This is part three of a four-part interview with Philippe Desurmont Chief Investment Officer and Portfolio Manager of SMA Gestion. The interview is part of ValueWalk’s Value Fund Interview Series.
SMA Gestion is the asset manager of insurance company Groupe SMA. The firm manages in excess of €20 billion and its leading fund has outperformed the Eurostoxx 50 index by an average of 5% per annum net of fees since its inception 2005. This impressive performance places the fund in the top five best-performing European equity funds since 2010.
The interview has been divided into several parts and will be downloadable as a PDF at the end of the series. So stay tuned for the rest of the series as well as the downloadable PDF!
Interview With The CIO Of SMA Gestion [Part 3]
What’s your outlook for the European equity markets over the next 12 to 24 months and how are you positioning to manage these themes?
In our view, equity markets (both European and US) are now conjoined due to the convergence towards zero interest rates and the desperate search for yield. Investors across developed markets are facing the reduction or disappearance of regular income on bonds and money market products, are looking for alternatives which triggered a general rise in asset prices (real estate, unlisted, infrastructure, actions, …).
An assets value is equal to the discounted sum of cash flows (coupons, rents, dividends, capital gains, …) it generates. Mechanically, discounting lower interest rates may, therefore, justify the observed price revaluation of assets including equities, provided. However, that the anticipated cash flows materialize. If not, the effect of the lower discount rate is offset in part or in whole and may even be accompanied by an increase in the risk premium.
Case in point is the Japanese stock market during the period 1990-2010.
Implicitly today the European markets are split into two groups. On the one hand, companies whose earnings forecasts and dividends seem assured and thus are being re-priced in line with the decline in interest rates. On the other hand, companies whose prospects seem more uncertain and who see their growth and expected profitability decline face high risk-premiums. In the first category are such companies as Nestle, Compass, Essilor Schindler.
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European banks are, conversely, the archetype of companies in the second category.
This polarization phenomenon can last as long as interest rates remain at near-zero levels. However, it should not be forgotten that earnings, dividends or cash flow used to value a company are inherently much more random than the coupon of a bond. The valuation level of certain companies considered “safe” have reached very high levels. A historical reminder can again be useful. In the early 70s, a group of fifty companies dubbed the “nifty-fifty” was renowned for their ability to continue to grow regardless of the economic climate. In 1972, their aggregate PE reached 42x. The phenomenon ended with a very violent correction in 1973-74.
We don’t make calls on the prospects of the stock market. Our portfolios are both better quality (higher ROIC, stronger competitive positions, and better management) and cheaper than the market. As a result, we believe they should benefit from a rise in equities, including a catch-up of European companies which have severely lagged behind their US counterparts a theme that in our opinion does not seem entirely justified. If the environment deteriorates our portfolio is well positioned to weather the storm.
You currently run a well-diversified portfolio. Do you think diversification holds back the fund’s returns or do you believe broad diversification is essential to long-term investing success?
Running a concentrated portfolio (20-30 stocks) can allow for significant outperformance versus the index. However, we believe that we can achieve a similar result with lower risk through diversification.
The necessity for a substantial margin of safety in our valuations protects us somewhat against adverse events, but it does not protect us entirely. There is a multitude of unpredictable risks that any business faces. Diversification provides an essential level of protection which too many managers do not sufficiently value.
To “beat the benchmark,” it’s also necessary to make investments that are not in the benchmark and have prospects with higher returns. Specifically, our equity portfolios consist of fifty companies whose weight is between 1% and 5%. This level of diversification, combined with a “very high” level of “active share” leads us to what is an optimal risk/return profile in our view.