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Let’s start by your quest for unloved companies and valuation gaps: can you describe more precisely your convictions that shape your strategy?
We think there is a “Comfort bias” in the market. Market participants tend to overpay for the comfortable position of investing with ‘winners’. If you think about it, if feels good for analysts to recommend ‘strong, stable and growing businesses with a strong management track record and predictability of earnings to Portfolio Managers. Also Portfolio Managers are less likely to be accused by clients of poor decision making if they lose money after investing in a ‘good’ company.
At Zadig we think there is outperformance to be generated by investing in less consensual companies at the expense of comfort. We look at growing companies that temporarily stop growing, change their management, have profit warnings, are affected by regulatory challenges, experience M&A that the market does not understand, or do a spin off where the track record is nonexistent etc. In the end, what matters to us is to be very well remunerated for the risk taken when we are right and not suffer too much when we are wrong as bad news is already priced in. We don’t make money because we are right all the time, we make money because of the asymmetry between the size of our winning investments and the relatively small losses from a poor investment.
That process also leads to the Memnon European Strategy’s excess returns being decorrelated from our peers (who are generally highly correlated to each other). This matters a lot for our investors.
It’s a quite defensive approach for stocks, but what about the risk reward?
Risk/Reward is at the heart of every investment decision that the team makes. Equity investing is about choosing the right options and our job is to measure both the upside potential, as well as the risks tied to each investment case. This can be financial risk, hence our focus on cash flow generation, but also business risk which we tend to uncover via intense meetings with management of the invested companies as well as their competitors. There is also ESG risk, which is integrated into our equity research. All in all, there is no reward without risk and our priority is to control risk to preserve capital, while pricing the potential for the stocks in which we invest.
The catalysts play a huge role in that model - can you share some of the ones you pay attention to?
Catalysts are the ‘cherries on the cake’ of our investment process! While we can invest in companies that offer a positive risk/reward without a clear catalyst and patiently wait for the market to react, our largest positions in the portfolio often have a clear catalyst identified that could trigger an acceleration of the recognition by market participants that the business is undervalued. It could be corporate action like a disposal, spin offs, M&A or expected newsflow that may reassure investors and lead to a quick reduction of the risk premium priced into the stock.
Catalysts typically help reduce the time needed to realise the potential reward we have identified.
If this works at a stock level, how do you manage to implement this at a portfolio level?
The challenge for the team is not only to find interesting risk/reward cases, but to find a limited number of investments that are sufficiently diverse in style (value, growth, defensive, cyclical) so that the portfolio as a whole is not exposed to a particular theme and becomes resilient to market rotations as a result. We know for a fact that we will often be proven wrong by the market, however, what matters is that such negative events do not spreadto the whole portfolio because the investments are highly correlated. The portfolio is a diverse set of best ideas that might be perceived as risky when looked at individually, but less so at the portfolio level. This is the power of diversification that dramatically reduces the stock-specific risk as long as correlation between stocks is low.
Having a limited number of names in the portfolio allows us to clearly identify the risks attached to each of them and diversify the risk away by selecting a variety of names. This matters as much as the single names analysis and it is key for us that the Memnon European strategy’s performance does not correlate significantly with any style - that way its excess returns cannot be replicated. It cannot be replaced by an ETF - even the smart ones! That is what makes the strategy a unique asset for European Equity allocators.
2022 played a role of revelator for Memnon, what happened more specifically?
After a long period, during which investors could ignore valuations and focus exclusively on growth, higher interest rates triggered by rampant inflation pushed investors to review how much they should pay for the future cash flow of companies in which they invest. This triggered a sharp derating of ‘expensive’ companies and favored cheaper ones that are typically those the Memnon European Strategy invests in. 2022 was the year where ‘Growth at an Unreasonable Price’ strategies stopped working and valuation-driven strategies were again in favor. That said, we like to put 2022 in the context of 2021 as the challenge was to navigate the huge style rotations during these couple of years. The Memnon European strategy has done well, underperforming somewhat in 2021 but outperforming very strongly in 2022 and generating strong excess returns over the 2021 – 2022 period.
· The portfolios are large cap oriented in the US but midcaps in Europe… A low correlation portfolio’s performance with peers aimed to position the fund as a diversifying asset?
It is true that larger caps in the US have driven index returns for the last few years, while European larger caps have not seen such stellar performance. Some European large caps have seen great returns too (Novo Nordisk, LVMH, ASML etc.) but it has been easier to generate positive excess returns while investing in large as well as mid caps. It is true that the more diverse source of performance in Europe helps strategies like Memnon European beat the market while offering enough candidates that generate performance while also allowing us to be de-correlated from the peer group.
