Cazenove’s European fund recently breached the £1bn in assets mark despite the continent’s current unpopularity, with over £440m in gross sales year-to-date. According to the group, this is testament to the ongoing outperformance of manager Chris Rice, approaching his eight-year anniversary on the fund since moving from HSBC in 2002.
Rice is a business cycle investor, which he says is often misinterpreted as trying to time the economy.
Instead, the team simply recognises that share price performance is driven by more than just bottom-up factors and will skew the portfolio depending on the current stage of the cycle – whether recovery, expansion, slowdown or recession.
Rice says: “For us, the key factor for a company’s perf-ormance is operational gearing, which basically means the amount of fixed costs. With more cyclical businesses in consumer or industrial sectors, a higher proportion of costs are fixed, so when we enter the recovery stage of the cycle and sales pick up, there is much more leverage on profits and the company will outperform. On the other side of this, however, a small drop in sales will also be magnified hugely at the company’s bottom line, which is exactly what happened during the slowdown.”
In contrast to cyclicals, more defensive sectors tend to have low fixed costs and therefore little operational leverage, meaning they can adapt their cost base according to demand. In basic terms, then, Rice will be overweight in operationally geared cyclicals in the early recovery part of the cycle, moving to a more balanced stock-picking approach in the expansion phase and going overweight defensives when the cycle starts to slowdown.
“Overall, this tends to mean we take a mildly contrarian approach and are more value than growth investors.
“If you take a steady earner such as Nestle as an example, if the company is trading consistently at 15 times earnings, we would see that as expensive at the bottom of the cycle and cheap at the top. At the bottom, companies with more operational gearing should go on to outperform whereas the relative value of Nestlé’s consistent earnings is greater at the top of the market.”
While Rice says this market pattern will exist for as long as capitalism itself, the length of individual cycles looks set to be much shorter from here. He cites an ongoing structural rise in Western savings rates as the key factor in shorter cycles, with the trend of overcon-sumption and huge domestic demand finished in the wake of the credit crunch.
On the European portfolio, Rice says the team identified massive imbalances building up in the last bull market and had moved the portfolio against this early in 2007.
This defensive bent – long in areas such as healthcare and telecoms and underweight domestic and global cyclicals – led to massive relative outper-formance through to 2009 in one of the best patches of Rice’s career. As the market turned in early 2009, the Cazenove team looked to buy beta in anticipation of an inventory-led recovery.
In hindsight, however, Rice says that while he locked in gains and caught most of the market upswing, he should have increased beta to 1.3 rather than one.
He says: “We boosted domestic cyclicals such as retailers, banks and insurers but remained cautious about the massive transfer of debt from personal and corporate balance sheets to the state.
“We got the macro right and cut beta again later in 2009 but our mistake was underestimating the huge re-rating of companies with earnings exposed to emerging markets. We have been too focused on Western defensive areas such as pharmaceuticals, food and telecoms.”
Looking forward, Rice says mixed economic indicators should present some interesting investment opportunities for the fund in the coming months.
He says: “We are cautious on another round of quanti-tative easing as we feel this new money will chase the current hot areas such as commodities and potentially cause mini-bubbles.
“Our strategy is to ride out the next few months without rushing into high-momentum, high p/e stocks and we have kept faith with cheaper defensives.”
Another major theme in the portfolio is consumer stocks exporting to emerging markets as a play on falling savings rates in the East. Favoured companies in this area include Heineken and Danone.