Forecasting the future
Loomis, Sayles & Company teamed up with IML late last year and launched the Loomis Sayles Global Equity Fund to retail investors in Australia. The Fund – which has a long and successful track record of consistent performance – is now available on many leading platforms and has been well rated by the major research houses in Australia.
The Loomis Sayles Global Equity Fund’s (the Fund) international diversification delivers a range of benefits to investors by offering them a good geographical spread of quality companies which have been selected by the Loomis Sayles investment team.
The Fund is co-managed by Eileen Riley and Lee Rosenbaum, both based in the Loomis Sayles head office in Boston where they have worked together for 11 years. Working closely with their investment team, they take a highly disciplined approach to finding opportunities that they believe represent the best ideas and that are expected to perform well over the longer term.
The Loomis Sayles team has a bottom-up approach to stock-picking that involves layers of financial modelling, deepening the level of precision with which the team forecasts future cashflow and other important measures.
In this interview, Eileen and Lee describe their process ahead of Lee’s visit to Australia in September 2019 and discuss what they’ve learnt from working together for more than a decade.
First up, can you walk us through how you value a business?
Lee: We arrive at our valuation through a discounted cashflow (DCF) approach. What we are seeking to do is understand a company’s ability to increase its free cashflow over time, in a sustainable way. Free cashflow growth is our best estimate of the intrinsic value of a business (free cashflow and the re-investment rate).
The focus on cash reflects our discipline when it comes to investing only in quality businesses. By focusing on cash, we gain a clear line of sight over things like earnings, margins, capital expenditure and working capital – factors critical to a business’ ability to deliver sustainable performance over time.
How does the competitive advantage period relate to the alpha drivers of the portfolio?
Lee: The competitive advantage period (CAP) – which we define as the number of years where we can explicitly express our assumptions about the future progress of a business based on our understanding of a company’s quality and ability to grow intrinsic value – is an integral part of our DCF assessment. It allows us to add another layer of precision to our valuation and, in general, higher quality companies have a longer CAP.
But CAP is just one input. To get the bigger picture, we need to look at what we call the alpha drivers and where CAP fits in with them.
Quality: Here, we’re measuring the level of quality of a business as well as the sustainability of that level of quality. To do that, we look at seven dimensions of quality; strong management, capital allocation, return on invested capital, business model, market structure, intangible assets, ESG (environmental, social and governance) factors.
We don’t need to see all seven to consider a business a candidate for the portfolio, but a business must demonstrate sufficient quality standards, as well as the ability to sustain that quality in the future.
Intrinsic value growth: Free cashflow growth is the key driver of intrinsic value and we look for five sources; revenue growth, margin expansion, corporate restructuring, capital intensity, capital allocation.
When it comes to the sources of the free cashflow growth we are agnostic, but we need to be confident in management’s ability to grow intrinsic value. The combination of quality and intrinsic value growth generates a ‘duration effect’. In other words, they add value to a stock over time – which is what we want to see in any company we add to the Fund’s portfolio.
Valuation: To identify undervalued securities, we develop three scenarios – a base case, a best case and a downside scenario. In addition, we use our forecasts to help determine how long we expect a business to outperform its competitors.
By analysing companies in this way, we have consistency whether we’re looking at a pan-Asian insurance company (AIA) or a Swiss software company (Temenos).
Can you share an example or two of companies – one using a security currently held by the portfolio and another for a security that didn’t make the cut?
Lee: One of the companies we hold is Dassault Systemes. It’s a French software company that spans all types of markets from manufacturing to city planning. It’s got two or three main competitors and is taking about 1-3% of market share annually. We forecast Dassault’s CAP to be 10 years.
We like the company because it has a high degree of recurring revenue, about 70%, and its market structure is large. It leads the industry in product lifecycle management software and it just acquired Medidata, which is based in the US. Medidata’s software analyses pharmaceutical trials so this gives Dassault another vertical.
Dassault is very big in industrial design software – aerospace and defence – but a large portion of the market is fragmented so they have scope to do a few more acquisitions of this nature. They have opportunities to deploy capital organically as well as inorganically to capture markets.
Eileen: So on the other side, I’ll tell you about a business we exited. We sold out of Newell Rubbermaid, a global consumer goods company, in 2017. We had owned this company for several years.
Our assessment of the business changed as the company’s wide distribution footprint, once a competitive advantage, was at risk of becoming a disadvantage. With many retailers selling Newell’s products and offering those products online, greater price transparency posed a threat to Newell maintaining their MSRPs (manufacturer’s suggested retail price). This dynamic, ultimately, diminished our view of Newell’s CAP.
With the market becoming increasingly focused on short-term news, does this short-term focus inhibit or benefit your CAP analysis?
Eileen: Short-term views can create volatility, and volatility can create good opportunities. The Loomis Sayles Global Equity Fund is a best ideas fund, so where we see new opportunities, we can allocate capital to new positions or add capital to ideas we already hold in the portfolio.