| Illustration by Harry Haysom. |
Sell-side analysts operate as barometers of markets and securities. Not only do they offer insights into what they believe is happening inside companies and how corporate initiatives might ultimately work out (or not), they must factor in views of investor sentiment and where the markets might be headed. It’s a tough job, no matter the mood of the markets or the state of the clientele.
But given that, the analysts who top Institutional Investor’s Alpha’s 2017 All-Europe Hedge Fund Research Team ranking are a special breed. Hedge funds live and die off their ability to generate alpha — that is, excess returns. Hedge fund managers are, in the main, intensely speculative, active traders who measure their performance on a daily basis, are voracious consumers of information and analysis, and are a major source of fees to the banks. The hedge fund universe is crowded and competitive, and over the past few years it has underperformed mainstream equity benchmarks, creating tension with the sell side. Because of all this, the analysts they favor occupy a very special niche: They have risen to the top on the votes of some of the toughest critics in finance.
| Research & Rankings The LeadersWeighted WinnersHedge Fund vs. Core Research TeamHedge Funds’ Favorite European Equity Research Analysts |
To determine the rankings of hedge fund favorites, Institutional Investor’s Alpha retabulated the results of the 2017 All-Europe Research Team survey (published in II’s February edition), counting only votes cast by hedge fund personnel. The survey tapped opinions of 545 hedge fund managers at 290 firms overseeing an estimated $414 billion in European equity assets.
This year analysts at Bank of America Merrill Lynch lead both the All-Europe Research Team and the All-Europe Hedge Fund ranking. Morgan Stanley remains at No. 2 among hedge funds, and J.P. Morgan Cazenove keeps the No. 3 spot. Deutsche Bank moves up one place to No. 4, and UBS falls one to No. 5. The big mover this year is Citi, which jumps to No. 6 after coming in ninth last year.
How do the banks’ research strengths with hedge funds compare to the broader All-Europe team? Actually, it’s fairly close, with a few exceptions. Bank of America tops both polls, but this year Morgan Stanley holds on to its No. 2 spot among the hedge funds, versus its No. 5 position in the All-Europe ranking. UBS does just the opposite: No. 5 in the All-Europe Hedge Fund ranking and No. 2 in the broader survey. The nuances grow more interesting at the analyst level. J.P. Morgan Cazenove equity strategist Mislav Matejka and his team, Citi’s Andrew Baum in pharmaceuticals, and UBS’s Gareth Jenkins in technology/hardware all take No. 1 in both surveys. In fact, the same analysts appear on top in 13 of 28 sectors. Still, that leaves over half with different leaders, and in most sectors throughout the ranking the order is reshuffled or new names appear.
These top analysts recognize the value of research and how it’s changing. “All of our clients, but hedge funds especially, are really focused on data right now,” says UBS’s medical technology analyst Ian Douglas-Pennant. “We’re looking at ways to create new data sets that will be useful. We’re also looking at how to use new types of data, like geospatial data or more sophisticated surveys, to inform our opinions.”
Many analysts, most of whom work in tightly knit teams and have spent their careers in research, echo those ideas — and the rising demands from clients for better, deeper, more consequential information and analytics. One of the strengths of the sell side is its access to executives, which investors, including hedge funds, generally lack. “It’s become more important to rely on company executives directly,” says Alastair Syme, who leads Citi’s oil services team in London. “Anyone can get information from terminals or online. I’ve found that maintaining a running conversation with company executives provides greater insight than what’s in the news.”
UBS has turned to external research partners for an edge, working with a survey company, for instance, to professionalize its industry polls by making them more comprehensive for a wider range of respondents. “The need for differentiated research has never been higher,” says UBS’s Jenkins. “As researchers, we have to be willing to try new things and hold ourselves to a higher level of accountability. That’s how we will stand out for not just hedge funds but any client.”
But for all the new technologies and data, sell-side analysts still live off their insights and their predictions. These are worth a premium in a period of profound economic uncertainty, with interest rates moving up and a broad wave of populism sweeping both Europe and the U.S. Despite all that, top analysts on the All-Europe Hedge Fund Research Team generally agree on a kind of uber-theme encompassing companies and sectors: the renewed need for value in a world of diminished returns.
It might seem counterintuitive to talk about value amid a broad equities rally — albeit one that could fade tomorrow — and what looks like the emergence of a significant reflation trend on the Continent. But after years of divergence between bullish U.S. equities after the financial crisis and a period of, at best, muddling through in Europe, many global industries are showing signs of fatigue. If, as appears possible, developed economies retreat within their borders to pursue national trade, economic, and monetary goals, companies will struggle to keep growing over the long term while dealing with a considerable amount of uncertainty. In such an environment, strategists, traders, and CEOs alike start to look more closely at value.
Beginning in 2016’s third quarter through the so-called postelection Trump bump, market sectors have rebounded. “Obviously, infrastructure is going to be a big theme heading into the new year in both the U.S. and even the U.K. post-Brexit,” says Gregor Kuglitsch, who leads the building and construction analyst team at UBS. Kuglitsch and his team, which includes two analysts based in the U.K. and one in India, take first place in the sector this year. “Increased infrastructure spend could extend the cycle in the U.S. for at least a few years, which is significant because the market more broadly has assumed we were approaching the end of the cycle. But we’ve also seen construction tick up in the U.K. after Brexit. It’s unclear if that holds.”
To be sure, the incoming Trump administration has talked up a big U.S. infrastructure push, and local construction was also part of the Brexiteers’ campaign. However, neither has been explicit about details. Kuglitsch argues that this is where it becomes important to seek out companies that can both create the most value from this trend and be resilient if conditions change. “We’re very focused on trying to figure out which businesses are going to have the best pricing power in this environment,” he says. “I think there is still a lot of upside in U.K. and European names like CRH.”
Dublin-based CRH manufactures and distributes a variety of products for the construction industry. The company operates in six segments — three in Europe and three in the U.S. — selling everything from cement and concrete to construction accessories and sanitary, heating, and plumbing supplies. The consensus rating on CRH stock has it a Hold, according to Reuters.
CRH should profit from an infrastructure play. U.S. concrete companies rose on talk of Trump’s border wall and his infrastructure agenda. Brexit is meant to bolster local industries, and, so far, builders have seen demand for new construction edge up. Still, whether any of these plans will prove long-term trends remains an open question. If the U.K. makes a conciliatory deal with the European Union, domestic construction could take a hit, which may create value opportunities for companies that perform through the uncertainty. If the U.K. goes it alone, construction companies will still need to make the most of the recent boom, given Britain’s potentially limited economic scope.
Another traditional segment, metals and mining, has also found new life, after several years of being dragged down in a global commodities slump. According to Heath Jansen, lead metals and mining analyst at Citi, miners represent a solid value opportunity for investors over the next year or two. Jansen with Ephrem Ravi and their team take the No. 3 spot in metals and mining in this year’s ranking.
“What you’ve seen in this category are significant behavioral changes on both the supply side and the demand side,” Jansen says. “Mining companies have reined in capex and are planning to become value-over-volume businesses. On the demand side you’ve seen the global customer base start rationalizing supply in areas like steel and aluminum, which have allowed prices to rebound.” He adds that the sector has also delevered significantly, paying back debt and streamlining operations, two areas that can unlock value for investors.
Infrastructure and mining aren’t alone in having to stay focused on value creation. Newer industries and those disrupted by technological change are also starting to move away from growth for growth’s sake and reorienting themselves to generate long-term value. Citi’s oil services analyst Syme, a geologist before he moved into financial research, says that the recent down cycle in oil is one of the first in his memory where executives have had to think about how to create value during a long slump in prices. Syme works with a team that covers both Europe and the U.S. and comes in second in the survey.
Pricing isn’t the only reason oil services will need to change. Renewable-energy sources are powering new electric vehicles, and hybrids are getting more miles than ever before having to be recharged. “Electronic vehicles are on our radar in a bigger way than they have been in the past five years,” Syme says. “I think the potential impact from these innovations is growing and investors will have to start thinking about oil and gas in new ways to capture the return they seek.”
The notion of widespread technological disruption isn’t new. Citi’s Baum, who leads its pharmaceuticals research team in London, is no stranger to disruption in his sector. M&A activity in pharmaceuticals has been going on for decades, driven largely by consolidation, as major players merge with one another and pharma giants gobble up smaller companies that have mastered emerging technologies.
“M&A is a perennial part of the industry,” says Baum, who trained as a physician at the University of Oxford and concentrates on drug research, with a special emphasis on immunology and cancer therapeutics. “The multinationals lack revenue drivers, which fuel M&A. The momentum for M&A is likely to be augmented by the likely beneficial impact of U.S. tax reform on funding costs of selected transactions.”
Despite M&A, major drug companies have watched their biggest drugs age and lose their patents, only to be hurt by low-cost generics. Baum points as well to a new, if related, threat: so-called biosimilars, which are generics for a new wave of blockbuster biologic treatments. Rheumatoid arthritis, for example, is now commonly treated with biologic drugs such as Amgen and Pfizer’s Enbrel or AbbVie’s Humira. These therapies are genetically engineered and are often effective in patients who don’t respond to more conventional medicines. That advance comes at a price, however. Biosimilars bring down costs, a boon for consumers but a bane for pharma’s bottom line.
Medical device companies have also started to focus on the long term. New regulations, as well as potential changes in the U.K. and U.S. health systems, mean the future for medical device companies has grown more uncertain. Governments are pushing health care providers to concentrate on affordability and outcomes-based care. UBS’s Douglas-Pennant, whose team comes in second in the ranking, says that “medical device companies have been some of the most stable performers for investors, but the industry will have to be prudent in its approach to growth in a value-based care environment.”
UBS’s Jenkins notes that new automotive features, like parking assist and automated braking, were instantly popular with consumers. That helped hardware providers, but widespread adoption quickly drove down costs and margins. “There is still room for Moore’s law [that the number of transistors on an integrated circuit doubles every year] to play out in [technology/hardware],” he says. “We expect costs will continue to go down.” Investors that were early to this segment and cashed in on the growth trade may find that it’s time to shift to long-term value if they wish to keep these hardware providers in their portfolios.
All this talk of value has to be good news for many hedge funds. Chasing value suggests an active approach to investing, the kind of stock picking that many hedge funds have traditionally practiced — but which has been eclipsed by broadly rising markets and the mounting popularity of passive, indexed investing. A return to value may be one big thing that the hedge funds and analysts can quietly celebrate together.
