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Taking Stock Winter 2019

Investing in the age of data

14 August 2019
Authors: Hannes van den BergCo-Head of SA Equity & Multi-Asset, 4Factor, Terry SeawardPortfolio Manager, 4Factor

According to IBM, we create 2.5 quintillion bytes of data every day, with 90% of the world’s data having been produced in the last two years alone.1 While individuals may at times suffer from information overload, businesses across the spectrum, from social media and entertainment to banking and investments, have recognised the benefits of harnessing big data.

The use of machine learning to supplement human intelligence demands innovation across industries. A systems view is imperative for leaders who want to lead their respective organisations into the future.

Advances in technology and big data have resulted in data screening tools (quantitative analysis) gaining a strong foothold in the investment management industry. When it comes to finding good companies in which to invest, information and timing are key. This requires the ability to speedily process huge volumes of information from multiple sources.

While quantitative analysis focuses exclusively on the numbers behind data sets, fundamental analysis also incorporates judgement (qualitative analysis) such as company forecasts, industry dynamics and the quality of strategy and management. In this article, we take a closer look at these two approaches and how we combine them in the Investec Equity Fund to optimise idea generation and the risk-return profile of the fund.

Investec Equity: fundamental research is key to what we do

In our search to find good companies in which to invest, our investment team analyses financial statements; the overall health of companies; the management and strategy of the businesses; and industry and economic conditions that impact operations. Fundamental analysis typically entails determining a company’s earnings potential as well as assessing if these fundamentals are reasonably valued. Essentially, fundamental analysts do a ‘deep dive’. Besides critically assessing financial statements, our team visits companies, engages with management, board members, competitors and industry experts, and researches firms’ products and services to identify good investments. A qualitative approach should also include behavioural analysis, which considers investor sentiment to determine share price direction.

As active owners we focus on sustainability of earnings, which includes environmental, social and governance (ESG) principles, which we integrate into our fundamental analysis. Since businesses can circumvent rules, good governance requires strong leadership and sound judgment. Better governance can foster trust in leadership and provide greater confidence in forecasting company earnings. In turn, good corporate governance should lead to better corporate performance and shareholder value over the long term.

Combining fundamental analysis with a quantitative investment approach

A quantitative approach uses mathematical and statistical modelling that collects immense volumes of data at lightning speed to help identify good investment ideas and assess portfolio risks. To put it in perspective, more than 16 million discrete pieces of information feed into constructing a portfolio from a 4000-stock universe. Quant analysts are often described as data analysts working in finance, as they need to be highly skilled in maths, statistics, computer science and finance.

Our Investec Equity quant team’s focus is on mining company-relevant data far and wide, as opposed to considering intangibles such as brand value and intellectual property rights. Such qualitative factors are typically the domain of our fundamental analysts. Quant analysts adopt a disciplined, evidence-based approach to investing and they are not influenced by human emotion or behavioural biases. They rely purely on numbers and data to identify good investment ideas that help to reduce and manage risk.

Figure 1: Harnessing human insight and technology

When it comes to big data and machine learning, public debate tends to pit humans against machines, reinforcing the stereotype of an ‘us versus them’ scenario, rather than entertaining a ‘marriage of two minds’. Even within the asset management industry, it is common to find that active equity managers only employ quantitative analysis as an initial screening tool to identify good investment ideas based on a specific set of criteria. So, quants is often used as a filter to narrow a large investment universe, after which fundamental analysts do a deep dive on these stock ideas.

However, in our view, each approach (quantitative and fundamental analysis) has key strengths and weaknesses. To put it into perspective: quants is ‘a mile wide, but an inch deep’, while fundamental research is a ‘mile deep, but an inch wide’.

Table 1: Both approaches have strengths and weaknesses

  Strengths Weaknesses

Quantitative research

Discipline, repeatability, objectivity and efficiency Slow to adapt to changing trends
Breadth: the ability to analyse a vast amount of data in a short period of time Based on historical information
Good at portfolio construction and risk management: the ability to optimise correlations and co-variances of all possible combinations of holdings

Fundamental research

Judgement, insight and experience Emotional bias
Depth: the ability to assess many different aspects of a company in detail and to consider multiple angles using the same data Inconsistent
Ability to communicate, debate portfolio positioning and express a view Slow – a finite amount of time to analyse available data
Flexibility and the ability to adapt to new situations/breaking news

 

Idea generation – finding the right balance

Over the last eight years we have refined our investment process, blending fundamental insight with quantitative analysis to produce more consistent investment returns for our investors. We employ a two-fold process to generate ideas:

  1. Qualitative: bottom-up fundamental research from our experienced team of analysts, where the best investment ideas are identified based on fundamental company research. For instance, our analysts will examine the market’s earnings forecasts for a company. The aim is to determine whether a company is likely to have higher (or lower) earnings than other market participants expect. When profit forecasts are revised upwards or downwards, we believe it can have a material impact on a company’s share price.
  2. Quantitative: a stock screen process which identifies the best investment ideas, based on very specific data-driven, fundamental criteria. This screening includes finding companies, based on fundamental investment data, with favourable dynamics (earnings/profit expectations) and reasonable valuations.

Figure 2: Idea generation in the Investec Equity Fund

Idea generation in the Investec Equity Fund

It is important to note that our quantitative stock screen research and fundamental analysis run parallel to each other, so the one process isn’t relegated to a supporting act: both have a star billing. The investment ideas that are identified by both our quantitative and fundamental analysts typically represent our high conviction stock picks in the Investec Equity Fund. For example, Anglo American and BHP Billiton came up as top picks based on our quantitative and fundamental research. These stocks currently both represent a material holding in the Investec Equity Fund.

A difference of opinion can be healthy

As these two research processes run independently, one may identify a stock as a good or bad investment idea, which might not be supported by the other. For example, Naspers scores poorly on our quant-based metrics (valuation). But a more detailed fundamental analysis reveals that Naspers represents reasonable value, when valuing each business within the internet and media giant separately. Both processes may fuel debate, highlighting the need for further analysis of an investment idea.

This integrated approach reduces the risk of ‘over-confidence’, which can be a pitfall where idea-generation favours only one of these two research processes. Essentially, we capitalise on the best attributes of both. Quantitative screening offers discipline, repeatability, objectivity and efficiency, while bottom-up fundamental research provides depth, human insight and judgement.

Portfolio construction – more than implementing your best investment ideas

Investments may result in financial losses, which is why it’s so important to manage the tension between investment conviction and risk. Portfolio construction and risk management are complex processes for humans. Constructing a simple 30-stock portfolio requires managing hundreds of pieces of expected return, risk and related information, easy for a machine but difficult for a human. Some asset managers will try and manage risk by limiting the weighting of an individual stock or by imposing sector-specific exposures. We believe these measures are a blunt way of managing risk as they constrain potential outperformance and do not consider the multiple correlations between stocks and sectors.2

Having quant expertise within our Investec Equity investment team has enabled us to develop an extensive risk and portfolio management process over years to address these challenges. Proprietary quant tools allow us to combine key risk and return metrics to optimise our portfolio and maximise diversification. Our internally developed system provides crucial information to us on a pre-trade basis. As an example: before we implement a trade to reduce the allocation to one stock in favour of another, the system tells us how it will impact the overall portfolio risk.

While our proprietary models have greatly enhanced the risk management and portfolio construction process, human insight and common sense remain crucial. Fundamental analysts are best placed to interpret breaking company news, market dynamics, regulatory or tax changes, and ESG issues. For instance, fundamental analysis allowed us to assess the risks to Sasol’s earnings when carbon taxes were introduced this year. Given deteriorating fundamentals, we reduced our position in Sasol. When governance issues hit Glencore last year, we took the decision to exit our position.

Figure 3: Investec Equity Fund

Purpose
Deliver consistent returns

Philosophy
Upward earnings revisions at reasonable value

Process
Humans harnessing technology

In conclusion

In our view, fundamental analysis and quantitative analysis have strengths and weaknesses. We believe both these approaches have an important role to play in finding good stock ideas, as well as constructing a portfolio and managing risk. Over the last eight years we have refined our investment process, blending quantitative analysis with fundamental insight to produce more consistent investment returns for our investors.

 

1 IBM, 10 Key Marketing Trends for 2017.
2 Correlation measures how assets and markets move in relation to each other, and can be used to manage risk – Investopedia.

Hannes van den Berg
Hannes van den Berg Co-Head of SA Equity & Multi-Asset, 4Factor
Terry Seaward
Terry Seaward Portfolio Manager, 4Factor

Important information

All information provided is product related and is not intended to address the circumstances of any particular individual or entity. We are not acting and do not purport to act in any way as an advisor or in a fiduciary capacity. No one should act upon such information without appropriate professional advice after a thorough examination of a particular situation. This is not a recommendation to buy, sell or hold any particular security. Collective investment scheme funds are generally medium to long term investments and the manager, Investec Fund Managers SA (RF) (Pty) Ltd, gives no guarantee with respect to the capital or the return of the fund. Past performance is not necessarily a guide to future performance. The value of participatory interests (units) may go down as well as up. Funds are traded at ruling prices and can engage in borrowing and scrip lending. The fund may borrow up to 10% of its market value to bridge insufficient liquidity. A schedule of charges, fees and advisor fees is available on request from the manager which is registered under the Collective Investment Schemes Control Act. Additional advisor fees may be paid and if so, are subject to the relevant FAIS disclosure requirements. Performance shown is that of the fund and individual investor performance may differ as a result of initial fees, actual investment date, date of any subsequent reinvestment and any dividend withholding tax. There are different fee classes of units on the fund and the information presented is for the most expensive class. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. Where the fund invests in the units of foreign collective investment schemes, these may levy additional charges which are included in the relevant Total Expense Ratio (TER). A higher TER does not necessarily imply a poor return, nor does a low TER imply a good return. The ratio does not include transaction costs. The TER of the Investec Equity Fund (A) class is 1.15%. The current TER cannot be regarded as an indication of the future TERs. Additional information on the funds may be obtained, free of charge, at www.investecassetmanagement.com. The Manager, PO Box 1655, Cape Town, 8000, Tel: 0860 500 100. The scheme trustee is FirstRand Bank Limited, PO Box 7713, Johannesburg, 2000, Tel: (011) 282 1808. Investec Asset Management (Pty) Ltd (“Investec”) is an authorised financial services provider and a member of the Association for Savings and Investment SA (ASISA).
This document is the copyright of Investec and its contents may not be re-used without Investec’s prior permission. Investec Asset Management (Pty) Ltd is an authorised financial services provider. Issued, August 2019.

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