Finding Expectation Gaps
Principal International Small Company Fund
Author: Ticker Magazine
Last Update: Sep 04, 11:44 AM EDT
|Principal International Small Company Fund avoids excessive style biases by following a process that identifies companies that are not well understood by the market. Recognizing the distinction between a good company and a good investment, portfolio manager Tiffany Lavastida explains how the management team seeks to capitalize on market inefficiencies.
ďWe consider valuation to be our anchor to reality and we focus on relative valuation, because we donít want to overpay for the strong fundamental change characteristics.Ē
Q: What is the history of the fund?
The mutual fund was launched in June 2014, but the strategy has been in place in its current form for 15 years. At Principal Global Equities, we have been managing international small-cap strategies since the end of 1994 and our current process has been in place since 2003.
I joined the team in 1997 and was named co-manager in 2006. Brian Pattinson became a portfolio manager in 2001 and we are co-managers of the fund.
Currently, the majority of our assets are in developed markets outside of the U.S. We have a separate emerging market team, which handles the frontier and emerging markets, but the mutual fund focuses on international developed markets outside of the US.
Q: What core beliefs drive your investment philosophy?
A key feature of the fund is that it is a core strategy by design. It isnít meant to have excessive style biases in terms of deep value or aggressive growth; we simultaneously deliver both growth and value.
The strategy is driven by a pure bottom-up approach. We are aware of the macro factors but we donít have a macro-driven process, so we donít make bold calls on interest rates, oil or gold prices. We are fully invested and the outperformance comes from differentiating companies within sectors and regions, not from sector or region calls.
We recognize that there is a distinction between a good company and a good investment, and that leads to a concept that we refer to as a Ďfundamental change.í We are earnings-based investors who embrace principles of behavioral finance.
We believe that there are market anomalies due to the tendency of market participants to underappreciate the potential value of change. With that in mind, our stock-selection approach focuses on capitalizing on these inefficiencies. We achieve that by identifying companies with sustainable fundamental change, expectation gap and attractive relative valuation.
Finally, we believe in a strategic and a consistent approach to portfolio construction, whereby we build well-diversified portfolios with minimal systematic risk exposures.
Q: How does that philosophy translate into an investment strategy?
The goal of our process is the early recognition of positive fundamental change. We apply the distinction between good companies and good investments by identifying companies, where sales growth is increasing and/or profit margins are expanding. These features signal a potential sustainable positive earnings trend. The underlying driver of the change may come from market share gains, new product cycles, cost cutting, or even from an improved and more efficient balance sheet.
We look for situations, in which the current market expectations do not fully appreciate the magnitude of possible future change. The expectation gap is the difference between our estimate of a companyís earnings potential and the prevailing consensus expectations. We analyze recent earnings revisions and look for underlying change drivers that can deliver further positive surprise and close the expectation gap. Understanding the biases of sell-side consensus estimates gives us an opportunity to get ahead of the curve.
We consider valuation to be our anchor to reality and we focus on relative valuation, because we donít want to overpay for the strong fundamental change characteristics. The companies that trade at unattractively high multiples often already completely factor in the expectation gap potential.
Q: Could you describe your research process?
There are two components of our process. First, we have a team of dedicated analysts and, second, we have a proprietary stock ranking tool. We start with our Global Research Platform, or GRP, which is our proprietary stock ranking tool. The GRP provides a consistent comparative framework for measuring the relative attractiveness of all the companies in our large universe.
We rank our entire universe weekly from 1 to 100 based on the key drivers of fundamental change and relative attractive valuation. The ranking process is efficient and effective; it represents an objective, unemotional tool, which helps our team to prioritize their efforts. Our analysts focus on the stocks, which rank in the top quintile, because this is where the largest alpha potential resides.
We develop multi-factor models based on regions and sectors to determine which of these stocks have positive fundamental change at attractive valuation. The analysts use their industry and regional expertise, along with company due diligence, to identify the existence and the sustainability of positive fundamental change that is underappreciated by the market.
The GRP and our fundamental analysis serve as important checks and balances to each other. The analysts look at the top quintile of stocks to pick out the companies with positive fundamental change. Conversely, when the trend in our favored companies begins to moderate or when companies weíve been avoiding start to show early signs of life, the ranking process points in the direction where the analysts should spend their time. As new companies begin to drift to the top quintile, we are forced to look at them.
Changes in the rankings would prompt a review to make sure that the initial thesis is still in place. When a company starts to deteriorate in rank, we donít want our analysts to get caught up in behavioral biases, such as favoring a company because they just met the management or because Wall Street is talking about that company. Our analysts would have to examine the companies to make sure that the fundamentals are in place and that valuations have not caught up with the fundamental change.
Q: What is your sell discipline? When would you sell a stock?
We would sell a company if the fundamentals deteriorate, if there are better opportunities elsewhere, or if valuation catches up with the fundamental change. We want the analysts to recognize and identify those signals, and then to assess if that indeed is the case.
Q: Is your multi-factor model based on market momentum or on the business performance of companies?
I would say both. Ideally, we look for an early recognition that something fundamentally is happening to a business or for a change that has not been factored into the stockís performance. A good example would be a company beating expectations, when we see positive earnings revision and a valuation that has not caught up with the higher estimate. Another example would be a company that hasnít announced earnings yet, but we see positive revisions that could signal a potential change.
An attractive valuation is a signal that the company might be worth examining, if indeed a fundamental change is occurring. Our analysts use their industry expertise and knowledge of the sector to assess if there is a positive change, a favorable product cycle, or cost cutting and margin improvement.
We have found that the sell-side tends to increase its estimates only incrementally, so our analysts leverage their industry and regional expertise, along with the company due diligence, to identify the existence and the sustainability of positive fundamental change. More importantly, they look for positive change potential that is not being appreciated by the market.
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