Q&A: Amundi Asset Management’s Nick Melhuish on global equities

Nick Melhuish, head of global equities at Amundi, talks to Colin Marrs about why reports of the death of active management might be greatly exaggerated.

Room151: The concept of active management has taken a bashing over the past couple of years. What is the role for active managers when investors can access passive so cheaply?

Nick Melhuish: We all know that over the medium term, the situation has been problematic for active management. However, active management will still have a role to play, despite being more expensive. You also have smart beta strategies which are an interesting hybrid between the two approaches.

From the point of view of pension fund plans, parts of the cycle will work for active: typically, when you have big macro-economic driven events or you get big sector moves, beta works better than alpha. When returns are driven by risk or sector movements then you can successfully play with passive. Active works when you get big differences in sectors and unpicking them becomes more difficult – that often happens at the beginning and also towards the end of cycles.

However, unpicking differences within a sector is something only an active manager can do. There will be times when alpha strategies struggle compared to beta. There will always be a role for real stock picking in a diversified portfolio.
When beta returns are low, it plays to active rather than passive management. One of the reasons active management has got into trouble over the years is that we got a bit over the end of our skis. Too many funds were claiming to be active when they weren’t really. They were running index shadowing, low risk strategies. That lie has been exposed by the availability of passive. Successful active strategies need to be truly active.

R151: Is that message getting through to investors and pension funds?

AM: Our active strategy is highly active – we have 30 stock portfolios. When you look from the point of view of trustees, it makes sense that they might look at having a core of investments under cheaper passive or smart beta management, but on top of that have satellite strategies that will add value and diversification. That message resonates with the sector.
The current cycle has been unusual: long and flat. I don’t think that it is about to end –though inevitably it will end in the next few years. Because it has been a long and flat cycle, stocks have tended to mean revert over time. The problem is that a lot of valuations have crowded around the middle, making the active manager’s life more difficult. If you had bought materials or oil stocks in January and February where there was a wide dispersion (although these sectors were out of favour) and at the same stayed out of European banks you could have made a good active return year to date, though few managers have managed to do both.

Overall, the opportunity set is quite wide. You have to pick through the sectors to find companies that are relatively good value. That’s something you won’t pick up through a passive strategy.

Low interest rates have meant a lot of crowding. The reason we have low interest rates is that we have an undynamic global economy. The healing process following the downturn has taken much longer than expected. Very few people believed it would take 10 years – and we still have a lot of collateral damage. It has made investors very risk averse. Sectors with earning stability and low variability over time, such as staples and utilities look expensive now. As we get interest rate normalisation over the next 18 to 24 months, it will present interesting opportunities for fund managers.

R151: Is the best strategy to buy and hold or to buy during dips and sell when stocks recover? What strategies will outperform the market over time?

AM: I think if you look at some of the most successful managers over the past 10 years, those who have bought and held have done the best. Long/short guys, aggressive investors trading frequently, and hedge funds have found it very hard. There have been a lot of unexpected surprises. Over the past decade, some managers have identified companies with enduring franchises and positive capital returns. The good managers have identified these stocks and sat on them for a long period – they have a tremendous record. The problem now is that these stocks are relatively more expensive than they have ever been. My view is that you should ignore the dips – that is just noise. It is important that investors act like investors and not traders.

R151: What is your approach to this dilemma?
AM: At Amundi, we do a bit of both. We have a valuation discipline. We decide what a company is worth and review it every four to six months. We have a number of stocks from 2014 still sitting there. One company we bought in the dip because we thought it looked under-priced. It went up by a third in three months, so we sold it. Then it went down so we bought it again. Sometimes when you have a valuation discipline, you buy a stock, thinking it will take two or three years to rise, but if it happens quicker you have to sell and if you get a chance to own it again at the right price, why not?

R151: How much has that strategy been tested by the EU referendum result in the UK?

AM: We did very little after the EU referendum on the basis that life is very uncertain at the moment. We do cash-based valuations, so the vote doesn’t really change things in the short term. Rushing off in one direction due to a vote in one country that is a small part of the global universe would be surprising. There were some opportunities that arose in the immediate aftermath but the future is uncertain in the UK and in Europe and stocks behaved quite rationally. Nobody is sure what the rules of the game will be in three years – not even our lords and masters do. Our stocks in the UK are large cap and multinational so they have benefitted from a lower pound (which we had hedged ahead of Brexit).

We are confident in the long term intrinsic value of the companies we invest in. The fundamentals haven’t changed that much in the situation for these firms. But if you don’t know the future and have no insight into how a company might be impacted then putting money in that company is not investing. It is flipping a coin.

R151: How much do long term trends, for example demographic trends, or the improvement in the economy of Africa, influence your decisions?

AM: I don’t really do trends or thematic investing. I don’t really like it. There are important ones like green energy and water scarcity but we have a subsidiary that focuses on these called CPR, they are a very good thematic manager set up appropriately to deliver thematic portfolios. You can fit many companies into a broad trend like this. To me, it becomes less helpful than something that an assessment of a company that is highly specific.

In appointing a manager, you have to assure yourself that the manager has identified something they can consistently make money out of and a process to find the alpha generating factor. For some managers that might be long term thematic trends. But you can’t be all things to all men. We believe valuations are the most important factor and focusing on getting those as right as we can is a better use of our time. Other factors do feed into that, but we think that taking a company apart and coming up with a robust valuation not appreciated by the market as a whole is the best way to add value.

R151: What implications do the prevailing political turmoil in Europe and beyond have for equity investors?

AM: I think it is something that it is important. From a cash flow perspective Europe looks like a cheap market, particularly if you are prepared to believe there will be a normalisation in earnings and cashflows. It looks like a mispriced, good value market.

You also have to take a view on politics and what economic levers could be pulled. Profits are currently depressed. If firms can get top line growth then things will improve significantly. But this has been our fantasy since 2011. We always predict earnings rising by 11% in January but by the end of the year growth is zero. This year, our expectations got rebased early as we hit zero in February as the market fretted over oil and China. There is a potentially coiled spring if companies can begin to show some sort of improvement in earnings and cash flow.
I am optimistic that some good could come out of the Eurozone crisis in that it is clearer that what Europe needs is more constructive fiscal policy and institutional reform. Germany has been effective in transforming its economy over past 15 years. It was painful but they are reaping the benefits of a significant surplus, employment growth and improved living standards. Other countries have been less quick to reform and it is important that policy encourages this to happen. The ECB has been very clear on the need for reform at the member state level.

The main fulcrum at the moment is Italian banks and it will be interesting to see how the EU deals with that. Banks there sell junior bonds to retail investors. If you bail in these bonds as the regulations now require then you end up giving a lot of haircuts to people’s savings, a tremendous vote loser. It is a complicated situation and the European authorities are caught between being steadfast in the face of Brexit, refusing to bend the rules and the fact that Italy doesn’t really fit the rules because it has an unusual structure of retail savings. A good ending could be recapitalisation, if it doesn’t affect Renzi’s election chances.

R151: How about China. Is slowing growth there a threat to the global economy?
AM: It is still an important issue. You have to remember what China has achieved since 1979 is remarkable. No country has ever industrialised at its pace. The current correction is just dealing with that transition. You can’t have capital formation at the rates we have been used to. GDP is going to be in lower single digits – 4% rather than 8%. The government has to grow through other means, such as consumption, and that doesn’t happen overnight.

Around the turn of the year, the Chinese government introduced more stimulus, boosting the property market, and the world economy is benefitting. It pulled back and now seems to be increasing stimulus again, following the Brexit vote. It is feathering the throttle. But the end game is clear – growth of 4% to 5%. However, China is very sensitive to currency. If the US continues to do a lot better, then the US Fed will start increasing interest rates, pushing up the value of the dollar. China won’t like that and I see that as more of a risk later in the year than the fallout from Brexit.

This article was sponsored by Amundi Asset Management.

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