Legg Mason – Long-Term Investing Through Covid-19 Impacts: Zehrid Osmani, Q&A



Martin Currie

What have been the primary outcomes of the pandemic so far, and what is your outlook?

The pandemic crisis that hit the world this year has brought the most severe global recessionary environment since the Great Depression. As a result, many corporates have been issuing profit warnings and cutting dividends. Earnings forecasts have been coming down significantly, as consensus has been adjusting to the changed reality.

At the same time, policy actions have been commensurate with the magnitude of the recession, with fiscal and monetary policies equating to more than 10% of GDP for many of the large economies. As economies are now coming out of lockdown, the fiscal stimuli will be helping economies recover. We are likely to see some pick up in leading indicators over the next 1–3 months from the lows seen in Feb-April. Some of this initial improvement might appear rapid, which could give the illusion of a V-shaped recovery.

The shape of the economic recovery is, however, still highly uncertain in our view, due notably to uncertainty about what a post-lockdown world looks like, and the potential downside impact of any negative feedback loop of weakening labour market on the demand outlook. And in fact, we are more conservative as a result and believe that we won’t reach a return to normal activity levels until at least 2022.

Of course, as long-term investors, we measure the performance of companies years into the future, not just their prospects for the next handful of quarters. Indeed, the portfolio’s investment horizon of five to ten years has enabled a sanguine and opportunistic response to exactly this type of event.

A clear focus on quality businesses with strong balance sheets, pricing power, high returns and sustainable business models helps withstand short-term downward pressure while accessing the economic benefits of longer-term growth themes.

It feels like a risky time to invest, what is your view?

After such a major ‘black swan’ event such as the coronavirus, it’s understandable that there is a lot of fear and uncertainty still kicking around in the marketplace – in particular, as the reverberations of the outbreak are likely to be felt for some time to come. There are also lots of additional uncertainties, despite the markets having recovered sizeably.

Specifically, regarding the speed of stimuli channeled into the economy which will drive the magnitude and pace of the recovery, as well as the threat of pandemic relapse risk once lockdowns end, which could act as a dampener to any recovery.

At the same time, there are other risks to factor in, not least the renewed geopolitical tensions between China and the US, but also the increased risk of credit default in some pockets of the economy, notably small and medium-sized businesses.

Given the uncertain environment, we continue to favour companies with high management quality, strong balance sheets and cash flows, operating in industries with high barriers to entry and with strong market share, which gives them pricing power, and therefore an ability to generate high returns and attractive growth profiles.

The pricing power will be particularly important, in a world where there are ongoing underlying deflationary pressures. In such an uncertain environment, our research remains focused on finding attractive quality growth sustainable opportunities around our three long term mega-trends, which are Demographic Change, Future of Technology and Resource Scarcity.

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In the world after COVID-19, is emerging market demand still an investment theme that interests you?

Most definitely. The pandemic has certainly been impactful in terms of demand and supply in the short term, but one aspect to highlight from the lockdowns is that there has been a sizeable increase in savings. This could provide some readily available disposable income that could be rapidly deployed into stronger consumption in the next few months. Indeed, we are already seeing this pent-up demand starting to come back in China, where some luxury goods brands have been commenting on strong traffic and strong conversion rates in some of their stores.

And certainly, looking longer term, with the rapid expansion of the emerging market middle class as a long-term growth theme which remains valid, luxury goods is one area which is going to be of interest over the coming decade and beyond.

Our expectation is that luxury growth in emerging markets, especially in China, continues to significantly outpace the global market growth rate and can, and will, continue to accelerate as price harmonisation, more sophisticated marketing and e-distribution democratise access. At a time when the market is increasingly worried about a short-term slowdown, we believe there may well be a good opportunity for long-term unconstrained investors such as ourselves to increase exposure here to capture this long-term structural growth.

ESG is mentioned a lot by investors? Are these important factors in your thinking?

Environmental, social and governance (ESG) factors form a fundamental part of how we analyse and assess the ability of companies to generate long-term sustainable returns. We find that well-stewarded companies tend to have a higher potential to perform and therefore to reach or sustain leadership in their sectors over the long term. For us, stewardship goes hand in hand with long-term investing. After all, sustainable investing is about growth that is inclusive to every part of society and the environment.1

At Martin Currie, we have strong expertise in ESG analysis, which we have developed over multiple decades of fundamental research. Indeed, our leadership in ESG has been rewarded by the UN PRI over the past three consecutive years with a top rating of A+ across all three of its categories. ESG analysis is integral to our fundamental analysis because, in our view, ESG goes hand-in-hand with long-term investing.

We have put in place a proprietary ESG framework which all our teams apply. That framework assesses each company we research in terms of Governance and Sustainability risks. Within Governance, we assess four fields, which are: boards, management, remuneration and culture. On the sustainability side, we assess environmental and social risks, the understanding, integration and ambitions of the companies in these fields, and the common factors related to climate change, cybersecurity and human capital.

All in all, we have more than 50 fields that our analysts assess in detail and rate. We put this proprietary ESG risk assessment framework in place at the end of 2018 and are able to feed this analysis to our investors to give them a better understanding of the ESG risk exposures in the portfolios we manage.

We welcome the industry’s increasing focus on ESG matters, because the more investors focus on ESG, the more we raise the standards and the demands on corporates to manage their businesses in a sustainable manner, which should ultimately benefit all stakeholders in our view.

How did your investment processes enable you to be ‘crisis-ready’ during COVID- 19?

We have a proprietary, bottom-up approach to investing based on in-depth company-specific research. The portfolio has an unconstrained approach and invests with a five- to ten-year horizon. Stocks are selected using a rigorous three-stage selection process:

1.    Idea generation – a universe of 2,800 stocks is screened down to an investible universe of 500 companies and then to a research pipeline of 90+ names, to identify companies with a combination of quality, sustainable growth and an attractive valuation. We look for companies with a high and sustainable return on invested cash above their weighted average cost of capital, which can generate above-average total returns over the long term, and which have high-quality governance and strong balance sheets.

2.    Fundamental analysis – companies considered for inclusion in the portfolio are likely to have a dominant position and pricing power in a market with high barriers to entry and low disruption risk. We seek companies with structural growth prospects, high returns on invested capital, strong cash flow generation and a strong management team. A proprietary research template is compiled for each company reviewed to ensure a consistent approach. Added to this process, there is a systematic risk assessment focusing on industry risks, company risks, governance and sustainability, and portfolio risks. The company risks include a focus on accounting risks, to ensure that we do not invest in companies where we are not comfortable with the accounting practices. Against a backdrop of recent news stories about investors being negatively impacted in this way, we see this as a crucial means for us to protect our clients’ assets.

3.    Portfolio construction – we use analytics to break down the portfolio by geographic revenue and profit rather than where a company is listed, to understand the fund’s geographic exposure by economic value; in absolute terms it is more heavily weighted to developed markets with less exposure overall to emerging markets currently. The portfolio is also assessed in terms of end-user exposure at a tier-one level – the consumer, business and government – and then at a more detailed tier two level focusing on individual sectors and industries. We also assess the portfolio on thematics exposures, to have full visibility on the long-term structural growth themes that we are able to harness.

We believe the rigour and depth of this selection process not only helps identify the best, high-conviction holdings for our portfolio, it also inherently manages risk and diversification at both a company and portfolio level. So, it didn’t come as much of a surprise to us that the portfolio experienced limited downside participation during the pandemic sell-off, mostly because we knew that the quality of the companies in the portfolio made it ‘crisis-ready’.

Can you explain how the portfolio achieves differentiated alpha generation?

There are many ways we are able to generate attractive returns and to achieve this in a differentiated manner. Our geographic exposure database ensures that we accurately measure our risk exposures on geographies, and enables us to diversify our exposure appropriately. Our end-user markets analysis of the portfolio ensures that we do not have an overly amplified exposure to any specific end-market, which helps us at times to be less consensual than some of our peers. Our thematics analytical framework, helps us point our portfolio exposure on the three long-term mega-trends that we have identified, and which give us exposure to favourable long term structural growth opportunities, in the areas of (i) Demographic Change; (ii) Future of Technology; and

(iii) Resource Scarcity.

There are some very exciting nascent themes within each of these three mega-trends, which our in-depth fundamental research is able to identify and harness for the benefit of our investors. Finally, because we point our research forward towards the future quality growth opportunities we foresee, we are able to capture some opportunities early in their development cycle, which means that we are typically less exposed to the established blue-chip mega-caps that some of our peers might be holding. All of this helps us be differentiated while at the same time capturing attractively priced, long- term, sustainable quality growth opportunities in a consistent and structured manner.

1The analysis of Environmental, Social and Governance (ESG) factors form an important part of the investment process and helps inform investment decisions. The strategy does not necessarily target particular sustainability outcomes.