Credit Suisse’s Todd Leigh and Rushil Khanna invest in stocks using a unique industrial life-cycle approach that classifies companies according to the five stages of their corporate maturity. Find out how the fund managers use computer power and human expertise to pick stocks.

Unlike many fund managers around the world who group and pick stocks based on sectors, countries and regions, Todd Leigh and his atypical team of nine investment professionals at Credit Suisse Asset Management’s (CSAM) HOLT Active Equity Group prefer to do their equity selection based on the life-cycle stages of companies.

Dividing 10,000 stocks across the globe into five stages of corporate maturity, namely startup, growth, cash cow, fading winner and restructuring, Leigh’s group — using a powerful proprietary quantitative model — will search for the best stock ideas in each corporate maturity stage. This unique industrial life-cycle (ILC) approach not only gives a high degree of “active investing”, it also minimises traditional sources of “active risks” associated with country, sector and style biases, according to Leigh, managing director and head of HOLT Active Equity Group at CSAM.

HOLT is an independent research division of Credit Suisse that converts board accounting data into a standardised set of economic cash flows that provides a consistent valuation methodology for over 20,000 companies in 64 countries. HOLT is the acronym for its founders’ last names: Bob Hendricks, Eric Olsen, Marvin Lipson and Rawley Thomas founded HOLT Planning Associates in 1985.

The company, which pioneered the cash flow return on investment (CFROI) concept, was acquired by Credit Suisse in 2002 and is now a group within the equities division of the Swiss bank.

“If you look at other managers, they are organised by sectors, countries or regions, with all trying to pick the best companies [within these groupings]. For instance, they could be looking for the best telecom companies in Asia. We thought by throwing that out and looking at the world differently, we could have a potential source of excess returns,” says Chicago-based Leigh in an interview with Personal Wealth when he was in town recently.

Looking at companies using the ILC approach leads to a “different peer group ranking”, the fund manager explains. Indeed, growth stage companies could include tech, auto and consumer stocks as well as different types of companies from a variety of sectors, he points out.

“We compared all [the] growth stage companies. For instance, we would compare [ social media company] Facebook with [electric car maker] Tesla, both growth-stage companies. But they are in totally different industries. So, we get a different peer group and apply a different ranking methodology to each [of them]. That’s our secret sauce. We think having unique peer groups and applying a different set of rules for ranking the stocks in each group lead to different insights,” he says.

Leigh, who has been with HOLT for two decades, observes that there are a lot of “copycats” in the global fund management industry, where fund houses use similar investment processes. “A big part of my time at HOLT was [spent] selling HOLT tools to other asset management firms. I have had an inside look at 70 asset management firms and their investment processes over the past 20 years. What I have noticed is there isn’t a lot of innovation that truly differentiates their investment products,” he says.

Innovation and differentiation are reasons HOLT came up with the ILC investment process 10 years ago, Leigh says. “Like in any industry, if you have a lot of competitors, you need something to really differentiate yourself.” The proprietary ILC approach does not take information from external sources but generates in-house data and ideas. “We run our process and it generates the ideas. We then go out and do research on the companies, as opposed to reading brokers’ reports on stocks. We’ve never had an investment idea that came from outside. It always comes from the internal process.”

HOLT’s huge database and insights on how companies evolve during boom and gloom periods gave the CS HOLT Active Equity team “a competitive advantage” when using the ILC investment approach, says Rushil Khanna, a Singapore-based director and portfolio manager at CSAM’s HOLT Active Equity Group. “We are fortunate to be part of an organisation that has an enormous amount of data and history of stocks.”

Investment process
Once the universe of 10,000 stocks is classified into the five life-cycle groups, four “primary drivers of future share price performance” — valuation, price momentum, earnings momentum and quality — will be used to identify the potential winners and losers in each group.

For stocks in the start-up and growth phases, factors such as price and earnings momentum as well as quality are given more weight in terms of the selection process, says Leigh, who points out that most growth and start-up companies tend to exhibit high valuations. “For these companies, differentiating them by valuations would not be very helpful because they all trade at very high valuations. It is about which one gets the better momentum. That’s what drives the stock price.”

Cash-cow companies, however, are selected using valuations and earnings momentum, while restructuring firms are gauged primarily using the valuation indicator. In the restructuring stage, companies there tend to be “ broken, underperforming and low-quality” counters, Leigh notes. “Using the quality factor there does not make a lot of sense. It is like comparing the worst-quality company with the second-worst one. For restructuring companies, what we have found is that when you buy them as cheap as you possibly can, it can give you a great investment.”

Within each life-cycle stage, stocks are then systematically ranked from an ILC score of one to 100, according to the primary drivers of excess returns. Stocks in ILC portfolios typically have a ranking of above 70. If a stock drops to 60, it is a signal to sell, says Khanna. “We mo nitor the scores on a weekly basis. If there is a cash cow, for instance, that was ranked 90 when we first bought it but has since dropped to 60 because it has already done very well with limited upside, that is an easy trigger for us to sell the stock,” he explains.

Having this systematic buyand- sell approach takes the emotion out of investing, says Khanna. “We all love our [preferred] stocks and there are certain companies that even I like on a personal basis. But if the framework is asking us to sell it because there is a better idea on a risk-adjusted basis, that will force us to switch. Without this guide or invisible hand, we can be vulnerable to style drift, following consensus, or [falling in love with a stock].”

ILC products
Since 2012, CSAM has gradually rolled out equity funds that use the unique ILC investment approach to high-net-worth investors. The first ILC fund — Credit Suisse ILC Global Emerging Markets — was incepted in October 2012, followed by the ILC Global EM Small & Mid Cap (incepted in May 2013), ILC Global Developed Markets ( January 2014), ILC Global Small & Mid Cap (February 2014), ILC US Core (August 2014), ILC Europe ( November 2014) and ILC Asia Pacific (May 2015).

Although many of the Credit Suisse ILC funds, which are only available to accredited investors in Singapore, have yet to achieve a track record of three years, their performance on the whole has been decent, according to Leigh. As at end-September, six out of the seven ILC funds had outperformed their benchmarks since inception, he says. On the whole, the ILC funds did better than the equity market indexes 66% of the time during a bullish uptrend, and 60% of the time in down markets, according to a performance report by Credit Suisse. Assets under management of the ILC funds have swelled to around US$1 billion ($1.4 billion) on the back of their recent performance.

“In an environment where most active managers are struggling to beat the markets, the majority of our strategies are beating the markets. The only one that has not outperformed is our US strategy. Our European and global strategies have done well,” he adds, beaming.

The CS ILC US Core was down 2.83% from August 2014 to end-September 2015; in comparison, the MSCI USA Index was up 0.92%. Leigh admits that strategies that invest in less efficient equity markets, such as those in EM as well as the small- and mid-cap space, tend to lead to more stock selection alpha, while generating excess returns is more challenging in highly efficient stock markets such as the US.

“But the US strategy is just one year old. It is still too early to make a judgement on it. In general, however, our expectations for outperformance are lower with this strategy because the US is a more efficient market.”

Not pure quant managers
Although a quantitative model is first used to screen stocks, Leigh says equity names are only included in the portfolios of the ILC funds after careful evaluation and scrutiny by his team of investment professionals, who have dual roles as analysts and fund managers. He emphasises that the ILC investment process is not a pure quant approach, but one that combines “a structured approach to data analysis and human expertise” for fundamental stock selection.

“We are not a pure quant manager, where the machine picks all the companies with no oversight. The idea-generation process is quantitative. But with every name that comes out from that process, we do due diligence on those companies before they go into the portfolios. It is really a combination of man and machine [working] together in the investment process,” he adds.

The main advantage of using computing power is its ability process a lot of data. Computers also help “cast a wide net” for investment ideas, Leigh says. “But one disadvantage is that a computer system often misses some very basic things that a human can find.” That’s why experienced analysts and portfolio managers are needed to carefully evaluate the list of stocks generated by the machine.

Ultimately, the lead fund manager of the ILC funds will have the final say as to which stocks go in and out of their portfolios, says Khanna, who reveals that even powerful computers can get their stock picks wrong at times.

“An example is a Hong Kong-listed solar company, a growth-stage firm that generated strong profits and had strong [share price] performance. The machine really liked it. But when our analysts looked at the company, we found that one particular customer was dominating the sales. The customer is an affiliate. That was a yellow flag and as we went through our due diligence, we decided not to invest in the company because it didn’t fit the entire criteria,” says Khanna, who declined to talk about stock names.

The particular company cited by Khanna is Hanergy Thin Film Power, whose shares have been suspended indefinitely since May by Hong Kong’s share market regulator on suspicion of fraudulent accounting. More than 60% of HTFP’s sales came from its unlisted Beijing-based parent, Hanergy Holding Group, which buys solar panel-making machines from its Hong Kong-listed subsidiary and makes solar panels for sale to third parties.

HTFP is accused of using transactions with its parent company to cook up sales, which were booked as receivables but never paid for. Shares of HFTP, which sank more than 40% in price in May, surged more than sixfold in the 12 months prior to its suspension, despite questions from analysts and investors who were suspicious about its sales numbers. “We don’t always get it right, but we got that one right,” says Leigh, whose team did their due diligence and avoided investing in HTFP shares.

For every stock idea generated by the ILC quant model, Leigh and his team will find out why it is ranked highly in the life- cycle stage. They will also “double check” the data to ensure the qualitative process does not produce any “false positives” about the stock.

Earnings momentum, for instance, is a key driver when gauging the attractiveness of growth companies. A company will look like it has positive earnings momentum when the most bearish analyst stops covering its stock. “When that happens, it looks like the earnings consensus estimates have moved up. But when you dig deeper into analysts’ estimates, you will know it is not really an increase in company’s earnings; it is just a change in the analyst mix. There could be ‘funnies’ in data like that,” Leigh warns.

“We question every idea generated by the machine. How often do we kick out a name? Probably one out of four, or 25% of the time. If we find an issue with a top-rated stock, we will look at the next most attractive idea. There may be company-specific issues that we do not like.”

To be sure, Khanna says, he and his team have no shortage of stock ideas. “We could easily switch to the next high-ranking growthstage idea for instance.”

On the whole, all the 10 investment professionals managing the ILC funds cover and analyse about 30 stocks each. “I am the head of the group but I am also an analyst for 30 companies,” says Leigh.

Stock holdings
On average, the CS ILC funds hold from 50 to over 100 stocks in their portfolios, according to the head of HOLT Active Equity Group. The CS ILC US Core fund, for instance, has about 50 equity names in its holdings while the CS ILC Global Emerging Markets funds have about 100 stocks, Leigh reveals. “We basically need enough companies to fill the life-cycle stage buckets in all the countries. The more complex the strategy, the more names we will have in those buckets.”

The top holdings of the ILC Asia Pacific fund as at end-October were Samsung Electronics, Taiwan Semiconductor Manufacturing Co, Hon Hai Precision, China Construction Bank, National Australia Bank, Suncorp Group, Australia and New Zealand Banking Group, Macquarie Group, Dr Reddy’s Laboratories and BHP Billiton, according to data from Morningstar.

Chinese Internet company Tencent Holdings, which has an ILC score of above 80 owing to strong CFROI and improving earnings and price momentum, is one example of a growth-stage counter, while South Korean electronics giant Samsung Electronics (with an ILC score of more than 90) is considered a cash cow. Samsung’s high score is mainly a result of its attractive valuations, according to a CS report that explains the ILC investment process.

“Samsung in the 1980s was a growth-stage company. General Motors was a growthstage company in the 1950s, but today it is a restructuring company,” says Leigh, who declined to talk about the stock names in the portfolios of the ILC funds.

But his team considers Asian stocks such as China telecommunication giant China Mobile a fading winner, whereas Chinese oil company PetroChina is an example of a firm in the restructuring stage.

The ILC Asia Pacific fund is not invested in PetroChina shares but has Tencent Holdings and China Mobile in its portfolio, which also includes Singapore-listed stocks such as DBS Group Holdings, United Overseas Bank and SembCorp Industries and Jardine Strategic Holdings. As at end-October, the top five holdings of the CS ILC Europe fund were Roche Holding, Novartis AG, Old Mutual plc, BNP Paribas and Fresenius SE & Co. The top five names for the CS ILC US Core were Apple Inc, Valero Energy Corp, Facebook Inc, Intel Corp and Johnson & Johnson, according to data from Morningstar.

On average, a typical ILC fund will have 1% of its assets invested in the shares of start-up companies, 20% to 50% in cash cows, 15% to 25% in fading winners and 10% to 15% in restructuring firms.

The leading drivers of share performance at the moment, however, are not valuations but price and earnings momentum and quality, says Leigh.

“If you are a value manager right now, you’re probably getting killed. Our portion of strategy that relies on valuations is not performing as well right now. But the [beauty] of our process is that we are diversified across all life-cycle stages and we also have a section of our portfolios exposed to growth, momentum and quality. Those parts of our portfolios are doing better.”

Looking ahead, Leigh reveals that some of the ILC funds approaching three years in terms of track record will soon be marketed to institutional investors.

“At the moment, 100% of our investors are high-net-worth individuals and many are quite happy [with the performance of the funds],” he says.

This article appeared in the Personal Wealth of Issue 707 (Dec 14) of The Edge Singapore.