Due Diligence on Litman Gregory Masters International Fund Sub-Advisor Pictet Asset Management
Added to the fund: June 30, 2016
Strategy: International Blend
Pictet Asset Management is a wholly owned subsidiary of Switzerland-based Pictet Group. The Pictet Group is an independent partnership and has been focused solely on managing assets for private and institutional clients for over two centuries.
We have been performing due diligence on Pictet Asset Management and in particular their EAFE strategy for the past two years. Over this time, we have spent many hours meeting and speaking with Fabio Paolini, head of EAFE equities, and other portfolio managers and analysts that work with him on this strategy. In addition, we have met with senior management at Pictet to cover organizational issues. The focus of our due diligence was on assessing the research and decision-making process. This included evaluating the clarity and the consistency of the investment approach, the analysis supporting individual stock-picking decisions, the sell discipline, the approach to portfolio construction. In addition, we evaluated the quality of the broader team, and the support and resources Pictet provides to the investment team.
Litman Gregory’s portfolio will be managed by Paolini and Benjamin Beneche. Paolini joined Pictet Asset Management in 1997 and works closely with the EAFE and European teams. He began his career in Pictet & Cie’s financial research department in 1994, initially on the economics team and then on the European equities research team. He holds an economics degree from the University of Siena, Italy, and is a Chartered Financial Analyst (CFA) charterholder.
Beneche is a senior investment manager on the EAFE equities team and works closely with Paolini and the other analysts and portfolio managers on the EAFE, Europe, and Asia teams. Beneche joined Pictet Asset Management in 2008. He has an economics degree from the University of York and is also a CFA charterholder.
Pictet’s Investment Philosophy and Approach
Paolini believes in cash flow, not reported earnings, because the former is more difficult for management to manipulate. So, he wants companies to be able to generate free cash flow in the future. (Broadly speaking, free cash is calculated by adding depreciation and amortization to net income and subtracting capital expenditures.) In addition, he wants a company to have good opportunities to reinvest this free cash and to do so in a profitable manner (i.e., generate high returns on capital, in order to compound investment returns for shareholders).
When looking at free cash flow (FCF), Paolini and team focus on how much free cash a company can generate on a normalized basis. The period over which the team may expect normalization to happen varies by business model and is also dependent on the stage of the business and economic cycle a company may be operating in at any point in time. For example, in the event the team expects a business model to attain normal sales growth, margin, and capital expenditures over the next three years, the team’s task would be to estimate those free cash flows three years from now and discount them back to the present to assess what “normalized” FCF yield (FCF/stock price) the company’s stock is offering (we will discuss the relevance of FCF yield in buy and sell decisions further below). The discount rate used is the company’s cost of equity.
Assessing whether a company has good future reinvestment opportunities is typically a function of what sales growth it can achieve and its pricing power. So the team assesses what organic and inorganic growth opportunities are available to the company and whether the company has a competitive advantage versus its peers—the latter helps in terms of achieving relatively higher sales growth (as the company gains market share at the expense of its peers) and maintaining pricing power. The combination of higher sales growth and superior pricing power helps generate higher profitability and, therefore, high returns on capital. How company management will allocate capital is also important in understanding whether a company can generate high returns on capital.
The consistency of generating high returns on capital is also important. Typically, a company that is relatively less cyclical (i.e., less impacted by economic cycles), has good reinvestment opportunities, and is run by capable management has a higher likelihood of consistently generating high returns. Paolini calls these companies compounders, and they are most attractive to him in terms of their business-model attributes because they compound shareholder value at a faster rate than cyclical companies. To assess valuation for compounders, in addition to normalized FCF-yield assessment, Paolini and team will also look at discounted cash flow (DCF) modeling, as that incorporates the cash flow a company is likely to generate beyond what the team considers to be a normalized or forecastable time frame. Paolini says, for compounders, it’s essential to look at DCF-type metrics to capture the long-term compounding effects of their superior growth and return-on-capital profile relative to more cyclical business models.
In the case of more cyclical business models, there is greater variability in free cash generation, so balance sheet quality assumes greater importance in the team’s overall analysis. In addition, the valuation hurdle for cyclical business models prior to purchase is typically higher than in the case of compounders. For example, the target normalized FCF yield (i.e., the sell target yield) for a compounding business with relatively high growth and a high return on capital could be as low as around 5%. But for a riskier, cyclical business model with lower growth and lower return on capital, this target yield could be 10%, or higher in some cases (such as for oil- or commodity-related business models). Ultimately, the target yield at which a company’s stock would be sold is a function of Paolini and Beneche’s assessment of its business model. The difference between this target yield and the current yield (based on current price) indicates the potential upside in a stock.
Pictet’s flagship EAFE portfolio consists of about 70 to 80 stocks. The EAFE team’s stock weightings are a function of the amount of upside in a stock, the level of conviction they have in the business model and in the investment case, the downside risk in the business model, and liquidity. In addition, the EAFE team aims to diversify “investment drivers” or common risk factors. For example, they do not want the portfolio to be overly exposed to external factors, such as oil, economic growth in a country or region, or rising or falling interest rates. Stocks are sold when they reach their price targets or target yields, when there are better opportunities, or when the investment pillars on which the initial purchase was based are no longer valid. In the case of the concentrated Masters portfolio, all these portfolio-management considerations will apply.
Litman Gregory Opinion
We believe Pictet will be a strong addition to the Litman Gregory Masters International Fund sub-advisor lineup. We have met and spoken with many portfolio managers and analysts at Pictet and are most impressed by Paolini and Beneche. They have a deep understanding of business models and are very clear on the factors that make a business model better or worse, and accordingly, what to pay for them. Importantly, they know their companies very well. They are patient, long-term investors and bring a healthy balance of optimism and paranoia to investing. The rest of the team supporting them—global sector analysts and the European portfolio-management team—is also very strong.
Pictet has not run concentrated portfolios before, which is a typical situation for us in that managers often do not have a track record running concentrated portfolios. We analyzed the performance of more diversified portfolios run by Pictet’s EAFE team and that positively informed our view of their investment capabilities.
In addition to our confidence in Paolini and Beneche’s investment skill, we believe Pictet will be a strong addition to the Masters lineup for the following reasons:
- We believe Pictet will outperform their benchmark: This is always our primary consideration in adding a sub-advisor.
- We believe they will add valuable diversification benefits to the overall fund. Paolini tends to gravitate toward mid-cap names ($3 billion to $20 billion in market capitalization), and historically Pictet has added significant value in this market-cap bucket.
- Paolini and Beneche have a superior understanding of business models and the risks inherent in businesses. In our experience, managers who are value-conscious, but who also have a good understanding of business models and risks, tend to do well running concentrated portfolios.
- Paolini and Beneche’s passion for stock picking and their genuine enthusiasm for running a concentrated portfolio from the outset has been very clear. As part of our due diligence process, we also asked them to run a mock portfolio with no more than 15 stocks for us and monitored it for nearly two years. This process has led to some insightful discussions on how they will approach the Masters portfolio, and it has been a factor behind our confidence in both Paolini and Beneche.