Analysts at Deutsche Bank cut against the grain when they issued a high-conviction call in July 2013 urging investors to unload shares of British aircraft engine manufacturer Rolls-Royce Holdings, at 1,200.39 pence. Arguing that the company’s cash flow was poor and underlying costs were rising in its civil aerospace unit, the researchers forecast that the stock would tumble 15 percent, to 1,020 pence.
This bearish view was not widely shared at the time, recalls Benjamin Fidler, who heads the two-person team covering aerospace and defense stocks at the bank’s offices in London. Rolls-Royce — the world’s second-largest aircraft engine maker (in terms of order volume), behind U.S.-based General Electric Co. — had enjoyed a decade of strong growth. It had recently posted a 6 percent rise in revenue for the first half of 2013, besting consensus expectations, and its earnings-per-share increase outpaced even the Deutsche analysts’ forecast by 7 percent.
“We were only one of two large sell-side banks who were sellers of the stock at the time,” notes Fidler, 44. “I’m not always Mr. Out-of-Consensus, but we certainly differentiated ourselves on that call.”
Indeed. By the end of April 2015, Rolls-Royce shares had fallen by roughly 13 percent, to 1,046p, since the Deutsche team downgraded the stock from hold.
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Advising investors to be circumspect, Fidler, who has been covering these companies since 1997, and his associate expressed wariness over what they considered Rolls-Royce’s complex accounting. They pointed to several distorting influences on reported earnings, such as capitalized research and development, and the way that operating expenses on new engine sales and engine maintenance costs are tabulated. “We have a number of ongoing question marks over the quality of Rolls-Royce’s reported profit-and-loss earnings,” the analysts declared in their report accompanying the downgrade notice.
Last year the company issued three profit warnings. The underperformance of the stock — battered further by a stronger English pound that hurt exports, along with plummeting energy prices that impeded sales of its gas-turbine and diesel-powered engines — shocked the markets. At least one London hedge fund manager now wishes that he had listened more closely to the Deutsche team and less to the conventional wisdom.
“I should have paid stricter attention to [Fidler’s] call,” this money manager acknowledges. “He never abandoned his position that something was rotten at the company and that Rolls-Royce was an accident waiting to happen. But the market had a different opinion, and I tended to migrate to that view.”
The Deutsche squad’s work represents the kind of cutting-edge stock research — fundamental, bottom-up, high-conviction, often contrarian — that endears sell-side analysts to all investors but hedge funds in particular, investors say. Although this duo captures second place on the 2015 All-Europe Research Team, Institutional Investor’s annual ranking of the region’s top equity analysts, hedge fund managers insist that no one does a better job covering the region’s aerospace and defense names.
Nor is Fidler’s team the only one held in higher regard by this type of client. To find out which are their preferred research providers, Institutional Investor’s Alpha recalculated the results of this year’s All-Europe Research Team survey using only the votes cast by hedge fund participants. Morgan Stanley captures first place; its analysts earn a spot in 20 of the 28 sectors that produced publishable results. In second place is Bank of America Merrill Lynch, with 19 positions, followed by J.P. Morgan Cazenove, with 18. Sharing the No. 4 spot, with 13 places apiece, are Deutsche and UBS. Each of these firms has a lower team position total this year than last; indeed, of the top ten research providers, only Redburn does not see a decline in its total. It claims five spots again this year and shares seventh place with Sanford C. Bernstein.
Survey results reflect the opinions of more than 440 hedge fund managers at some 230 firms overseeing an estimated $372 billion in European equity assets.
Ideally, sell-side analysts say, they provide research that’s useful to both hedge fund and long-only investors. “All our clients are equally important,” asserts Fidler. But there is an obvious difference between the two types of clients: hedge funds are able to make money by shorting stocks, as in the case of Rolls-Royce.
Simon Greenwell, director of research for Europe, the Middle East and Africa at Bank of America Merrill Lynch in London, also sees the fact that “hedge funds are not constrained by regional boundaries or asset class” as an important contrast with long-only funds. Their greater latitude enlarges their appetite for a wider spectrum of research.
“Hedge funds want to anticipate investment trends and play them aggressively,” he adds.
“Feed the World,” a massive tome BofA Merrill published in April that examines issues related to the security of the world’s food supply, is the kind of report that strikes a meaningful chord with hedge fund clients, Greenwell says. The 250-page analysis delves into a whole panoply of food-related issues, including climate change, obesity and pandemics. It notes that the world must increase food production by some 70 percent by 2050, when the United Nations expects the world population to reach 9.6 billion — an increase of roughly 2.5 billion over the current level. It also estimates that the chronic malnourishment of more than 800 million people costs roughly $2 trillion a year in lost economic growth.
Perhaps most significantly, the report warns that the security of the water supply is emerging as the 21st century’s most alarming ecological risk.
The BofA Merrill analysts don’t just outline problems, they also explore investment strategies. The report notes that the $600 billion market for water technology could grow to more than $1 trillion by 2020, with Brazil, China and the U.S. leading the charge. Technologies ripe for investment include water treatment and management; so-called “smart” meters, which track customer usage and can alert service providers to problems (and even enable remote shut-off capabilities); and such “water-friendly energy technologies” as environmentally sensitive hot-water heaters and water-saving shower heads.
“Hedge funds look at these long-term trends,” Greenwell explains. “They want to know what pressure points and shortages will occur, who’s resolving these issues and who the beneficiaries will be.”
Christian Kern, director of European equity research at J.P. Morgan Cazenove in London, notes that the sheer number of investment opportunities open to hedge funds is one of their defining features. But, he adds, strong sell-side analysts know that “the same product can provide angles to the investment thesis” for both hedge funds and long-only investors.
“You can have a fundamental call on a stock which can play out over different time horizons,” he points out.
Hedge funds, for example, were able to respond more quickly to the firm’s upgrade of euro zone equities from underweight to overweight in mid-November. Most analysts had been bearish on those stocks, which then trailed their U.S. counterparts by nearly 21 percentage points year to date, in dollar terms, when the J.P. Morgan team broke with the consensus. Since then euro zone stocks surged 8 percent, compared with the 2 percent rise for the U.S. market, through April.
“We were ahead of the curve, and it’s been a very powerful call because European stock markets have done very well,” Kern says. “But it’s up to the investor as to how you implement that equity strategy. Hedge funds can buy the index or equities, or they can invest across asset classes. A long-only would just buy blue chips or other underlying equities in Europe.”
Mislav Matejka directs the crew of four that made the call; it captures first place in Equity Strategy not only among hedge fund voters but also in the broader survey.
“We believe our research and views can sometimes be branded as a bit more contrarian,” he says.
It’s a character trait, the London-based team leader believes, that has helped his strategists earn a following among hedge funds.
“We definitely see that they want to be the first ones to spot a new trend,” affirms Matejka, 38. “Their trades don’t necessarily result from a deep dive on a specific topic, but more often from trying to connect a number of global and macro factors. The rebound of euro zone equities after the region was a consensus short is an example of this.”
Andrew Stott, who heads the four-strong BofA Merrill squad that takes top honors in Chemicals, says there are clearly instances when a particular report will resonate more loudly with a hedge fund audience — especially when analysts identify an inflection point on a stock.
A recent case in point, the 44-year-old says, is Croda International, a U.K.-based specialty chemicals manufacturer that sells additives and ingredients to an array of companies in the cosmetics, household and personal care products industries; its major clients include France’s L’Oréal, Procter & Gamble Co. of the U.S. and Unilever, which is dually headquartered in the Netherlands and the U.K. Croda’s stock has slumped after it had experienced “zero organic growth,” Stott says, throughout much of 2013.
In March of last year, the London-based analysts published a report noting that “underlying sales growth picked up modestly” in the fourth quarter and that Croda’s higher-margin products were most in demand. After an exhaustive series of channel checks — “digging around the world and talking to customers and competitors in the U.S., Asia, Latin America and Eastern Europe,” Stott says — the researchers upgraded the stock from hold to buy, at 2,416.86p, alerting investors to the fact that there was “no actual slowdown in growth of the supply chain,” he explains.
In addition, as an innovative producer of canola and palm oils, grape seed and wool grease, among other products, Croda was adroitly positioned to meet the demands of consumers clamoring for natural products, the analysts maintained.
“They saw this trend years before any other chemical company,” Stott marvels.
There were other factors contributing to the bullish thesis. Croda’s debt burden was low, and it boasted stable cash flow, he adds. The researchers set a target price of 2,750p, which indicated potential upside of roughly 14 percent.
Moreover, in a pitch aimed at hedge fund investors, they noted that short interest in Croda stock had been growing, reaching some 5 percent of outstanding shares.
“For a quality stock short interest is never more than 2 percent,” Stott contends. “We argued that this was an overreaction and that investors would have to buy back shares to cover their positions. That’s a great position for a stock to be in.”
By late April 2015 Croda’s shares had shot to 2,835p, a gain of 17 percent that bested the sector by nearly 3 percentage points. Not only have hedge fund investors been pleased, but long-only clients that kept their shares and hoped for a rebound have been well served, too. The BofA Merrill team continues to recommend the stock, with a new target price of 3,100p.
Thomas Chauvet, who pilots the Citi trio that leads the Luxury Goods lineup, notes other differences between investor types.
“Hedge funds generally are more focused on both the long term and volatility of quarterly results, on accounting-related issues and on regularly assessing how management guidance may differ from consensus expectations,” he says.
Chauvet, 37, and his teammates are “almost obsessed” with the quality and precision of quarterly and yearly forecasts, he declares. “We also spend a fair amount of time looking at balance sheets and cash-flow generation and at potential accounting issues.”
Hedge funds clients particularly appreciate Citi’s series of “head-to-head” reports, the London-based leader says, that compare and contrast companies in the same industry. One recent example: A 64-page report in March juxtaposing Swiss watchmakers Cie. Financière Richemont and Swatch Group. The analysts subjected both companies to an exhaustive examination, scrutinizing every angle from category exposure and geographic reach to foreign exchange, use of cash and valuation.
The bottom line? Richemont was judged the better stock, earning a buy rating (versus neutral for Swatch) on the belief that it possesses an attractive growth story with a superior business model. The Citi review sets out a litany of positive attributes: Richemont’s superior earnings and pricing power, brand strength and long-term strategy, as well as a stable executive team and a strong balance sheet. One of the arguments against Swatch is its limited product-line diversification. Watches account for roughly 87 percent of sales, which makes Swatch more of a pure-play watchmaker and thus more vulnerable to direct competition, particularly from Apple’s new watch. Richemont sells not only timepieces but also jewelry, leather goods, writing instruments — even clothing, via its Chloé, Alfred Dunhill and Shanghai Tang subsidiaries.
The stock, which was trading at Sf83.35 when Citi published its report, was little changed by the end of April and a long way from the analysts’ target price of Sf98. Swatch shares had slipped roughly 3 percent, from Sf422.89 to Sf412.30, over the same period.
Celine Pannuti, who oversees the J.P. Morgan Cazenove team in first place for coverage of Household & Personal Care Products, also points to differences between long-only and hedge funds investors. The latter “usually have more of a short-term focus, with discussions around quarterly numbers ahead of reporting season,” she says. “Hedge funds also like detailed research on particular subjects that they may not have the time to do themselves and are relevant to investment angles.”
Finally, the Geneva-based team leader notes, “there is also more of an interest around event-driven research” such as coverage of mergers and acquisitions or divestitures.
In September the analysts generated a flurry of excitement among hedge fund clients after publishing a report speculating on whether U.S.-based battery maker Energizer Holdings’ pending spin-off of its personal care products division would make the latter entity an attractive acquisition target, Pannuti says. (The separation, which will result in the creation of a newly independent company, Edgewell Personal Care Co., is expected to be completed in early July.) The unit chalks up roughly $2.6 billion in annual sales and holds the No. 2 position globally in wet shave products.
Such a sale “could be one of the biggest deals in years,” worth some $7 billion, the researchers contend, with Beiersdorf and Henkel of Germany and Sweden’s Svenska Cellulosa the most likely potential buyers.
Any one of these three “could benefit from being leveraged in a wider global platform,” Pannuti explains, and would gain “scale and distribution clout in the market” — especially since the U.S. accounts for 60 percent of the operation’s sales. However, a potential tax liability estimated at more than $1 billion “makes the timing of a deal uncertain,” she adds.
No suitors have yet come forward to woo the soon-to-be-liberated division, but if there should be a wedding announcement — and it proves to be one of the three prospective grooms cited in the J.P. Morgan Cazenove report — then investors can’t say they weren’t invited to the reception.
— Paul Sweeney
