios to reduce factor risks. Whilst much of our focus has been on stock-specific risk, there are additional risk control measures that we employ when constructing portfolios, such as position sizing. We will seek to avoid investments where there are realistic scenarios of an impairment to capital even if our valuation analysis shows there to be upside to the share price. This reflects a bias towards capital preservation where the cash flows are more predictable and we can evidence robust corporate governance.
Ultimately, we rely on our thematic approach to build an investment universe that is skewed towards companies that offer strong, sustainable growth. It is the company’s idiosyncratic factors and the stage of their lifecycle that will drive differentiated returns and thus build diversification into an unconstrained, concentrated portfolio.
This document has been issued by Sarasin & Partners LLP which is a limited liability partnership registered in England and Wales with registered number OC329859 and is authorised and regulated by the UK Financial Conduct Authority. It has been prepared solely for information purposes and is not a solicitation, or an offer to buy or sell any security. The information on which the document is based has been obtained from sources that we believe to be reliable, and in good faith, but we have not independently verified such information and we make no representation or warranty, express or implied, as to their accuracy. All expressions of opinion are subject to change without notice.
Please note that the prices of shares and the income from them can fall as well as rise and you may not get back the amount originally invested. This can be as a result of market movements and also of variations in the exchange rates between currencies. Past performance is not a guide to future returns and may not be repeated.
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