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Trade secrets declassified

Global institutional investors have revealed the tricks and tactics they use to secure success in their dealings – and they’re all available to small investors too
May 15, 2015

In a very real sense, the act of buying and selling shares is rigged in favour of large institutional investors. They, not the retail investor, are given direct (and often first) access to a company’s board, its brokers and investment bankers, off-market deals, IPOs and fundraisings. Taken together, it can help to remove some risk from the investment process. Fund managers – and indeed many companies – argue that this is a good thing, in that it provides a strong and stable institutional shareholder base.

At heart, these funds still share the same goal as retail investors: they want to make a good return on their capital. But do fund managers differ in the way they approach an equity investment? And, allowing for different strategies between funds, what trends can be detected in their approach? Earlier this year, accountancy firm BDO asked these questions – or rather a series of questions on this theme – in a survey of institutional investors with a combined $10 trillion (£6.58 trillion) under management. All were described as “global” organisations and included hedge funds, private banks and pension funds. The typical respondent was a generalist investment or mutual fund with shareholdings in the UK.

You’d hope people trusted with portfolios larger than the GDP of a small nation are at the top of their game and would have something definitive to say. Smart money managers will, of course, weigh up each investment case on its own merits – and break their own rules when required. Equally, their investment strategies will sometimes lead to errors, hiccups and surprises; bigger is not necessarily better, or wiser. But BDO’s survey throws up some interesting findings and factors easily overlooked when considering any investment. Based on those results, we’ve compiled 10 recommendations for investors who wonder how fund managers pick stocks.

 

When considering whether to take a stake in a company in its initial public offering (IPO), only 2 per cent of the investors BDO quizzed said they valued pre-money broker recommendations. “The group’s discount of investment advice from house analysts was probably the most surprising finding,” says Chris Searle, a corporate finance partner who put together the survey. “There’s still some lingering suspicion around research where there is a lack of independence.”

The textbook example of this, suggests Mr Searle, is Glencore (GLEN), which has steadily lost value since its shares floated in 2011. At the time of its IPO, the Anglo-Swiss commodity group appointed an extraordinary 23 investment banks as book-runners and managers, seven of which recommended buying the shares soon after the listing, effectively crowding out any bearish sentiment. Nomura was the only banker to Glencore to publish research recommending shareholders reduce their stakes in the company in its first year. This isn’t to dispute or discredit the investment cases made by any of those banks, or to suggest brokers should get it right every time. And, clearly, a large number of institutional investors (most likely including some of those surveyed) bought in anyway. However, taken together, large fund managers take a more critical view of house brokers’ forecasts.

In some cases, particularly with smaller companies, it may not be possible to find an independent broker – and, in any case, brokers’ notes aren’t aimed at retail investors. But house broker views shouldn’t necessarily be discredited. The lesson is important in a broader sense: any recommendation for a share should be viewed alongside the motivations and proximity of the broker or tipper.

 

Asked for the most important source of information when considering IPO-stage investment, the fund managers surveyed were three times more likely to cite research by outside analysts. Of course, independent analysts and brokers still might have something to gain from writing positive research notes about companies. But critical distance is an important commodity in stock brokerage. To remain with the Glencore example, independent analysts at MF Global Equities Research and AlphaValue put out sell ratings on the company’s shares shortly after its flotation. They were also in the small minority of analysts who had initiated coverage but who had no banking relationship with the £39bn company.

 

None of those surveyed cited press comment as an influential factor when choosing to invest in a new public listing. Equally, public opinion, a company’s commitment to corporate social responsibility and even the sentiment of stakeholders such as employees, unions and suppliers are all largely ignored by institutional investors.

Taken together, this suggests a company’s reputational issues aren’t of much concern to fund managers. As we explain later on, this isn’t entirely true, but nonetheless provides an important lesson on how you should view press speculation and comment on a plc. This isn’t to recommend that investors ignore general newsflow; rather, it’s about keeping sight of the investment case. A negative editorial about the behaviour of Libor traders at Deutsche Bank (DBK) and the repeated moral failures of financial institutions may be emotive, but it shouldn’t detract from the fundamentals of the company or the sector. To take another example, for all the column inches written about Tesco (TSCO) in the past year, it’s hard to see how any of that comment might have affected consumer sentiment in the company. It’s important not to conflate the two. Pronouncements on the death of large supermarkets are important for context, but profit warnings, like-for-like sales and market share are all better indicators of the investment case. After all, the fund managers surveyed ranked ‘valuation’ as the most important factor in an investment decision.

What's on the cards?: What's important to the press isn't so important for institutional investors

 

Asked how they would respond if one of the listed companies they held shares in had engaged in unethical activities, 44 per cent of fund managers said they would sell instantly, without waiting for more information or contacting management. It’s an easy claim to make in the abstract, begs the response ‘define ethical’, and ignores the obvious point that fund managers with such huge portfolios will inevitably hold shares in companies many will deem ‘unethical’. It’s a sliding, subjective scale, but just two UK companies – Marks and Spencer (MKS) and technology group Premier Farnell (PFL) – make the Ethisphere Institute’s annual list of the world’s most ethical companies.

While it’s tempting to dispute the fund managers’ collective response here, the response is still revealing: UK companies accused or found guilty of illegal or unethical activity can quickly find their shares on the slide. That’s as much a case of investment logic as moral judgment. Early reports of the 2013 prisoner-tagging scandal involving Serco (SRP) did not immediately affect the outsourcing group’s share price, but inevitably precipitated significant fines, lost government contracts and profit warnings. Scandals can be hard to shake and distort or overshadow the investment case. An immediate exit may sometimes be the smart thing to do.

 

Bonuses, share schemes and pay packets of executives feature heavily in the way business is reported in the press and occasionally – as was the case in 2012 with Barclays (BARC) – lead to a shareholder revolt. But assessing levels of boardroom pay isn’t a major priority for large institutions invested in or considering investment in a company; just 30 per cent of those questioned said details on board remuneration helped to guide a decision.

More important are a company’s corporate governance policies – 43 per cent look for guidance on this front – suggesting that institutional investors are less concerned about absolute pay than absolute accountability, and tend to assume the logic that the market sets its own rate for talent and performance. If there’s a reason to dispute this, it might be that fund managers often occupy the same income bracket as board members and are at least in theory subject to a similar discipline from members of their funds. And while it might be hard to determine the going rate for any company, it’s worth scrutinising proposed pay where possible, to ensure it aligns with the investment case for the company.

Pay attention?: Executive pay, for example to ex Barclays chief Bob Diamond, features heavily in the press, but a company’s corporate governance policies are more important

 

Sometimes an investment opportunity looks too good to miss. It might be based on a disruptive, proprietary technology, momentum in the shares or a shift in consumer trends. But for the survey respondents, all of this is second to the calibre of a company’s decision-makers. Institutional fund managers listed “quality of executive management” as the third most important factor when making an investment, ahead of a company’s growth strategy, long-term financial performance or the market it operates in.

Large fund managers are often able to meet with and call on management directly, a luxury rarely granted to smaller shareholders. Yet this often does not confer the advantage you’d think it would. So, even though the survey respondents listed “meetings with management” as the most important source of information when considering investment in an IPO, which should be taken as a proxy for other fundraising situations, without a track record, it can be hard to quantify. “It’s very difficult, unless that director has built up a company previously, of assessing how good they are,” says Mr Searle. “Otherwise, the general issue is they’re an unknown quantity.”

Few board members, particularly at smaller companies, are likely to be recognisable names. So it’s worth doing a background check, if possible, on the performance of companies previously managed by executives. This, combined with option schemes that align shareholders’ interests with board members, is an important check for any investment.

 

Asked what constitutes the best guidance when appraising an investment, large fund managers take a different view to the political orthodoxy of our age: debt is less important than growth. Although 51 per cent view gearing as an important valuation metric for a company, 73 and 72 per cent of institutional investors think cash-profits and revenues, respectively, are more reliable gauges of a company’s prospects.

“The view is generally that gearing can be a good thing, as long as it’s not overblown, such as a multiple of three times ebitda for a quoted company,” comments Mr Searle. Whether this is a reflection of a benign interest rate environment, a general ease with debt or confidence that listed companies can attract fundraising is not clear. However, Mr Searle cautions that most institutional investors would place a greater emphasis on debt when looking at a company coming to the market through a private equity exit. “I’d want to know how much is exited on float, and I’d also look at how long that private equity is locked up for.”

 

Not one to miss a trick, BDO also asked the fund managers what they thought of auditors. Like all professional services firms, accountants are eager to create a halo around their brand, a common sentiment shared by the respondents to the survey. But the identity of a company’s auditor does in fact matter to a majority of respondents.

Nearly two-thirds said the decision to invest in a large company would be positively affected if the auditor was one of the ‘Big Four’ accounting firms, Deloitte, KPMG, E&Y and PwC.

Almost every company in the FTSE 100 is audited by one of those four firms, so that association is effectively a given. The issue is more contentious when it comes to smaller- or medium-sized companies, which may be in the growth stage, operate in far-flung jurisdictions, or are newly listed.

For a retail investor – as for large institutional investors – the relative strengths of various professional services are probably intangible. Indeed, the fact that Aim-traded Quindell (QPP) was audited by KPMG did not stop endless speculation on the company’s accounting practices, which were eventually found to be on the “aggressive” end of acceptable by PwC. But it forms part of the due diligence in a company, and is a rough way of pinning the credentials of a professional services giant to a company’s financials. It’s worth bearing in mind when investing in small companies.

Held to account: retail investors should pay attention to auditors

 

It seems whoever we are – the manager of a trillion-dollar fund, or a retiree with modest savings – everyone likes, if not needs, a good story. Reassuringly, three-quarters of respondents said the investment proposition or story would influence the purchase of an equity stake. Getting a handle on the investment story is not just a point of interest, but a way of understanding what it is a company does and what can be expected of an investment. That’s not about emotional involvement, but establishing clarity in a narrative. It’s always worth following Warren Buffett’s advice that you should never buy what you don’t understand.

 

More than any other financial figure, detail on capital expenditure plans was cited as the most helpful for understanding a particular investment. After all, it’s the main way a company adds value to the equity a shareholder puts into the business. The finding was nonetheless “a real surprise” to Mr Searle and BDO, although as any investor who has bought shares in an early-stage natural resources group will tell you, it is often the key concern. Understanding when the funding of capital-intensive projects will be rewarded is important for managing one’s own expectations.