Searching for alpha in large-cap equities is a team sport

[Music] What we're using to help guide our attention as stockpickers is obviously fundamental conviction. So within the Wellington investment platform we have sector specialists including within defense of course who will be recommending ideas. We also then filter those ideas based on Quantmetrics and NICS top down macro inside. [Music] Welcome to Well Said. Conversations with Wellington Management Investment Professionals about the intersection of financial markets, geopolitics and long-term research. I'm your host Thomas Mouchou. In the world of active investing alpha is king. Now delivering higher returns than a benchmark with the same amount of risk is of course what active managers are paid to do. Generating this alpha consistently requires skill, experience and teamwork. And while it's never easy to do certain areas of the market are even harder than others. Large cap stocks for example are notoriously stingy with alpha opportunities given their cap weighted indexes, large investment flows, high liquidity and of course extensive analyst coverage. Now despite those challenges there are ways to generate alpha in global large caps. In my guest today portfolio manager Anna London and macro analyst Nick Bellenzic are testaments to that. Anna started her career as a small cap manager and now applies her approach to alpha generation in that asset class to large caps. Nick is a veteran macro analyst who believes as I do from the geopolitical perspective that top down views are an important alpha discovery input for the investment process. They're both here today to spill their secrets. Anna Nick great to have you here and welcome to well said. Thanks so much Thomas great to be here. That's great to be back thank you for having me. All right Anna let's start with you and with the big picture. So from your experience what does it take to generate alpha consistently with long only large cap investing? I mean what are the key variables here? So I think as a combination of obviously great bottom-up stock ideas but you cannot have that alone. It's a lot around a process discipline and what we like to do is also make sure that we are drawing on every tool in the toolbox. So what we reference as a multi-disciplinary approach is really the secret we believe to success. To go back to your point around this is a part of the market that everybody is pouring over. You need to have differentiated insights and they might come from the sector specialists who's looking at the stock but they could equally come from Nick's top-down work that helps pivot conviction in a certain direction. Or the geopolitical strategist who might have an insight that you can use. Absolutely. In fact geopolitics has featured heavily in recent years as you will be acutely aware. We're really trying to pull all the pieces of the puzzle together in a very structured way and then when we build our portfolios we do it also in a very disciplined fashion and we're trying to maintain very good balance across the portfolios so that really it allows the stock-specific risk to be the main contributor to performance as opposed to factors or country bets or sector bets because that's not where we think we have our edge. So I did mention that you were also a successful small cap investor. What aspects of managing small caps do you find useful in your current role? I cut my teeth in small caps as an investor. I think it's a great way to first of all hone your skill as a fundamental analyst. Small caps are less well-covered than large caps. You have to do a lot more of the heavy lifting yourself. So it's a wonderful way of coming across a very diverse range of business models and companies. It also teaches you to sift through an enormous universe of stocks so as I'm looking globally I've basically used different screening methodology that has evolved over time to help me focus my attention on the stocks that are most likely going to generate alpha for the client. Small cap also teaches humility. This is a part of the market where we see a lot of volatility. Things can change very quickly. Risks can flare up and so having earned our battle scars in small cap I think equips as well to navigate other parts of the market and then you know the portfolio construction technique that I learned as a small cap investor was very bottom up and I think that's how a lot of small cap portfolio managers approach their opportunity. I learned through many tough lessons that portfolio construction and risk management is absolutely key to the long-term return profile. So fundamentals and battle scars? Yes most certainly. Nick let's turn to you macro and geopolitical dynamics are important investment inputs even for fundamental stockpickers like Anna. So two questions for you. Why do you think this is true and on a practical level how do you filter your input to be most helpful to Anna and her team? Yeah I think both are great questions. So first of all I firmly believe that top-down drivers such as growth, interest rates, policy uncertainty, volatility have a major influence on the revenue and earnings growth as well as valuation of most listed companies. So especially when these macro drivers change I think it's important for even the most fundamental stock pickers to be aware of these changes. In fact I think we're in one of these periods of change at the moment I think we're going through a major macro regime change similar to what we experience in 2000, 2007 and that's particularly true in Europe and Japan but also applies more globally. The world is increasingly fragmented, decades of deflation have turned into global inflation accelerating, supply chains are being redrawn, populism is on the rise. So a lot of things are changing. At the same time policy makers around the world are using both monetary and fiscal tools to support their respective economies and while some of these changes are clearly a bit worrying they create a lot of alpha opportunity for investors like Anna. And I see my role in the role of my colleagues really as twofold. First make PMs like Anna aware of these changes and what implications that might have for equities from a regional perspective as well as sector perspective. I think my role is also to help them narrow down the opportunity set. So for example Anna has one of the broadest opportunity sets in the firm. There are very few companies she can't invest in so by flagging the sectors for example most exposed to the German fiscal announcement we had earlier this year who stands to benefit from a pick up in Japanese inflation which sectors are not priced for higher rate environment. All these things help her to narrow down her opportunity set and hopefully make better decisions. When Nick I agree that there are a lot of structural changes happening in the global economy and the global policy backdrop. A lot of that is obviously being expressed through a greater emphasis on national security geopolitical change. This is absolutely undisplained Europe. We've had a big change in particularly the US policy orientation towards Europe. I'm curious how you think changes in the defense sector, changes in the national security environment are impacting a lot of these variables that you just outlined. I think Europe is a great example. For the decade after the global financial crisis the best performing parts of the European market were international growth companies that benefited from ongoing globalization and exposure to markets like China and the US. These stocks rightfully traded in a premium to their more domestic peers. But that's clearly changing right. As you said the world is getting more fragmented geopolitical tensions arising at the same time national security is becoming a more important driver in Europe. We're seeing a bigger focus on encouraging domestic demand and that now favors more domestically oriented companies. The second example I would give where Macquarie is really important is when interest rates were at zero there was essentially no time value to money. This benefited companies with a strong growth trajectory but very long payback period. Unsurprisingly growth companies in Europe traded a record high relative to value companies. However with rates now well above zero this valuation gap is no longer appropriate. So there's opportunities there so Anna as a stockmaker how do you apply these big structural shifts in national security and the geopolitical backdrop to your process. This is where the multidisciplinary approach comes in that I alluded to at the beginning of our conversation. So what we're using to help guide our attention as stock pickers is obviously fundamental conviction so within the Wellington investment platform we have sector specialists including within defense of course who will be recommending ideas. We also then filter those ideas based on quant metrics and nicks top down macro insights and so if we look at the selection of for example a German defense company the route to getting there would have been a strong fundamental conviction coupled with a positive quant signal and then where we have the highest conviction in the ability to meet those higher ending commitments. So that's how we build conviction using all these multiple layers of information. When you then introduce that stock into the portfolio we would be looking at how the risk metrics evolve with the introduction of that name and while this example might not be the perfect one there because there are fewer defense companies in Europe to select from we might have other instances where you're choosing between two similar and one might have a much better impact on the risk profile of the strategy than the other. It's then very obvious for the team which way we want to go and it drives towards that balanced portfolio construction. Okay, that makes a lot of sense. And I do think from my perspective there's a lot more disruption coming and on the geopolitical side, disruption to me means differentiation. And so I think UNNIC will have a lot more work ahead as you try to decipher these big changes that are happening. Now, let's stick with you here. Another theme that obviously is happening in the markets right now of course is artificial intelligence. The AI majors, as I'll call them, have been dominating a large cap indexes. Massive market caps here with continued upward stock price appreciation so far. So what are the challenges for an investment team like yours? Whose remit is delivering alpha in large caps when you see this kind of index skew. This is a big difference compared to small cap obviously where we don't have to deal with benchmark concentration. Everything you own is a big bet so to speak. When we look at large caps I'd say the world has changed in the last even a shorter period as five years. These stocks have become such big parts of our opportunity set that we've had to adapt our approach to portfolio construction in this time period to manage some of those risks just because they've become so big. Now in the context of a global strategy that's a little bit easier to do than in a US only right where we have less differentiation. It's easy to think about these names as all moving as one group but of course there's been quite diverse performance between these big US tech companies. And that's where our esteemed colleagues on the tech team have really helped us at different points throughout the very rapid evolution of this trend. But I think it's also interesting to see how this over time is likely to broaden out because the US has obviously led the charge here and has a first mover advantage in many of these areas. The companies have built up huge scale and intellectual property. But we are now moving into a period where we're seeing ecosystems being built in other parts of the world, most notably China. And I think over time there's going to be an acceptance that there can be winners outside of the US as well in this field. There will also be a pivot towards more and more use cases evolving over time. So we'll as investors I think move our attention from purely being focused on building the foundations of this world to what are the applications going to be. So we're trying to keep up with the very rapid evolution of this. And I think to some extent my small cap background also drives me to want to look for alpha opportunities outside of these very intensely watched stocks. So whilst we want to play where we feel we as a firm have a differentiated view, we'd also love to just try and neutralize this part of the market to enable ourselves to earn alpha in other pockets where people are paying less attention. Be it industrials, be it consumer, be it in the material sector and so on and so forth. So broaden the horizon. The world is bigger than just a correct. That's that I do want to ask you on more AI question. Of course. There's so many aspects to this. I'm curious how you think about the second and third order impacts here of artificial intelligence and how they might impact the performance of other companies across your portfolio that are not in the AI world specifically. So how is that likely to change your process and what are you looking for in terms of finding these opportunities that haven't quite materialized here? Yeah. It's a really good question. It's something that we spend an awful lot of time thinking about as a team. Some more obvious areas are emerging within software, within the internet names. I'd say there's going to be more evidence in areas such as healthcare and industrials over time. But it's really about analyzing what the individual company is doing and what they're prioritizing and how they are thinking about incorporating AI because some will want to do everything themselves. Others are trying to collaborate to bring in the expertise. When we analyze companies, one of the key things is the capital allocation discipline of the leadership. So I think there's going to be a lot to sift through as this goes into use cases in a more tangible way. I don't have all the answers today. I'm just extremely grateful to be surrounded by lots of very smart people who are looking at this from their individual sector lenses and seeking out companies doing smart things. Well, I'll share my specific lens here too because one of the messages I'm trying to get across is just the centrality of national security when it comes to artificial intelligence. And I don't have a meeting with the Pentagon, the CIA, any NATO country that doesn't have them focusing first on AI in the national security context. So I do think there's a lot more change coming in that aspect. And I think that's going to create more winners and losers, more differentiated opportunities across the board. So I do think we're just getting started in understanding where are the opportunities here. Absolutely. Nick, how do you see this playing out across the European landscape, especially given the fact that European tech firms are mostly lagging US and Chinese rivals here. As well as the national security implications that this might bring to the continent. I think it's another great question. So as Anna highlighted earlier, the US as the enabler of AI so far and closely followed by China, you see that in the performance of some of the AI stocks in the US. But I think what hasn't fully played out yet, who are the big beneficiaries? And I think that's where a Europe or Japan could really benefit. So the productivity growth in both of these regions has lacked significantly behind the US, for example, we look at the last 20 years. But these old economies, sectors that dominate Japan and Europe, they can really benefit from a pick-up in productivity. So similar to the internet, initially the big winners with the enablers of the internet boom in the 90s. But the big beneficiaries were also the, for example, the retailers that were able to move online and other sectors. So I think that's something we don't know yet how far AI can actually boost the productivity in Japan and in Europe. And that's also clearly not on the price. So I think that's where big opportunities. As you said, Europe clearly lagging in terms of the enablers of AI, of in terms of the users of AI, I think the jury is still out there. And I think Europe has a lot of opportunity to kind of catch up in those areas. And of course, same with, because you mentioned defence, they're increasingly more defence startups in Europe. They're exactly trying to use AI and develop defence AI as well. So I would say defence is one of the areas where Europe can still catch up, especially because also these technologies are not exported as much from the US to other regions or a lot of funds in Europe are flowing into these areas as well. Certainly a lot more opportunity coming in that sector. And I'm going to wrap up the conversation here, but I want to give you the final word on anything else that you think we've missed in this wide-ranging discussion. Oh my goodness, well, there's obviously so many different pockets of interesting alpha-generation opportunities across the globe. I guess what I would say is the opportunity to distill this in a structured way that is well-risk-managed is an underappreciated way to get more alpha out of your ideas in all pockets of the market. Not just defence, not just AI. And all around the world. All right, well thank you both once again for fully-manager Hannah London and macroanalyst Nick Valenzic. Thanks for being with us on WellSet. Thank you very much. Thank you very much. The WellSet podcast is a Wellington Management production. Our producers are Colin Hopkins, Mark Murphy and Dana Wickstedt. At a tutorial support by Amanda Dockerty, Colin Hopkins and Dana Wickstedt. The show is recorded, mixed and edited by Mark Murphy. Animation support from Rasa Cermonte, production support from Dave Crowt. You can listen to WellSet at Wellington.com and at most podcast platforms. Thanks for listening. All investing involves risk, including potential loss of principle. Past results are not a reliable indicator of future results. Forward-looking statements should not be considered as guarantees or predictions of future events. This material was current as of the publication date. Wellington assumes no duty to update the content in the event that the information changes. This commentary is provided for informational purposes only. 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