Q: What is the history of the fund?
The MainStay Epoch Global Choice Fund is an open-end mutual fund that was launched on July 25, 2005 with Epoch Investment Partners as its subadvisor.
With an investment philosophy rooted in a free-cash-flow approach, Epoch offers traditional, diversified, and geographic-focused strategies to both institutional and retail clients. Our global, concentrated portfolio consists of 20 to 35 high-conviction securities chosen from the broader research efforts of Epoch.
Many global funds are significantly more diversified with far more holdings. In contrast, in addition to being highly concentrated, our portfolio’s holdings include companies that don’t necessarily fit more conventional descriptions of growth or value.
Currently, the Global Choice strategy has $4.7 billion of assets under management with the open-end mutual fund being a small piece of that. I became a portfolio manager in 2014.
Q: What core beliefs drive your investment philosophy?
We firmly believe that our free-cash-flow approach, which is rooted in the fundamental principles of finance, does a better job of representing the true economic health of a business. As free-cash-flow investors, it is our belief that a company’s ability to generate free cash flow is what makes it worth something to begin with. How management allocates free cash flow is equally important, as this determines whether the business’s value will rise or fall.
We look for management teams that allocate free cash flow in one of two broad ways: by reinvesting it on behalf of their investors or by returning to investors who can then decide for themselves where to reinvest.
In the first case, management may reinvest free cash flow either internally in new production facilities or research and development, or externally through mergers and acquisitions. We are happy when they reinvest in projects that will earn a return that exceeds their cost of capital, because that is the fastest way to grow shareholder value. However, we also appreciate management teams with the discipline to give back to investors through a dividend, share repurchase, or by paying down debt.
Q: How do you transform this philosophy into your investment process?
We rely on our fundamental investment team as the primary source of ideas that are consistent with our free-cash-flow philosophy. Our analysts average over 22 years of experience and are largely organized on geographical and/or sector lines. Epoch’s investment culture is collaborative, allowing us to share and leverage insights across the firm, portfolios, and strategies.
Beginning with these well-researched, bottom-up ideas, we then marry in our top-down thinking to identify where the best risk-reward opportunities are globally. But, because we realize that sometimes we miss opportunities, a secondary source of idea generation is also used.
The Epoch Core Model, a quantitative tool, ranks securities by focusing on free cash flow, earnings quality, and metrics analyzing balance sheet strength. It’s an efficient and effective way to review an investable universe of over 10,000 securities.
Q: In what other ways do you narrow your investment universe?
To make it more manageable, we begin with a technical exclusion by liquidity and market cap. Although Epoch does have small-cap strategies, some of those stocks wouldn’t be appropriate for us; they’re too small for our concentrated global portfolio.
Primarily, though, our focus is winnowed down to the key stocks followed by each analyst. Epoch actually requires that they flag their three best ideas at all times in our research management system. This way, I and the other portfolio managers can follow up on a specific name with an individual analyst.
Finally, because price targets are also required of analysts, we can use them to narrow the list further. Every security in the portfolio is analyzed in terms of its upside/downside ratio to assess the relative attractiveness of the various opportunities available to us.
Q: What steps are involved in your research process?
Regardless of how an idea is sourced, our process involves a bottom-up, deep-dive research analysis which focuses on understanding three main areas of a business: its free-cash-flow profile, capital allocation, and valuation.
We begin by developing a company’s free-cash-flow profile; we need to understand whether it can sustain and hopefully grow free cash flow over time. This involves a thorough examination of the business and industry, and addresses competitive advantage, industry structure, and corporate strategy.
Next comes capital allocation. We look at management’s track record, their key performance indicators and incentives, and whether there is significant insider ownership or alignment from a shareholder perspective.
In addition to understanding management’s framework for allocating free cash flow and whether they will be good stewards of it, we try to get a sense of whether they really care about creating shareholder value, and also consider trust and integrity factors.
The final step is valuation, during which we estimate the intrinsic value of a business based on our expectations for future free-cash-flow generation and look for a disconnect between our estimate and the security’s current market price. With at least a three-year time horizon, we tie intrinsic value to some measure of free cash flow: it could be free-cash-flow yield or its inverse, the price-to-free-cash-flow multiple; in some industries, a full-blown discounted cash flow analysis will be done.
Even though we are more fundamental bottom-up investors, our research process is layered with top-down context. An investment policy group meets quarterly to discuss significant risks and opportunities around the world which ultimately may influence portfolio construction.
These might include issues like central banking policies, global elections, China, the geopolitical risk related to North Korea, or what’s happening in commodity markets.
Q: Can you describe your research process with several examples?
Safran SA, a French-based aerospace and defense company, illustrates our research process well. Right now, the growth prospects for both the commercial aerospace industry and Safran are strong, and the company’s business model and free-cash-flow profile are attractive.
Its key business is producing engines for commercial aircraft, which is extremely technical and has high barriers to entry. There’s also significant demand for engines in both developed and emerging markets. In Western Europe and the United States, airlines have incentives to upgrade to newer aircraft because older fleets are less fuel efficient and maintaining them is costlier.
In the emerging markets, a true growth story has developed: more people are entering the middle class, and because travel and tourism is a top priority, additional planes will be necessary.
Finally, Safran has what we call a “razor blade” business model: once it sells an engine to an airline, they come back for regular maintenance, repair, and replacement of parts. This aftermarket stream can be worth five times the initial engine sale.
Our long-term outlook on Safran is strong – we see double-digit annual growth in its free cash flow – because its business is predictable and visible. Not only do we know how many engines it delivers every year, Safran has an order backlog of five years, if not longer.
And the company is ramping up production. As a result, costs will come down and margins improve, which benefits free cash flow and free-cash-flow growth. Moreover, Safran is in the midst of introducing its next-generation engine, so its capital expenditure and R&D have been a bit higher and have burdened its free cash flow somewhat. As this engine reaches its full run rate, we expect that it will boost free cash flow further.
We think Safran has been allocating capital wisely by primarily reinvesting in this engine launch. The company also recently announced it will acquire Zodiac Aerospace SA, a fellow French aeronautical supplier. Though Zodiac has a leading position in cabin interiors and seats, it has run into severe problems with production and margins. We are confident Safran will successfully fix these issues, and that this acquisition will provide a secondary source of upside.
Another company we find attractive is Universal Display Corporation, which develops and supplies material for the manufacture of organic light emitting diodes (OLEDs) displays. OLEDs are the next generation of display technology for smart phones, tablets, monitors, and TVs; for instance, the iPhone X will shift from LCD to an OLED display.
Today, 90% of display panels in the world are LCD and fewer than 10% are OLED. Although OLED technology is in the early stages of market adoption, we believe it will become the standard because it offers better performance, contrast, and color while consuming less power. This will eliminate a critical frustration among smart phone users who see every functional improvement offset by greater battery drains.
The most exciting differentiator of OLED, however, is that it can bend. In the next five years, we’ll see foldable OLED smart phones and a multitude of other products that would be impossible today.
Universal Display is an intellectual property company which monetizes OLED technology through license fees, royalties, and material sales. No other company can make an OLED panel without violating or infringing upon Universal Display’s intellectual property. Essentially, it’s a monopoly in a rapidly growing industry, and it garners an extremely high return on invested capital.
This year, we estimate about a 2% free-cash-flow yield for the stock, which doesn’t seem cheap. However, taking a longer perspective on valuation, we see Universal Display as a growth story and have a high degree of confidence in the trajectory of its free cash flow. In the next few years, our expectation is that the company’s free cash flow will more than double and valuation will become more reasonable.
Q: What is your portfolio construction process?
This fund is unconstrained and benchmarked against the MSCI World Index but the benchmark doesn’t dictate our investments. We seek the best risk-reward opportunities around the world and can deviate significantly both in sector weights and country weights, with positioning typically ranging from zero to two times that of the index.
The fund has a minimum of 20 names and a maximum of 35. Because our holdings tend to range from 30 to 35, the average position size is around 3% and the largest are about 6%. Technically positions can be 10%, but generally we don’t go there. We are mandated to have 40% in non-U.S. securities under normal market conditions.
Two overarching principles guide portfolio construction. First, we avoid unintended risks. Our alpha should come from risk we anticipate and expect to be compensated for rather than from places where we don’t have a strong view.
Second, we want to create an efficient portfolio from a risk-return perspective which takes into account volatility and correlation. In the simplest terms, if two positions have the same expected return with all else being equal, the portfolio will have a higher weight in the less volatile of the two securities. Despite the fund’s concentration, our volatility isn’t far off the benchmark’s. This is quite a feat considering it has 900 to 1,000 stocks while we have no more than 35.
Q: How do you define and manage risk?
To us, the most basic definition of risk is permanent loss of capital. However, because our focus on free cash flow tends to lead us to higher-quality companies with balance sheets that are appropriately capitalized, it’s hard to envision them going bankrupt and destroying our capital.
Epoch also has an integrated risk-management approach which protects the downside. On each of our strategies, a co-portfolio manager who comes from the risk-management team helps to ensure we’re informed of the risks in the portfolio.
In a concentrated portfolio some risks can be obvious. To look at the total risk in the portfolio, it’s important we understand not only our exposures to sectors and countries, but also what the biggest contributors to risk are from an individual security perspective.
We use Barra analysis to provide insight into the portfolio’s sensitivities and how it’s tilted with respect to certain factors. Again, if we don’t have a view on an item, we wouldn’t make a big bet on it and will minimize or neutralize such exposures in the portfolio.
