Lifecycle Categorization Research : Our High-Powered Telescope Into the Global Equity Universe

In a global equity universe of over 10,000 stocks, the mission of an active manager is to distill the best ideas into alpha. Yet there are many ways to approach this.

How do we invest differently?

Our process diverges from the traditional method of classifying stocks by sectors or industries. Consider Toyota and Tesla, for example. Both companies are in the automobile industry group of the consumer discretionary sector, yet they differ significantly in terms of their stage of growth and how the market prices their shares.

For this reason, we classify companies not by sector but based on their stage of growth and overall sensitivity to the economic cycle. This approach has helped us source alpha by identifying mispricings in company fundamentals over the medium to long term, typically between three and five years.

Our investment ‘telescope’

One of the key tools we use in seeking to achieve our alpha goal is our Lifecycle Categorization Research (LCR) framework. For over two decades, LCR has enabled us to be more finely tuned and forward-looking in evaluating companies and their potential for positive change.

Specifically, we assign companies to one of six different categories based on their level of growth and cyclicality. Once the categories are set, we can then start comparing like companies to like companies using a valuation method and return requirement particular to each category.

For example, we might assess a company’s underlying growth trend to determine whether it is currently a High Cyclical Growth or Mature Cyclical company, categorizing it as the former if it is growing more quickly through the cycle. We would subsequently value it using a higher multiple to reflect those higher future-state earnings estimates. By contrast, a company with a stable revenue and margin outlook is more likely to be a Mature Stable company.

For illustrative purposes only.

To elaborate further, we examine each stock for its cyclicality and maturity along a few different dimensions.

Stable vs. Cyclical:

• The sensitivity of sales and earnings to economic cycles is the primary driver leading a company to be categorized as Stable or Cyclical. Sensitivities to a product or capex cycle are also factors.

• Share price sensitivity to market declines is also measured to highlight potential cyclicality.

Growth vs. Mature:

• Revenue and earnings growth rates over time are the primary data points that lead a company to be categorized as Growth or Mature.

• We use median market revenue and earnings growth as the demarcation line, which is approximately 1.5x nominal global GDP growth.

For illustrative purposes only.

In practice, very few companies we invest in fall into the categories at the margin of our LCR framework – Exceptional Growth or Turnaround. Both present risks rarely justified by their upside.

Exceptional Growth is characterized by robust growth, but typically also by negative cash flows and margins heavily impacted by management spending decisions. Turnaround companies are at the other end of the spectrum, often undergoing restructuring or a strategic overhaul or grappling with negative surprises.

Spotting dislocations that others miss

In our experience, the market often overlooks important business inflection points. These are where the biggest mispricing opportunities start to emerge, and we find they are often missed by investors using standard sector groupings. The disciplined application of the lifecycle framework to highlight underappreciated catalysts and inflection points could be a key source of value-add.

Our best ideas come down to the movement – or lifecycle – of the company, given that we believe we now have a better opportunity to anticipate and capture changes in a business as it evolves over time.

Stocks don’t need to change lifecycle categories to be good investments. (Change within a category is fine, too.) But when they do, we want them shifting from right to left in the lifecycle S-curve chart above – a transition 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.

Lifecycle categorization in action: two examples of alpha-generating stocks1

1. A technology company with a diversified suite of software products and services across personal computing, enterprise solutions, cloud services, and developer tools.

Businesses increasingly rely on a broader range of software and cloud solutions, and platform providers are therefore appealing due to their scalability, interoperability, and cost effectiveness. This trend allows the company to capture market share from point solution vendors and smaller platform providers.

We think the market underestimates this company’s ability to continuously drive cross-selling and pricing opportunities at scale by expanding its product offerings and enhancing the features of its existing products. Based on our analysis, the integration of its flagship artificial intelligent (AI) solutions into existing products could provide an opportunity for a roughly 50%-80% price uplift.

While we don’t expect a category shift, we currently categorize the company as High Stable Growth, with its majority of revenue subscription-based, limiting macro sensitivity. Products have high market share and high switching costs, leading to stability.

2. A multinational industrial engineering group specializing in steam, electric thermal solutions, peristaltic pumping, and associated fluid path technologies.

The company benefits from the decarbonization trend. Industrial heat is responsible for roughly 20% of worldwide greenhouse gas emissions, with 30% of this heat generated from fuel-fired boilers. It is a leading efficient steam loop provider and provides the engineering for further efficiencies. The company is also rolling out industrial steam decarbonization solutions to assist customers’ net zero journeys.

We currently classify the company as a Mature Cyclical due to its exposure to industrial production trends. Decarbonization trends could help it transition to a High Cyclical Growth company over time.

Balancing risk through portfolio construction

Put simply, in our view, the lifecycle framework is trailblazing yet integral for identifying stock-specific alpha. But just as importantly, it is an essential portfolio construction tool for managing risk.

For stock-specific alpha to be effective, one consideration is to minimize market risks where we do not believe we have an edge. That means not taking unintended sector, investment style, or other top-down macro bets.

This framework can be an elegant way to control for such risks by matching portfolio’s exposures across the various lifecycle categories to the benchmark’s own lifecycle exposures. This results in a portfolio differentiated from the index and peers based purely on a deeper view of the stocks, without introducing added tracking error risk.

A question that investors frequently ask is, with a portfolio of high active share, how to manage risk?

As an example, consider a large retailer, whose potential profitability from new revenue streams and harvesting technology investments in recent years is, we believe, underappreciated by the market. This is good company-specific risk, in our view. But on the other hand, sizing an investment in this company is important, so that along with other holdings, the portfolio reflects the benchmark in terms of economic cycle exposure, investment style exposure, currency exposure, market cap exposure, etc.

In other words, we believe in bolting together each of the investments in a portfolio, so that the collection of companies behaves as investors would expect from a core portfolio, with volatility and other risk metrics in line with the index.

LCR is a telescope into the vast universe of stocks, helping investors to find those opportunities that others might miss. This distinctive approach to stock selection and portfolio construction can enable investors to achieve stock selection-driven alpha while maintaining a risk level similar to an index.