Investing in a Transforming World: A Singular Focus on Stock-Specific Sources of Alpha

• The disconnect between short- and long-term market and macro forces is creating attractive buying opportunities in companies set to benefit from secular themes, but whose valuations have dropped amid generalized declines across equity holdings.

• We have developed our Lifecycle Categorization Research (LCR) framework to help identify and isolate the mispricing opportunities that arise as companies evolve through time. This forward-looking approach may help investors to capitalize on transformational change within companies.

• We view stock selection as the most reliable source of alpha. We believe identifying companies that are well positioned to benefit from overarching secular themes in a transforming world, while minimizing market risks, may offer more attractive results relative to sector, investment style, or other top-down macro approaches.

It’s difficult to remember a single week since the pandemic without a significant event that has sparked unrest, or at least uncertainty, in financial markets and the broader macro landscape.

From lockdowns, war in Ukraine, US-China tension, persistently high inflation, and pivots in central bank policies, to the most recent geopolitical conflict in the Middle East – investors have experienced bouts of volatility. At the same time, shorter-term dynamics are masking several secular trends which are significant in reshaping the future of the world:

• The vast investments needed to achieve Paris Agreement net-zero carbon emissions targets

• The diversification of global supply chains

• Increasing digitalization across all industries

It is the disconnect between the short- and long-term forces that create attractive buying opportunities in companies set to benefit from structural shifts in economies and societies, but whose valuations have dropped amid the general decline across equities.

Lifecycle Categorization Research: A fine-tuned, and forward-looking route to potential alpha

We believe investors can potentially capitalize on this period of transformational change.

One approach, Lifecycle Categorization Research (LCR) framework, our proprietary tool helps us to evaluate a company based on its maturity and cyclicality, which contrasts with the more traditional approach of classifying companies by sector.

As a tool, LCR enables our portfolio management team to access a more fine-tuned and forward-looking instrument in an effort to identify and isolate potential mispricing opportunities that arise as companies evolve through time.

In this process, we assign companies to one of six different categories based on their maturity and overall sensitivity to the economic cycle. We then evaluate them using a valuation method and return requirement particular to each category. We have customized evaluation criteria and return requirements for each lifecycle category based on the different drivers of expected stock performance.

For example, by assessing a company’s underlying growth trend to determine whether it is presently a High Cyclical Growth or Mature Cyclical company, we categorize it as the former if it is growing more quickly through the cycle. By contrast, a company with a stable revenue and margin outlook is more likely to be a Mature Stable company.

Stocks don’t need to change categories to be good investments. But when they do, we want them shifting leftward in the lifecycle diagram, from a more mature or cyclical company to one with a higher, sustained growth rate and the higher multiple that tends to command in the market.

Stock-by-stock evaluation and robust risk management

We believe research including LCR is particularly well-suited to today’s era of change given that it can be used to identify early alpha potential from mispriced opportunities as companies move through the cycle. It is essential since stock selection is our only alpha source – by accurately evaluating a company and determining the likelihood of a stock outperforming the market’s expectations for it.

This distinct approach is also used for portfolio construction and risk management. In addition to using this framework to evaluate potential investments, we have used it to map the benchmark. This seeks to establish an active and high conviction portfolio that is highly differentiated from the benchmark and peers, yet with style exposure and factor exposures that are similar to the benchmark.

Adapting to the longer term

We believe a singular focus on stock specific sources of alpha can enable investors to minimize market risks. With this lens on company fundamentals, we believe we can make the most of what we see as four overarching secular themes in a transforming world:

• Corporate transformation – where companies are changing from “good” to “great”, enabled by data and transformed by emerging talent, and new skill sets, with service revenues adding equity value.

• Global capex investment – fuelled by the rewiring of supply chains via nearshoring, automation and efficiency, along with spending on reducing carbon emissions.

• Technology enablers – led by ongoing digitalization, with artificial intelligence (AI) and cloud-based technologies driving growth, and the goal of efficiency acting as a tailwind.

• Global affluence – highlighted by forecasts of rising affluence in key markets, such as China, which is expected to create between 300 million and 400 million middle-income consumers over the next five to 10 years.

Investing in change: tapping into megatrends

Under the global capex investment theme in particular, several trends appear to offer attractive risk-reward opportunities over the medium and longer time horizons.

One of them is near-shoring, spurred by years of trade wars and Covid-related supply chain disruptions. As companies re-think their distributed supply chains and start to near-shore, strategic industries such as semiconductor and batteries are leading the charge. This is supported by construction spending on manufacturing, with the increase since 2022 being a leading indicator for increased US manufacturing production in the future.

Factory automation is another area to watch. It is increasingly on the radar of companies of all types, given the difficulties and higher cost of hiring labor. Plus, near-shoring itself requires more automation to ensure product costs don’t rise due to higher labor costs in the US.

The opportunities stemming from automation are vast. In the US alone, industrial equipment and manufacturing plants require significant levels of upgrades after decades of under-investment. Further, the costs of robotics, the Internet of Things (IoT), and machine vision technology are falling, enabling more automation and plant efficiency.

With the environment in mind, the staggering incremental investment required to achieve net zero targets around the world creates multiple options for exposure to companies with products and services that enable customers to reach net zero goals.

For example, the International Energy Agency (IEA) estimates that around US$2.8 trillion will be invested in energy in 2023 with the projected average annual spend through 2050 now up at US$4 trillion. 

Added to this, as part of the EU’s “Fit for ’55” program, the European Commission estimates the equivalent of around US$289 billion of additional investment is needed each year to build energy renovation projects through 2030. And similar programs are being implemented in the US with spending relating to infrastructure and the Inflation Reduction Act.

We believe the potential from these emerging and robust themes cannot be overlooked. And despite near-term fears around the globe relating to inflation, rates and recession, we believe the LCR framework provides valuable insights which can help investors take advantage of longer-term trends.