Ignoring market sentiment and finding long term winners

I’m Staci West, and today I’m joined by Bertrand Cliquet, co-manager of the Lazard Global Equity Franchise. Thank you for joining us today.

[00:09] My pleasure. Hello.

Now, it would be remiss of us not to have a quick look back on 2022 and what was actually a really good year for the fund. It managed to post positive returns while most of its peers lost money. So, I’m sure inquiring minds would like to know how did you manage this? What worked well for you last year?

[00:30] Yes, I think there are two things to highlight really. The first one is the market putting its feet somehow back on the ground to a degree, especially around the normalisation of the interest rate environment. Therefore, less complacency on valuation, and that’s a point of emphasis for our strategy – we’ve always been adamant that cash flows need to be discounted with the appropriate discount rate. So, that has helped us tremendously. 

The second one as well, was about seizing a lot of the opportunities induced by the market volatility and discrepancy in share prices. So, what we saw is really a year of two halves, very strong defensive performance in the first half, but we’ve been able, with the emphasis on valuation, to see some of those really high-quality franchise companies that were, for us, really expensive for years, falling 50 – 60% and providing us [with] opportunities. 

So, our turnover actually has been over a hundred percent, which is quite unusual when you think about us as, you know, people investing for the long term! But we have this valuation discipline, which means that if you have a company such as Knorr Bremse [Knorr-Bremse AG], – which is the global leader for braking systems for trains and trucks – that has fallen 60%, for a company that hardly has any debt, then maybe that offers potential, and then you have this redeployment, and that’s really helped us in the second half of the year in terms of growing capital. 

Now your approach also uses a behavioural filter. So, can you just explain how this works and did this perspective benefit the fund last year?

[02:20] Yes, I think if you think about the process, it’s actually very transparent and you know, quite simply the first one is about defining this global equity franchise universe. So, we put the emphasis on companies that we think will have a higher degree of earnings forecastability – so, and that’s important we think, to be able to predict earnings and cash flows with a lower margin of error. What that provides us with, is the ability to be more assertive on valuation. 

So, we focus on companies with one of five sources of economic franchise; they can be a natural monopoly; they can be economies of scale; they can have switching costs; they can have brands or intellectual property; or a network effect. And what we have is companies where we can be so much more assertive on valuation, so that’s point 1 – this economic franchise, really saw the benefit in this economic uncertainty, companies where you offer a service or a product that is almost essential to your clients, irrespective of the economic environment. And that really helped us.

The second point I mentioned earlier, was the continued use of normalised interest rates. I think that using a value ranking – so, what we do is – once we have this investible universe, we do significant fundamental research on every single company, to ascribe an intrinsic value to this business. 

Then building the portfolio is very simple. We compare the intrinsic value to the share price, and if we identify a large gap, or significant upside, we want to place the emphasis in the portfolio on those companies. 

And what you have is, it gives you a very nimble way to deploy capital as [the] market become[s] more or less optimistic on one single company, the order on which these companies stand in our value ranking will change, giving us [the] opportunity to redeploy capital.

So, the redeployment of capital isn’t dependent on a company becoming fashionable or not, being the trend of the moment or not. It is very dependent on: does the market have too optimistic or too pessimistic a view on a very, very high-quality business at a certain point in time? And then we say, “Okay, yes, the market’s very pessimistic, it is an opportunity,” or “Well, I’m afraid it’s a business we would love to own, but the market certainly is too optimistic, so we’ll have to be patient and wait.”

Great. And looking forward now, what are your views on the markets and the economies going into 2023? And do these views impact your investment decisions that you’re looking for, for the year ahead?

[05:25] Yes, and I have to say, we’re currently in a peculiar situation where we have the most anticipated recession of all time I suspect, which leads some people to believe that because it’s so anticipated, it’s priced in, and to a degree we disagree with this. You know, we think that the monetary response has led to probably a reserve of inflation in the system that will have to be put through. So, even when commodity prices pressure abates, you know, there is still an underlying inflation problematic that will cause issues from a margin standpoint. And we don’t think the market is really pricing margin pressure to a very significant degree for the long term. So, what we have is for all our companies, we’ve incorporated a meaningful recession and, very much do believe that they might be very high-quality businesses, but they can’t all be immune from this inflationary pressure.

So, what we believe is that our companies will have a greater ability to weather these inflationary pressures, but they’re bound to suffer to a degree, which places the emphasis on valuation again. 

And to give you an example, that’s why we’re still at the lower end of number of stocks in the portfolio; we have a range of 25 to 50 names. 50 names we’ll own when the market has capitulated and most stocks are inexpensive, but we are the lower end of this because we think that we have a handful of opportunities that offer very significant value. We think the portfolio looks very well versus our 10% return target over the next three years. But it is a selected number of stocks. Overall, we still struggle to find value in a high number of companies.

You touched there a bit about the positioning of the fund and your outlook going forward. But maybe, do you have an example of a holding for us, to give an illustration of the fund’s positioning for the 2023?

[07:42] Yes. I think I’d come back on two stocks. The first one is a stock we added in September. I alluded to it earlier, Knorr-Bremse. So, you have a global leader in braking systems for trains and trucks – very high market share, a product that has a very high level of technical content. And the company share price was heavily impacted by one of its biggest markets, mainly mainland China grinding to a halt. And the market really derated this stock, essentially over 60%. And a company that is able to weather inflationary pressure through a combination of price measures and cost containment. So, we think they will remain a very, very high free cash flow generative business. And so that’s why it’s a large position in the portfolio.

The second one, which is a more recent addition to the fund. You know, we’ve owned tech companies to a large degree very much until 2018 and start of 2019. Then we frankly have struggled with the valuation, and we’ve added Alphabet [Alphabet Inc.] back to the portfolio in December, because we think that you have a high-quality company where the market has largely absorbed the pressures on the advertising market globally, linked to the recession, and the fact that their market share is going down. 

And for us, the investment case hinges on the ability of the company to be a bit more disciplined around cost. And that’s one of the few large tech companies that hasn’t announced a plan to tighten its belt. We are very confident that Ruth Porat, the CFO [Chief Financial Officer of Alphabet] will have a more significant influence now that the revenue stream is under more pressure. And therefore, we see a very interesting story from a margin standpoint and a valuation that has more than discounted these challenges.

That’s great. Thank you for those examples and for talking us through the portfolio today. It’s really appreciated.

My pleasure. Thank you.

And for more information on the Lazard Global Equity Franchise, including more information on the fund’s investment process, visit FundCalibre.com