Conviction investment and the importance of portfolio construction in generating long-term alpha

Successful equity investors understand that there are two fundamental, yet intrinsically linked processes, which must operate in tandem to achieve long-term outperformance. The first is stock choice, the process by which equities are assessed and chosen, and the second is portfolio construction, the process by which equities are combined over time.

When it comes to stock choice, at Hyperion, we seek to identify growth-oriented companies which will produce predictable medium to long-term earnings streams, have above-average growth potential, and high-quality business franchises in a large and/or growing addressable market.

As for portfolio construction, we rely on a proprietary, research-based process, which exploits non-fundamental short-term price volatility while keeping a weather eye on long-term fundamentals, and ignoring short-term market noise.

Our performance over time is evidence of the success of our strategy. Since 1996, we have achieved annual outperformance, or alpha, of approximately 4.6% p.a.[1] from our Broad Cap Composite, and since inception in 2014, our Global Growth Fund has outperformed by approximately 9.3% p.a.[2]

While much of our outperformance can be attributed to our ability to successfully identify quality, structural growth companies, a significant portion can also be attributed to our portfolio construction process.

Hyperion’s portfolio construction process explained

Our investment process is designed to generate long-term alpha for our clients by systematically comparing current share prices that are heavily influenced by short-term, non-fundamental volatility, to relatively stable but structurally growing long-term intrinsic value estimates.

In order to explain how we do this, it is important to first explain what we mean by short-term volatility and long-term alpha. It sounds simple, but the reality is that many market participants do not understand the difference between short-term opportunities and long-term fundamentals, or that exploiting short-term alpha opportunities is profoundly different from exploiting long-term alpha opportunities.

Short-termism is rife in equity markets

Most market participants are obsessed with short-term alpha and share price-based returns. To maximise short-term alpha, they try to predict short-term share price movements by buying stocks they think will outperform in the short term, and selling stocks that they think will underperform over a similar time period. In essence, these traders are trying to predict the short-term direction of share prices, which requires them to constantly reassess their short-term directional thesis.

Our view is that this is very difficult to do consistently, because share prices are highly unpredictable in the short term. In addition, when investors have a short-term mindset, they tend to focus less on the long-term fundamentals of the stock, and more on news flow and meeting or beating short-term consensus expectations as the dominant reasons for going long or short a stock.

To add to the problem, most market participants are trying to do the same thing at the same time. Many short-term alpha generating processes are well known, and commonly used by participants – which makes it a very competitive space to play in. Short-termism is a very crowded trade and becoming more so over time.

Focusing on the short term can have unintended negative consequences

Investors who do not have a good understanding of the underlying fundamentals of the companies they buy and sell, are unlikely to understand a business’ intrinsic value, and so can be forced out of the stock, or hastily buy in, at the worst possible times.

The market is directionally efficient in terms of news flow in the short-term. That is, if stock-specific news is negative or positive, then the share price will generally go down, or up, as a result, relative to the market. The challenge for investors in this scenario is that the news flow tends to be unpredictable at the individual company level, the industry level and the macro level. In fact, financial markets and economies are inherently random and unpredictable in the short term due to the influence of crowd-based behavioural factors and the general complexity of these systems. Markets and economies are complex adaptive systems, heavily influenced by human sentiment and behaviour and thus, extremely difficult to consistently predict in the short term.

Unfortunately, investors tend to overweigh the importance and meaning of recent share price movements, which are largely random and driven by non-fundamental market noise over short time periods. In order to overcome this problem, we have built multiple risk adjustments into the process to limit behavioural biases. In addition, we use the investment team’s knowledge, understanding and collective experience to assess the long-term fundamental relevance of the negative price momentum and associated negative news flow.

The difficult reality is that short sellers have become very effective at influencing the financial media as well as the short-term sentiment, regardless of the long-term fundamentals of a stock. It can be very difficult to retain and grow positions in the face of short seller and media-driven negative feedback loops and price momentum, if you don’t understand why you own the stock and don’t have a strong knowledge-based conviction.

Value investing requires conviction and a long-term focus

Our investment process aims to actively avoid falling into the trap of short-termism, but instead to focus maximising long-term returns, long-term capital preservation and long-term alpha.

We do not attempt to generate short-term alpha through trading strategies such as momentum, near-term news flow, feedback loops, shorting or short-term macro trends. Our focus is on long-term business fundamentals and long-term valuation.

This is not to say that our investment process does not incorporate short-term share price volatility – it does – but we do not attempt to predict the direction and/or quantum of future short-term share price movements to generate alpha. In other words, our investment process is not predicated on accurately forecasting short-term share price movements. Instead, we take advantage of non-fundamental short-term price volatility to maximise long-term alpha for our clients. Predicting short-term share price direction and quantum is not key to our ability to generate long-term alpha.

Our investment process has consistently added long-term alpha regardless of the direction and quantum of short-term share price movements. This is in stark contrast to how most market participants try to generate alpha – by implementing investment processes that are reliant on correctly predicting the direction and duration of short-term share price movements.

Instead of aiming to predict stock price direction, we take advantage of short-term share price volatility, by using a portfolio construction process which shifts stock weights up and down as appropriate, typically from less than 1% to a maximum of 13%.

A contrarian portfolio construction system

Hyperion’s portfolio construction system tends to be contrarian in nature and provides liquidity to the market. We tend to be buying when individual share prices are weak and selling when they are strong. This is the opposite to most short-term alpha seeking investors who are sucking liquidity out of the market because they are trying to buy positive momentum stocks and sell negative momentum stocks.

Our proprietary portfolio construction system uses both long-term valuations and a collection of quantitative and qualitative fundamental risk adjustments. Many of these risk adjustment factors have been extensively tested, and shown to add significant value over the long term. They do however rely heavily on the collective experience and skills of our investment team, because their success or failure is a result of the quality and accuracy of the inputs from the team. Our team has 80 years collective experience at Hyperion and 130 years in the industry, and a track record of performance and accuracy.

Portfolio construction expertise is essential to long-term success, yet many market participants underestimate the importance of right-sizing porfolios and how much this contributes to overall risk-adjusted returns.

Despite what some believe, simply investing in some of the stocks we hold will not produce the investment returns that our process produces. An essential foundation of the process is our ability to retain positions against the crowd, based on our knowledge-based conviction. And as short-termism becomes ever more prevalent, and short sellers ever more aggressive, conviction, based on fundamental analysis, has become even more important.

The Hyperion difference

We have a different mindset from the many other investment managers, who follow investment processes which attempt to generate alpha immediately, by predicting short-term share price movements. Our investment process benefits from share price volatility. Our portfolio construction system is designed to generate long-term alpha from short-term share price volatility, without needing to predict the direction of that short-term price volatility.

We believe this is a significant competitive advantage.

Hyperion’s investment process, including its proprietary portfolio construction process, has been successfully implemented by the investment team for over two decades. Yet even with decades of experience, it is a challenge to hold and shift weights to appropriate levels because this quite often involves going against short-term news flow and short-term share price movements. However, our in-built proprietary system and experienced team mean we have the necessary structure, and focus on fundamentals to consistently benefit from portfolio construction and avoid the trap of short-termism.

[1] Figure is quoted pre-fees, compared with the Broad-Cap composite as at 31st January 2019.

[2] Figure is quoted pre-fees, compared with the Global Growth Companies Composite as at 31st January 2019.

The information in this document was prepared by Hyperion Asset Management Limited “Hyperion”, (ABN 80 080 135 897 AFSL 238380) of Pinnacle Investment Management Limited AFSL 322140 for the specific wholesale investor it is addressed to. The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment.  Hyperion believes the information contained in this communication is reliable, however, no warranty is given as to its accuracy and persons relying on this information do so at their own risk. Past performance is not an indicator or guarantee of future performance.  This document is provided to the recipient only and must not be copied or passed on to any other person without the consent of Hyperion.

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