Bruno Paulson, Managing Director within the International Equity Team at Morgan Stanley Investment Management, presents the group’s Global Brands Equity Income (GBEI) Fund.
A natural extension of the Morgan Stanley Funds (UK) Global Brands Fund, the GBEI portfolio is designed to offer access to the same high-quality stock selection with an enhanced income profile for clients seeking additional yield.
The Fund aims to generate this income via a combination of dividends from first-rate stocks and the premiums from selling index call options.
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Bruno Paulson discusses the Morgan Stanley Global Brands Equity Income Fund, its high quality bias, and where global equities are heading in 2018
Source: MSCI, Morgan Stanley Investment Management. (1) Data as of December 31, 2017.
Global equities got off to a mixed start in 2018, with a period of short-term volatility in February. The Dow Jones Industrial Average Index fell 4.6% or 1,175 points in one day, its worst drop in six years due to US interest rate rise fears.
“But if you’re looking to invest in high quality compounders, these companies are very rare and so you have to be able to look for them globally and seek out those that offer diversified revenues. When you’re looking at technology, the US is the obvious destination for most investments but Europe is actually a much better hunting ground for consumer staples. In a world where there is little absolute margin for safety given high valuations, and risk still seems to be ‘on’ despite February’s brief correction, owning high quality companies seems a sensible place for capital.
“To us, high-quality companies that should still be better able to grow sales and profits in a downturn look the best relative bet, even if they may seem unexciting in absolute terms.”
It’s not all negative though – Paulson feels positive about the subset of high quality equities his team focuses on, which they believe aren’t particularly expensive given their attractive returns on operating capital employed and gross margin characteristics.
He underscores the merits of investing on a global basis as opposed to a single geography. “If you’re concentrated in a single geography in a world of rising political risk, you’re taking the political risk of that geography of which Brexit is just one example.
And the wind-down of quantitative easing globally? This could also affect global equity valuations, according to Paulson. “Central banks have flooded the world with cheap money for a decade now and it’s going to be tough to wean asset markets off this drug; and there is plenty of room for policy mistakes.
“The other worry is that the free money has also driven a period of extremely low volatility, which is now seen as the norm. It’s been around for long enough that it’s in everyone’s risk models. And the return to more sensible levels of volatility could cause some unpleasant surprises for markets as various risk models will no longer work.”
“It is easy to appear unduly negative, but we prefer to think we’re investing with our eyes wide open. Global equity investment opportunities exist, but while identifying them one must also be aware of the risks, primarily valuation risk. It is possible to justify the current levels of markets, particularly when you compare them to very low bond yields. But there isn’t much margin of safety if something does go wrong.”
Paulson believes there are three particular risks: “Growth is good globally at present, but is in the price. Any disappointment could cause a significant let down. Secondly, we have the risk from monetary tightening following the fire hose of free money since 2008. And third is the geo-political risk which is always with us, whether we’re aware of it or not.
“Furthermore, we believe the rise of populism is an ongoing threat to equity markets,” Paulson continues. “Up to now, it’s mainly been right-wing populism we’ve had to deal with and protectionism threatening the world’s trading system. So far, this hasn’t actually tipped markets.“
But it’s also done nothing to reduce inequality or boost the median incomes. The concern is that the next wave could be left-wing populism with redistribution and attacks on corporates. Now, leaving aside whether this is good or bad for economies, it is unlikely to help corporate profits or asset prices.”
In retrospect, fears about global stock market valuations seem justified. “The bull market is now nearly a decade old and obviously 2017 was a very strong year for markets,” says Bruno Paulson, a Managing Director at Morgan Stanley Investment Management.
Paulson is a senior portfolio manager for the group’s Morgan Stanley Funds (UK) Global Brands Equity Income Fund which invests in high quality companies globally and currently targets a 4% yield.
“We are the first to admit to feeling distinctly nervous about markets,” Paulson states. “While the bulls may point to synchronised global growth and the potential of the Internet of Things and Artificial Intelligence to kick off a long cycle of investment, we remain distinctly cautious. It is true that there are signs of global economic improvement but an awful lot seems to be priced in.”
Eyes wide open
Where are global equities heading in 2018?
Managing Director, International
Equity Team, Morgan Stanley IM
The premiums received from the sale of index call options enhance the yield. This dynamic yet conservative options strategy is designed to help meet the yield target with confidence. For information purposes only, not to be construed as a recommendation to invest in or trade any securities or asset classes mentioned herein. *2% post withholding tax.
Morgan Stanley Global Brands Equity Income Fund
Source: Morgan Stanley. Data as of December 30, 2017 and subject to change daily.
2. May not sum to 100% due to rounding.
3. For additional information regarding sector classification/definitions please visit https://www.msci.com/gics.
Sector allocation (% total net assets)
Optimised Yield Enhancement
The MS Funds (UK) GBEI Fund generates income from a combination of dividends from high-quality stocks and the premiums from selling index call options, aiming to deliver a current yield of 4% per annum. Selling index call options rather than options on underlying stocks allows the group to retain the individual stock level exposure, in line with the portfolio of the proven Global Brands Fund. Morgan Stanley’s simulation of this approach demonstrates that the Fund achieves similar return and risk characteristics to the original Global Brands Fund over time, but offers an enhanced yield.
Peer group average
Artemis High Income
Source: FE, Artemis Investment Management. Since launch data from 9 September 2002 to 7 March 2008 reflects class R quarterly distribution units, and from 7 March 2008 to 30 June 2017 reflects class I quarterly distribution units, bid to bid in sterling. All figures show total returns with interest reinvested. Sector is IA £ Strategic Bond NR. *Negative/positive periods refer to monthly outperformance over five years as at 26 May 2017.
IA £ Strategic Bond
Artemis High Income
Our starting point is to invest in the highest quality companies, so there are certain sectors we just don’t go near. We don’t own any financials, utilities, telecommunications or energy companies. This is not a comment on the state of the economic cycle or the valuation of those sectors, we just don’t own those sectors because they are low return-on-capital sectors.
So with this very high quality approach in mind, we pivot towards consumer staples, services and software, and some elements of consumer discretionary such as US media.
It’s not about any particular theme as such, but the fundamentals of the individual company and whether it meets our very demanding framework.
Regionally, therefore, we’re just looking for the best companies in the world. For technology, that will tend to be in the US; for consumer staples it’s Europe. But given that these companies are usually geographically-diversified global companies, where they’re actually listed is secondary to where their economic exposure is.
What is your level of exposure to certain investment themes and regions – and why?
Which sectors do you believe provide the most reliable source of income?
We think on a long-term basis so the best opportunities over the next three or six months are extremely unclear. In terms of reliable income, we think it is these high quality companies with strong franchises, with recurring revenues and pricing power, which have proven, over time, to be able to preserve and grow earnings, even in tough times.
As such earnings for our Global Brands portfolio actually went up during the financial crisis. And the companies we’ve chosen are the ones that are, we believe, best placed to carry on doing that. And, as we’ve said, we have tended to find these companies in Consumer Staples, the Software and IT services elements of Information Technology and, to an extent, the Consumer Discretionary sectors. This distinguishes us from most income managers. Most income managers are invested in traditionally high yielding sectors such as telecoms or, increasingly, financials and energy.
Therefore our Global Brands Equity Income Fund is potentially a good balancing element to include within an income portfolio of funds, given our more defensive, high-quality focus.
What key risk parameters do you identify and how are you mitigating them?
There is lots of information in the market about the science of risk for the end investor, but if you ask them what risk is about for them: it’s about losing money. So our whole process is designed to minimise, within a fully-invested equity portfolio, the risk of losing money.
Hence we look for companies with high recurring revenue, because when there is an economic downturn, these companies aren’t affected as much. Everyone keeps buying the same shampoo, for example, regardless of the macro environment. These are also companies with pricing power, which means that whatever happens to inflation, they can pass it on to the consumer. Unlike oil, say, where the price goes from $125 to $25 a barrel and the company has no control.
We also want to be sure we are selecting companies whose management are looking out for and mitigating risks. What we dislike is the permanent destruction of the capital, so engaging with management is central to our selection process.
What is the Morgan Stanley Global Brands Equity Income Fund designed to do?
Very simply, to provide reliable income and steady capital growth. The Global Brands Equity Income Fund is designed to generate a decent level of income while also delivering long-term performance, and in particular a measure of downside protection. At the moment we target a 4% yield, around 2% of which comes from the dividends of the high quality companies we invest in while the other 2% comes from selling calls on leading equity indices.
The Fund looks to invest in extremely high quality compounders with stable top-line sales, pricing power and high returns on operating capital. The idea is that these companies should compound their earnings steadily over time, including in downturns, and the dividends should grow steadily over time as well.
We believe this is one of the highest quality sources of income around and if you look at the Global Brands Fund’s track record no company it has owned has had a dividend cut in the last decade, including during the financial crisis. We generate further income by selling short-dated calls on the world’s main equity indices. We’re selling calls rather than puts, which means we potentially give away some of the upside when the markets go up strongly, but if the market falls, we get the premium on the calls and don’t have to pay anything away.
We look for incredibly high quality companies. We start with a simple quantitative screen, looking at return on operating capital. We like high returns on capital, large gross margins and companies paying some dividend. That’s the simple screening which takes us down from a universe of about 2,000 companies to 200.
Then we do the detailed work on why these companies are profitable. We ask: What are the intangible assets that drive these companies? Will those assets stay strong over time? In particular, we look very hard at the companies’ risk and by this we mean the risk of losing money, be it through ESG factors or other risks.
And then the final element is the management. The management are crucial. Even if you’ve got the best of franchises, the company will not compound if it’s poorly managed.
What is your investment process?
"We’re just looking for the best companies in the world. For technology, that will tend to be in the US; for consumer staples
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Top row (l-r): Vladimir A. Demine, Executive Director; Nathan Wong, Executive Director; Alex Gabriele, Executive Director; Nic Sochovsky, Executive Director; Marcus Watson, Executive Director; Richard Perrot, Vice President
Bottom row: (l-r) Bruno Paulson, Managing Director; William Lock, Head of International Equity Team; Dirk Hoffmann-Becking, Executive Director
Prepared strictly for Professional Clients. The opinions expressed are those of the authors as of the time of publication and are subject to change as per economic and market conditions. We do not take responsibility for updating the information/views contained here or otherwise advise of changes in our opinion or in the research or information. This does not constitute investment advice, is not predictive of future performance, and should not be construed as an offer to buy or sell any security/instrument or to participate in any trading strategy. [The value of and income from your investments may vary because of changes in interest rates, foreign exchange rates, default rates, securities/instruments prices, market indices, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Investors are advised to independently evaluate particular investments and strategies, and are encouraged to seek the advice of a financial adviser before investing. Charts and graphs are for illustrative purposes only].