Q: What is the investment philosophy behind the Gavekal KL Allocation Fund? 

Our strategy is based on research that shows that highly innovative companies generate excess returns in the stock market and we aim to put these companies to work to generate superior risk-adjusted returns for investors. 

Our investment philosophy seeks to transform the Knowledge Effect into portfolio alpha. The Knowledge Effect is a market anomaly through which highly innovative companies tend to generate excess returns. It results from systematic errors in evaluating companies that invest large amounts of capital in producing knowledge. 

We capture the Knowledge Effect using a proprietary process designed to overcome the informational shortcomings of traditional financial statements. Our methodology capitalizes corporate knowledge investments, measures company fundamental data on a knowledge-adjusted basis, and selects investments on the basis of knowledge intensity.

Q: What are the reasons for the existence of the Knowledge Effect? 

The origins of the Knowledge Effect can be traced to two main factors. First, the surge in the pace of knowledge production was catalyzed by the release of the first commercially available semiconductor in 1971, Intel 4004. Due to the cumulative nature of knowledge, this acceleration resulted in an exponential increase in the total knowledge of humankind. 

The second factor which contributes to the Knowledge Effect was a mandate by the U.S. Financial Accounting Standards Board in 1974, which ruled that companies must expense knowledge investments in the period incurred. This measure deprived investors of relevant financial information on corporate knowledge spending at the dawn of a massive surge in the pace of knowledge production. 

The Knowledge Effect is grounded in academic literature. It was first discovered in a series of studies in the 1990s, when NYU’s Baruch Lev analyzed 20 years of financial data and discovered an association between a firm’s level of knowledge capital and its subsequent stock performance. 

Additional research advanced the findings, and in 2005 Lev proved the existence of a market inefficiency attributed to missing information about corporate knowledge investments. This phenomenon leads highly innovative companies to deliver persistent abnormal returns. 

Q: How do you differentiate between knowledge and information? 

There are three broad areas of intangible capital considered in the academic research - R&D, firm-specific resources, and codified information or databases. Through our proprietary process, we identify the different categories of knowledge investments and treat them in the same way accounting standards treat investments in tangible assets. 

For example, if a company invests in a fixed piece of capital, such as a piece of machinery, that piece of fixed capital becomes an asset on the balance sheet and is depreciated through time as it is consumed. The depreciation is recognized on the income statement as a non-cash charge. Under current accounting rules, intangible investments are treated as an immediate expense and are expensed through the income statement in the period it occurs. 

Our strategy treats intangible investments the same as tangible investments, putting the asset on the balance sheet and depreciating that asset over time, consistent with the academic literature regarding depreciation of intangible assets. In that way, we reveal an adjusted set of financial statements that provide an insight into a company’s true asset level. 

If we incorrectly measure the assets in traditional accounting, then we do not give ourselves the right tools to calculate the intrinsic value of companies. We seek to eliminate the accounting distortion to arrive at a better fundamental and valuation framework. 

Q: What is your investment process?

The first step in our process is creating our data. We adjust the financial statements for about 3,000 companies in developed and emerging markets taking into account their intangible investment. Through our proprietary model, we recalculate their financial data by treating intangible investments as investments rather than expenses, which helps us identify the most knowledge-rich companies in the world. 

The second step is screening for Knowledge Leaders based on the adjusted data. To pass our screen, the companies must show that they are knowledge intensive, have high quality balance sheets reflective of equity financing of innovative investments, and have strong profitability over an entire business cycle. This group of Knowledge Leaders are the constituent companies that compose our Knowledge Leaders Indexes. 

Our third step is to research the selected knowledge Leaders to identify the highest quality companies that are most attractively valued. The investment team conducts analysis of adjusted data to evaluate a company’s quality, potential earnings growth, and value. It assigns a quality score and a value score for each Knowledge Leader. 

The quality and value scores are designed to serve as a common denominator for later analysis and are factors that influence the general attractiveness of the investment. By assigning the scores, we can compare companies on an apple-to-apple basis, regardless of their geographic region, sector, or industry. The investment team also evaluates knowledge leaders on technical merits, to measure market-related factors. 

The fourth step is stock selection and portfolio construction. The experience of our chief investment officer, Steve Vannelli, is central for stock selection and portfolio management. He works with three regional portfolio managers, Eric Bush covering North America, Bryce Coward covering Asia, and Jennifer Thomson covering Europe. Together, the investment team selects each stock for inclusion in the portfolio based on its individual merits and regardless of its weight in the benchmark index. 

The last step in our investment process is risk control, including volatility control, and providing downside protection and capital preservation. 

Q: What are the key differentiators of your organization and how are they reflected in your processes? 

We believe our primary strength is our internally created data. Our core thesis is that highly innovative firms experience excess returns because investors are unaware of the true asset base that drives future profits. Archaic accounting rules obfuscate the true investments companies make, so we adjust financial statements to include intangible investments as a long-term asset. This unique adjusted set of financial statements for about 3,000 companies plays a role in every single step of our investment process. It is at the core of our strategy and differentiates us from other fund managers. 

We do not seek to make predictions about what will happen to companies with imperfect information about the future. Instead, we aim to eliminate a distortion that accounting rules create and gain better information about corporate investment activities. Our process does not seek to put a market value on intangible capital or to predict what a company’s financial statements are going to look like in two, three, five, or 10 years. 

In addition, we have spent many hours creating unique market internal data and our own initial investment universe, instead of paying a large index provider for its investment universe. In that way, we avoid the whims of a data provider and have control over the inclusion or exclusion of a stock based on simple and transparent rules.

Finally, the fund operates best within its functional capacity, which is the asset level consistent with the possibility to deliver alpha. No stock position accounts for more than one day of trading volume in that security, meaning that the fund has tremendous flexibility to initiate or sell positions even in relatively illiquid stocks. This flexibility has historically allowed the fund to pursue the ideas with the best alpha producing potential, regardless of liquidity. This is especially important in foreign markets, which are significantly less liquid than the U.S. market. 

Q: How do you look for opportunities? Would you describe your research process? 

The three regional portfolio managers are responsible for keeping a model portfolio of the best stock ideas in their regions. The model portfolio tends to comprise of 30 to 50 stocks in each region. Then, together with our CIO, Steve Vannelli, we sit down as a team to come up with the top 50 to 75 stocks that should be included in the Gavekal KL Allocation Fund. 

The fund employs an allocation strategy that moves between equities, fixed income, and cash, depending on market factors. We aim to construct a portfolio consisting of 50 to 75 of the world’s most attractively valued knowledge leaders. Despite the focus on equities, the allocation between stocks, fixed income, and cash is based on opportunities for diversification and risk management, relative valuation between asset classes, downside protection in distressed market environments, and income opportunities.  

Q: Could you give some examples of holdings that would illustrate your thought process?

When talking about Knowledge Leaders, people often think only about technology, and we do own several technology stocks. But there are many Knowledge Leaders from other industries, such as healthcare. In that industry, we own Henry Schein, for example, which considering it is a health care distributor, may be surprising.

While tech gets a lot of focus, actually our largest overweight relative to MSCI World Index in our Gavekal Knowledge Leaders Developed World Index is in the consumer discretionary space. We are very focused on consumer stocks: consumer discretionary stocks, consumer staple stocks, and health care stocks. 

In Japan, we like FamilyMart, which is a grocery store chain similar to a glorified 7-Eleven. It sells fresh produce, prepared food, drugstore supplies, etc. FamilyMart is in the consumer staple space, although people do not always associate grocery stores with high levels of intangible investment. 

However, we noticed that FamilyMart was investing a lot on employee training, development of logistics systems, and building just-in-time inventory management systems. The company has also been extremely successful at developing private label products, which tend to generate higher gross margins than a brand name product. The gross margins of FamilyMart are some of the highest in the world at about 71% which is about twice the gross margin generated by Whole Foods. All the intangible investments led to a high level of innovation in that company, which resulted in high gross margins, low debt levels, relatively high levels of profitability, and consistency. 

Q: What is your portfolio construction process?

To consider a stock for the actively managed mutual fund, it has to be a member of our suite of Gavekal Knowledge Leaders Indexes. The indexes are publicly available and include a Developed Market Index, an Emerging Markets Index, a U.S. index, and an International (Developed World ex-US Index). They represent variations of the global Knowledge Leaders universe of about 900 companies. A company has to be included in that universe before we consider it for the global portfolio. 

The portfolio is constructed on a roughly equal-weighted basis. The average weight of equity positions is about 1-2% of the overall equity sleeve of the portfolio. We tend to buy stocks in two different steps, meaning that we would initiate a position and then add to it as the stock validates our investment theses. We tend to hold a stock as long as it continues to perform acceptably. When its performance deteriorates, we will exit that position to help mitigate downside risk.

We have a strict liquidity filter, which limits the position size to 100% of the daily average trading volume of the stock. So, when we want to enter or exit a stock, we can do it easily within a day without affecting the price. For many of our larger competitors it might take weeks or months to unwind a position. 

In terms of diversification, we have the flexibility to invest in any geographic region in the world and are not constrained by predetermined geographic or sector weightings. The equal-weight position size means that no single security will dominate the performance of the fund. Finally, we have the ability to diversify out of stocks and move into U.S. dollar cash or government bonds. 

The decision to allocate to cash or bonds is influenced by the quality of new investment ideas we see, as well as by macro risk indicators that look at relationships among stocks and bonds, the correlation between stocks, and the general level of volatility priced into the market. 

The fund is benchmarked against the MSCI All Country World Index. We have a secondary benchmark, which is a blend of 60% MSCI All Country World Index and 40% Barclays U.S. Treasury Bond Index. Our turnover is about average for the category. 

Q: How do you define and manage risk?

The fund has a dual mandate of capital appreciation and capital preservation. The focus on capital preservation is in our risk management mandate. We feel that investors pay for active management to mitigate the downside risk. Therefore, our focus is to minimize our drawdowns during terms of market volatility or market turmoil. 

During the three largest drawdowns in the life of the fund, the fund has managed to fall less than half that of the benchmark index in each case. Drawdown mitigation is always a focus of the fund and can be attributed in equal parts to stock selection and asset allocation. 

Q: What lessons were learnt from the financial crisis, in your opinion?

The financial crisis understandably shook the confidence of investors everywhere and has rightfully focused investors’ attention on risk. For us, it reinforced our investment philosophy that mitigating drawdowns is equally, if not more, important than generating high returns, especially in the low return world we live in today. 

In addition, the Knowledge Effect proved its merits during the crisis as these stocks fell less than the overall benchmark and have since outperformed on the way back up. It proved that the market anomaly exists in both down and up markets.