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Fund Manager Focus - May 2011


Robert Anstey & Mark Sherlock, Hermes Fund Managers - London


Robert Anstey

Mark Sherlock

Hermes Fund Managers, a multi boutique asset management house, was established in 1983 and is owned by the BT Pension Scheme, which is also a client. As of December 31, 2010, Hermes had £25.6 billion (US$38.4 billion) of actively-managed assets under management for more than 190 clients across international equities, fixed income and alternative investments, with a commitment to generate sustainable risk-adjusted alpha. Recently, Hermes embarked on a programme to open up their investment capabilities to institutional investors. Consequently, Hermes strategies, including the one discussed below, are now accepting external assets for the first time. As well as the London headquarters, Hermes has offices in Boston, New York and Sydney. The Hermes Small and Mid Cap team has been successfully managing institutional money since 1987 and currently has nearly US$2 billion under management. There are 11 members of the Small and Mid Cap team, with an average experience of 18 years and eight years at Hermes. The $700m US SMID (Small and Mid) strategy, which is co-managed by Robert Anstey and Mark Sherlock, is benchmarked against the Frank Russell 2500 index. They seek to invest in companies with a market capitalisation of US$200m to US$5 billion.

As lead manager Robert has been involved with the fund since 2001, having previously worked in US equity sales at Bear Stearns and prior to that at Brown Brothers Harriman. Mark joined him in 2009 following four years working on UK equities with the Hermes Focus Funds. Alex Knox, who previously managed small and mid caps at Morley Asset Management, is the senior investment analyst on the team.



Am I correct in thinking all US fund managers and analysts are based in London rather than the US?

“The London office also houses the Hermes Equity Ownership Services (HEOS) boutique, which has pioneered a comprehensive responsible ownership service for both Hermes and other institutional investors. They advise and engage on Environmental, Social and Governance (ESG) matters with listed companies and currently have £70 billion ($105 billion) of assets under stewardship. The US SMID team liaises with them and they vote proxies on our behalf.

In addition, we have a Boston-based Global Equities boutique which manages a concentrated portfolio of large-cap stocks, including US listed equities.

As one of the largest Small Cap teams in London, we are in the fortunate position of having good access to company management when they come to London. However, it is not all desk-based research – we love getting out and seeing companies on-site too. Indeed, our research is not limited to the major cities like New York and Chicago – we often rent a car and drive to some of the more remote parts of the country. For example, we recently spent a day in Bismarck, North Dakota! Our view is that it is important to visit facilities directly, and have found that management teams appreciate the opportunity to discuss their business on ‘home turf’. Between London and our trips to the US, we see 200-250 companies a year.”

Could you elaborate a little on your style?

“We look for high-quality companies that we can buy at a discount to intrinsic value and then own long-term. Our definition of ‘high-quality’ is a company with a sustainable competitive advantage (often evidenced by strong market position, for example) and, more often than not, a healthy cash flow. Our average holding period for an investment is three to five years, compared to an average of six months for NYSE-listed stocks.

We have a strong focus on risk and aim to generate outperformance with relatively low risk for this asset class.”

Your benchmark is the Russell 2500. How do you follow so many companies?

“In order to capture the knowledge of all our combined meetings and trips we run what we term a ‘watchlist’. This comprises around 200 - 250 companies which we feel meet our quality criteria though for one reason or another are not suitable for immediate investment (this is often due to valuation). We are patient investors and are happy to wait until valuation is attractive – this could be anything from a few weeks to several years.

Additionally, we use various screening tools, most notably the S&P Quality Ratings (which measure earnings quality and stability) and Piotroski scoring (a measure of financial strength). We often prefer companies with minimal sell-side coverage as there is more likely to be market inefficiency – indeed some of our companies have no coverage at all. Compare this to Apple – currently covered by 54 analysts – and we know where we would rather look for opportunities.”

Is there anything you won’t invest in (e.g. defence, tobacco etc)?

“The only companies we would not consider investing in are those that do not fit our quality criteria. We do not have blanket bans on investing in certain sectors, preferring to work with HEOS where necessary to encourage a company to address any ESG issues. That said, stylistically we are unlikely to invest in a single product biotechnology company with no earnings, for example.”

How many US positions do you hold and what size?

“The US SMID team currently manages $700m, with around 65 holdings. This implies an average position size of $10m, though our largest holding is over $20m. In terms of market cap, a typical holding would be around $2 billion.”

How strict is the $5 billion cut off? Are you forced to sell an investment once the company grows bigger than this?

“We own some companies for many years and we don’t want to be in the position of being a forced seller when they reach this ceiling if we still like the underlying business. For this reason we have a 15% nonbenchmark allowance to give us the flexibility to sell only when we feel a stock has exceeded its intrinsic value.”

How have you performed?

“As you can see from the table below, the Russell 2500 has outperformed the S&P500 in nine out of the last ten years and returned significantly more on a cumulative basis. What may surprise you is that small and mid-caps outperformed large caps even during the down years of 2002 & 2008. The Hermes US SMID strategy has a long track record of outperformance within this asset class. On a risk-adjusted basis our strategy is top quartile over both three and five-years relative to our US-based peers*.”

What’s your active share (how much do you bet against the index) and do you have any sector constraints?

“96%. Our focus is on fundamental research and we want most of our risk to come from stock selection. As such we remain broadly sector neutral.”

What do you think of the US market at the moment?

“SSmall and mid caps have rallied significantly over the last couple of years and the Russell 2500 is back to its former peak, reached in the summer of 2007. Who would have imagined this with unemployment near 9% and the housing market still on its knees? In our view, valuations have become stretched in some areas as large cap investors have moved down the market cap spectrum in search of growth. We are still able to find attractive investments, for example within the insurance and healthcare sectors, but we are finding that opportunities tend to be more of the “80 cents on the dollar” (i.e. 20% upside) variety rather than the 50c we found two years ago.”

Favoured sectors / themes? Favoured companies?

“One of our favourite themes is Hawaii. This US state has long been popular with Japanese tourists and we believe is on the cusp of being discovered by a new, and high-spending, Chinese tourist population. Indeed Chinese tourists outspend their Japanese counterparts by a factor of five which could result in an exciting uplift in tourist revenue and the broader economy.

Two of our investments in the State are Alexander & Baldwin (a shipping and real estate business) and the incumbent utility, Hawaiian Electric. The conglomerate nature of Alexander & Baldwin means that sell-side analysis is scant, with just three brokers covering the stock. Due to the Jones Act stipulation that ship operators using US waters must be US owned and operated, significant barriers exist in its ocean transportation business. The majority of goods consumed on the islands are transported on one of their vessels. The real estate business comprises 43 commercial properties (located on the mainland US and in Hawaii) and 88,000 acres of land on the islands, making them one of the largest private landowners. While much of this is either agricultural or conservation land, 1,500 acres is entitled for development over time. The company’s cost basis is around $150 an acre (as it was bought many decades ago). In the not too distant past, ½ acre lots have sold for several hundred thousand dollars. Simply, we believe this land is a highly valuable asset. Interestingly, activist investor Bill Ackman of Pershing Square Capital Management recently took a large stake in the company, which may help accelerate value realisation.

Hawaiian Electric is the incumbent supplier of electricity and has been working closely with State government to reduce the islands’ dependence on oil. (Currently all fuel oil is imported into Hawaii by boat at a cost of between 2-4 xs that of oil on the mainland.) This has resulted in the Hawaiian Clean Energy Initiative which aims to increase the use of renewable energy to 40% by 2030. Hawaiian Electric is the vehicle through which the State will achieve this objective and the company now benefits from more favourable return dynamics to encourage investment in renewable technology and a decoupling from the previous regulatory framework which, counter-productively, incentivised the utility to use more rather than less energy.”

Recent sales?

“We have recently sold our position in Mettler-Toledo after eight years of ownership. It was like saying goodbye to a member of the family! The company is a global market leader in weighing and measurement technology, but being headquartered in Switzerland and listed in the US meant it had not received the attention it deserved. The stock was first purchased in 2003 (at less than one fifth of its current share price) when there was little analyst coverage and operating margins were in the low teens. Since then we have witnessed the company’s journey from obscurity to full coverage and 11 analysts now write on the stock. We remain of the view that it is a fantastic business but with margins now in the high teens, it is harder for us to price incremental upside. The company will go back onto our watchlist.”

Do you have a target price in mind when you buy a stock?

“Our assessment of a company’s intrinsic valuation must show at least 20% upside to the current market price.”

Can you invest in Canadian companies?

“Yes, we can, and do, invest in Canadian companies which fall under our 15% non-benchmark allowance. Only last month we were in Montreal visiting one of our portfolio companies, CAE, who are the largest manufacturer of flight simulators in the world. We were able to see the product first hand and step behind the ‘controls’. Suffice to say, we concluded we should stick to being passengers not pilots!”

Do you vote your proxy?

“Yes - in conjunction with Hermes Equity Ownership Services.”

How do you manage your currency exposure?

“We have very minimal currency exposure, too small to have an impact on performance.”

Outlook for the US Dollar?

“We’re not really trying to make big macro calls. Our focus is purely bottom-up stock selection.”

How important is it to meet management?

“It is very important for us to meet management. In fact we would choose not to invest in the company without having either met management or at least held a conference call with them. We also like to continue that relationship, aiming to have at least annual contact with each of the management teams in our portfolio.”

Who do you prefer to meet (CEO, CFO, IR)?

“One of the advantages of investing in small and mid-cap companies is that we are often able to meet with CEOs and CFOs directly. That said, there are a large number of very competent IR representatives who do an excellent job. Those that know their company well can be extremely informative and as useful, at least in the early stages, as meeting management. IR also come in varying shapes and sizes – the IR of one of our companies is led by its 84-year old Chairman and founder whose stake in the company exceeds $250m!”

Any US names who stand out in terms of IR?

“David Childers at the St Joe Company and Shelley Boxer at MSC Industrial both do a great job.”

How do you manage your corporate access via brokers, independent providers – do you actively seek out companies?

“Much of our corporate access is organised directly as part of our frequent trips to the US. Happily Hermes’ brand and reputation, which is well-known in Europe, is beginning to get recognition in the States which helps us with this. We are also seeing more managements coming through London – perhaps attracted by a longer-term and more stable shareholder For US companies seeking to broaden their audience, we would encourage them to visit the UK.”

*based on eVestment data as of year end 2010.

HERMES US SMID
Annual Returns
Hermes US SMID
Composite
(%)
Russell
2500
(%)
S&P500

(%)
2010 23.7 26.7 15.1
2009 36.2 34.4 26.5
2008 -31.3 -36.8 -37.0
2007 6.7 1.4 5.5
2006 16.4 16.2 15.3
2005 7.4 8.1 4.9
2004 23.5 18.3 10.3
2003 38.1 45.5 28.7
2002 -11.5 -17.8 -22.1
2001 10.3 1.3 -11.9

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