Q: What is the mission of the International Alpha Fund? 

The fund was launched in 2005, a year after we had created the platform to manage our global and international fundamental assets that we have today.

At Schroders we created a platform of global sector specialists who seek to leverage what we think are world class local research resources and to pick the very best ideas from the fundamental equity research and combine them in an international equities high conviction portfolio. 

We've been running this strategy for over ten years and the fund has been coming up to its ten-year anniversary. Today's market has become more and more short term and more news and information obsessed. What really separates us is that we believe that we can deliver sustainable and consistent outperformance by keeping a focus on fundamentals and most importantly on the long term sustainable growth of companies. 

That means you need patience, you need conviction in the work that you do in companies and you need to be prepared to stand against the crowd and to invest in companies where you really have conviction that their long term earnings growth will be sustainable and ahead of what the market is expecting. To do that we consider a number of important long term structural growth trends and themes and how they impact companies. 

It is a bottom-up fund and we are looking to only invest in those companies that we think can really create value over the long run and we seek to buy those positions at times when the market is looking the other way, or where it's getting things wrong or is overly concerned with the negatives. 

Q: What international markets do you look for opportunities in? 

The mandate of the fund is to invest in international equities and we define that as everything excluding the U.S. The fund includes Canada, South America and Europe, Asia and the Far East. 

The fund does include emerging markets, although we are selective and opportunistic in emerging markets. We think there are some great companies but also fragile economies and poor quality companies too.

We are very selective in how we invest in those markets and we have a high quality threshold for the types of companies we invest in there. 

Q: Do you have any minimum market cap requirement? 

Yes, we have a minimum size of $2 billion in market value so that allows us to go relatively small, but these are all well established companies with an operating history and we believe good future growth prospects. 

The fund is not a small cap or micro-cap fund, but anything from $2 billion and larger is in the investible universe for us. Of the 5,000 companies in our universe, nearly 2,500 companies match our market cap and liquidity criteria. 

We do look at minimum daily volume and broadly $10 million is a level below which we become uncomfortable. Daily volumes can always change; they can increase or decrease and we monitor that in conjunction with the size of the company and the development of it, and whether we expect liquidity to increase. 

The portfolio as a whole is highly liquid and the entire portfolio could be liquidated, 90 percent of it within one day and 100 percent of it within a couple of trading days.

Q: What are your core beliefs? 

Our core beliefs are firstly that the market is inefficient. The market is inefficient in many ways: it underestimates the sustainability of returns at good companies, it often overreacts to bad news and it can also over-extrapolate current trends into the future. 

We can take advantage of those inefficiencies. We seek to do our own work and our own modeling when looking at the future growth of companies. History can inform us but it's not always a guide to the future. We believe that if we can identify situations where the future growth of companies is not fully understood by the market by consensus then those are situations where the stock will outperform when the market revises up its view of the earnings potential and the profitability of that company in the future. 

We call that the growth gap, which in simple terms is our earnings numbers being different from consensus, being higher than consensus and we want to have a positive earnings growth gap for every stock that's in the portfolio. When we lose that growth gap when either the market catches up to us or when our estimate of future earnings goes below what the market is expecting that is when we will sell out because we don't want to be invested in those kinds of situations.

Q: How do you structure your investment process, where does it start, and what steps do you take to evaluate the merits of every investment you look at? 

When you're investing in international there's a very large opportunity set and one of the first tasks is to narrow that down efficiently. 

We have a network of over 70 equity analysts, who are on the ground, modeling companies, meeting with the management teams, producing research and grading them. We are based in 13 investment offices around the world. Then we have ten investors all based here in London on the global and international equity team. The ten investors in London are working with those 70 analysts around the world and taking their buy recommendations as the first filter. 

These investment teams filter down the investible universe to the stocks that our local research favors. Then our team is taking those ideas and providing a global perspective, applying our philosophy: that growth gap that we want to have in every investment and filtering down to a set of best ideas for the portfolio that have the support of our local research and our global sector analysts. 

We have seven global sector specialists; they're all experienced industry analysts and their job is to make recommendations, to model companies and to have that growth gap and to promote those stocks that they feel are best ideas to be in our international portfolio. Those ideas are scrutinized and debated by the entire investment team of ten investors and challenged by the portfolio managers and the other global sector specialists. 

Once we have been through the investment case in detail and we've considered risks and made sure we're confident in that growth gap and the future earnings being there, then it is my job as lead portfolio manager to construct the portfolio and make the final decision about what goes into the portfolio.

Q: How do you evaluate future earnings prospects and the positive growth gap? 

Our analysts, both located around the world and on our team, can conduct thousands of company meetings a year and in those meetings we will have a dialog with them. We will be assessing their capital allocation, assessing their investments and their strategy. That forms an important component of our assessment of the quality and growth potential of the company. 

Our analysts will then build a model. They will forecast out. I mentioned our longer term perspective; we think the market is often much too short term and we have a full model going out a minimum of three years and we will take it longer in many instances. 

We focus on what the medium to long term earnings potential is and model it out in detail. Then we will go through in our investment meetings what the drivers of those margins and those earnings are and why we feel differently than what the market is expecting. The modeling work is done by the analyst and then is subject to scrutiny and questioning and debate at our team meetings. I really emphasize the team elements of the investment process. 

We believe that by having a culture of challenge and questioning we make better decisions than anyone working in isolation in a silo can. That's a very important part of our process. The drivers of that growth gap will be informed by our meetings with companies, but they will also be informed by the background work that we do on an industry, on a country and on competitors. 

All of that research and work goes into our estimation of the future earnings growth of the company and by having a lot of scrutiny in every part of the process, we end up with only those situations where we have very high confidence in the earnings growth. Our analysts will exercise some discretion at a local level and their buy recommendations will represent about five or six hundred investible stocks for the fund; that is how we narrow down our investible universe.

Buy recommendations by our local analysts will then be filtered down again by our global sector team here in London. We will get down to a focus list of about one hundred stocks that our team here believes all have a growth gap and we like the growth prospects of the company and we believe they stack up in a global context. That is the pool of investible opportunities for me as a portfolio manager. 

We have various degrees of concentration; in the International Alpha Fund it represents the best 40 to 60 stock ideas that we have in the international universe. 

Q: What's your definition of alpha and how do you measure alpha? 

Alpha, we use here to signify conviction and concentration and this is one of our more concentrated stock picking funds. We expect it to be able to deliver a higher level of alpha generation than a more diversified portfolio of say 100-plus stocks. It's a sign of our conviction and the concentration of the fund. 

We target a level of approximately 300 basis points or three percent above the MSCI EAFE Index as a proxy for international equities. Our target is to deliver a consistent level of that three percent outperformance and that is our alpha.

Q: What is the structure of your research organization? 

There are 70 analysts based around the world. They report into their local teams and their job is to come up with an idea in their local market. Let's say European telecoms: we have our European analyst and it's his job to come up with his best ideas in European telecoms. He reports to the head of Europe and he publishes his work and his model for any one of the investors internally in Schroders. 

Our team, which is all based here at our head office in London, has ten investors and we take that work that's published by the local analyst and we have a global sector analyst who will really build a relationship with those individual local analysts in their sectors and understand the recommendations and the work. 

The global sector analysts on our team are only accountable to our global and international products. They work only for that one set of products and it is their job to take those good local ideas and put forward only the ones in which they have conviction. 

The accountability for any stock that goes into our portfolios rests with our team, the ten investors based in London, the stock picking at a sector level primarily with our global sector specialist and the portfolio construction and the final decision of what goes in with me and my partner James Gautrey who is working with me on some of the international portfolios.

Q: Could you highlight your research steps using two examples? 

For example, Japan based tire maker Bridgestone is the owner of both the Bridgestone and Firestone brands in the global tire market. Bridgestone is one of the top three global tire manufacturers and we believe that they have some competitive advantages. 

Bridgestone has quite a bit of manufacturing in Japan, which is very competitive at today's currency levels. It also has good brands and some of the best products that offer a good tradeoff of low friction, low rolling resistance and durability. They offer a good value product to the consumer. It's one of our largest holdings in the fund, so why is that? 

First, we have our analyst in Japan. In Tokyo we have an analyst who follows the stock. Earlier this year he identified that Bridgestone’s sales in the aftermarket is where they make the most money. You don't make money as a tire company selling the tire to the car company, but you make it selling to the consumers when they replace their tires. He noticed that they were seeing improved market share in that very important profitability of aftermarket. 

He tabulated his earnings projections for the company and published them internally and he had a very strong growth gap, higher earnings than consensus or what the market was expecting. Our global auto analyst based here on our team, Katherine Davidson, picked up his work and she wrote a note comparing Bridgestone to the global auto sector; comparing the growth prospects and the earnings growth opportunity there to the car companies and to the other tire companies that we could invest in.

She concluded the earnings growth and the earnings surprise opportunity at Bridgestone for this year and more importantly for the next three years was much higher than anything else she was looking at in her universe. We discussed that as a team and we couldn't find any holes in her argument and in fact she was strengthened in her conviction behind this view and as a result we purchased the shares for the fund earlier this year. 

In addition, Bridgestone benefits from weaker raw material prices; natural rubber and synthetic rubber, which is a derivative of oil, are both declining this year, so they also get a profitability benefit and that strengthens our conviction that earnings are going to surprise positively. 

Q: Do you exclude any company that has significant operations in the U.S.? 

If you exclude any company that has exposure to the U.S. then you dramatically narrow down the investible universe. We're talking about within the non-U.S. listed opportunity set where we can find the very best opportunities. I don't care whether that company has exposure to the U.K. or to Japan or the U.S. or to the emerging markets in their earnings.

What I care about is whether the market is properly understanding the growth potential of that company and whether that company is going to surprise positively and is going to outperform as a result. Samsung is a global company but it happens to be listed in South Korea. Proctor and Gamble is a global company and happens to be listed in the U.S. Within this mutual fund we're investing outside the U.S., but in the very best ideas we can find, wherever their earnings are coming from. 

Q: What metrics or trends gave you confidence in investing in Bridgestone? 

We felt there were a few big misunderstandings in the market. The market was taking the view that tire companies do not have very good pricing power. We disagree. 

We think that when you look at the price of tire on an SUV and compare it to a sedan tire the pricing goes up significantly. We feel that regulations around rolling resistance, around durability and safety, all strengthen the pricing power of the tier one brands, of which Bridgestone is among the best. 

We also felt that they were doing a very good job of using the competitive advantage that the depreciation of the currency in Japan had given them. Now the market quite quickly prices in translation of currency earnings, but what it always consistently gets wrong is the structural advantage, the sustainable advantage that it gives companies. You have manufacturing in that region and can use the higher profitability that comes to either take market share or to reinvest in their product or return the cash to shareholders. 

What we are interested in not just at Bridgestone but in Japan is companies in manufacturing or technology or industrial sectors where they take advantage of the more competitive cost structure to their business to be able to grow internationally. 

This gets onto an interesting area of Japan which we see as very much two halves. Domestic Japan is aging and is in a very difficult position, but there are some industries in Japan with good technology and very competitive cost that we expect to thrive. That was one of the things that we felt the market was missing with Bridgestone. 

This is an example where the view of the long run advantages and benefits are for the company. The market is often obsessed by the short term earnings translation when in reality the much bigger impact comes over the long run. 

Q: We can move on to the second example. 

I think a good example would be Reckitt Benckiser, the U.K. based consumer goods maker. They have a number of consumer healthcare and consumer products brands. Reckitt makes Finish dishwasher tablets and consumer health over the counter aids for headaches and colds and flu. 

A lot of their brands are quite well penetrated in markets like the U.K. but these brands are not well penetrated at all in emerging markets. When you think about the long-term growth potential of things like dishwasher tablets and some of these consumer healthcare products they're really early in their penetration story in markets like India, Indonesia, and South America. That means they have a long way to grow into the future. 

Some emerging markets are seeing weakening economic growth at the moment but if you have a brand portfolio that is high quality and underpenetrated then you should be able to have a sustainable level of growth as your products just incrementally penetrate the consumer base in those countries. This is not a new thing for Reckitt Benckiser, they've had this position for a good period of time. 

What we feel the market misses with them is that it gets too short-term about the Price-to-Earnings multiple and it persistently underestimates their ability to show organic growth that delivers a sustainable level of earnings growth beyond what market is expecting. 

The market models Reckitt Benckiser quite well in the next 12 months, not so well in the next 24 months and when you get to three years out it's always expecting a level of growth that fades down towards GDP kind of growth and we think the sustainability of returns they can put up is much higher.

Q: What stood out for Reckitt Benckiser that did not stand out for other large consumer goods makers like Unilever? 

Unilever is a great example to pick because Unilever has a fantastic position in India but their key products in India are shampoo sachets and hair care products and they are actually quite highly penetrated. Unilever can participate in India's growth and we're very positive on India but it will be growth that is closer to what the overall level of growth in that country is. 

What's different about Reckitt Benckiser is they have only single-digit penetration of dishwashers so hardly anyone is buying their dishwasher tablets, and hardly anyone is buying their over the counter medicines but their brands are in a good position in that country and as those categories grow in penetration they should see growth that's much higher than the overall level of economic growth in India. 

What we think is different is the very long run growth potential of their brands and their categories and that matters in consumer products or consumer branded products companies like this where the sustainability of growth is much more important than the medium term earnings.

The positive gap in your opinion comes from the market's view, which is a short-term view. When you're more patient and willing to take a longer view and you let your winners run longer, that's where you get the confidence.

Q: What is your sell discipline? 

Our sell discipline is very simple. When we lose that positive growth gap, when the market catches up to our view of earnings growth over the medium term and the short term, and our view of the earnings trajectory of the company is below the market then we sell. It goes through the same scrutiny and debate in our team meetings as the buy decision. 

If we don't have confidence that this company will surprise positively over a clear timeframe then we sell out and we have plenty of good ideas competing for capital to get into the portfolio. There's no space for stocks where we feel the market is going to be disappointed. That's our sell discipline and obviously we don't get it right all the time. No one does, but we work very hard at acting where our view of earnings goes below the market consensus. Diversification is absolutely important. 

Q: What are your views on portfolio construction? 

We do not have a top-down element where we try to be over or underweight Europe or over or underweight Japan. We are a stock focused team, stock buy investment cases and we let those drive the portfolio. But we believe it is important to have a portfolio diversified across industry. You don't want to have all one type of business model or all cyclical exposure and there is definitely also value in having a geographic diversification too. 

We monitor that as a risk and we will talk about risk management in a minute but in portfolio construction we first of all let the stocks drive the portfolio positioning and then we consider if that stock-driven bottom-up process has led to any risks we're not comfortable with and therefore we need to make adjustments to the process.

Our portfolio turnover is quite low, as you would expect from a strategy that targets the medium to long-term growth and the growth gap of companies. In the last 12 months under 50 percent the portfolio has been turned over.

Q: Do you hold views on macro-economic analysis? 

I think a lot of rubbish is talked about the macro view and a lot of people say they don't do macro but they really do. There are very few companies where the macro doesn't have an impact. We feel it is really important is to have a coherent, consistent framework in which we assess and model companies. 

So we're not having one very optimistic GDP growth assumption for one company and a different one for another. We have a consistent set of assumptions and we judge companies in that way but we are not trying to make the calls on growth and inflation and top down position. This is a bottom-up process where it is absolutely important that the economic assumptions we build into that modeling are reasonably accurate and that they're consistent. We have a great in-house economics team at Schroders. They brief us on their baseline scenarios and all our analysts use a similar set of assumptions to do their modeling. If there are any outliers on our team we can make sure those assumptions are consistent. It's a bottom up team but within a consistent framework.

Q: What accounting metrics do you focus on to compare companies in different sectors and countries? 

We think that the simplest comparable and common denominator is ultimately earnings. We have accounting standards for a reason and that's because earnings need to be calculated in an appropriate way. There are some differences around the world and our analysts work quite hard at making sure that any adjustments that need to be made are made and are transparent. 

We do look at cash flow as well because that's an important indicator of the health of the business, but our growth gap that we look for in all of our holdings is based on a set of earnings forecasts for every company we invest in. Those are net, after tax earnings, after stock options and after exceptional items. We believe earnings should be after all costs, not only the costs that the companies want us to focus on.

Q: How do you compare companies in the same sector in different countries? 

When we're making a comparison at a global sector level, we try to make most of the important adjustments if they're needed in accounting standards. An example would be Japan: when companies make acquisitions in Japan, and they're still under Japanese GAAP, they still have to amortize some of the goodwill. Many of these companies are now moving to more international accounting standards but when we're comparing companies we make those adjustments today and make sure that our modeling is done on a consistent basis for comparison purposes. 

Now the market consensus and the market expectation will be relevant in a global context but also locally, so we will want to look at whether our view of earnings for this Japanese company is above what the Japanese market is expecting in the Japanese GAP. But also when we're comparing that company to an international option that we can invest in are we using consistent accounting treatment in making that comparison?

Q: Do you have any views on country allocation, if you apply that, or are there any limits that you have to live by? 

We clearly do have some views about the developments of what's going on in countries. We're looking for an acceleration in growth and an acceleration in economic momentum in a country can often help with that. India would be a good example of that where we're full of ideas at the company level in India and that's partly because of the confidence in the trajectory that the country is on towards growth. 

But we will only invest there if we can find stocks that we have a very high conviction in from a bottom-up level. We have a couple of restrictions: we will not invest more than 20 percent of the fund in emerging markets, that's a hard limit. Within the other major regions we have found that we don't need to apply top down restrictions. 

We are always getting a balance of ideas coming through and we want this to be a fairly unconstrained fund where our best ideas drive the portfolio, rather than buying a couple of European stocks because we feel we need to be closer to the benchmark. That's not how we like to think and we want our best ideas to come through wherever they are in the world.

Q: How do you define risk and what kind of risks do you like to monitor and manage? How do you control risks? 

I think this is one of the other areas of clear differentiation that we have. We look at risk in two buckets. There's portfolio statistical risk and we have good systems for variance models and tools to monitor the portfolio level risk. Where I think we are unique is our approach to stock level fundamental risk as we call it. Those are many of the risks that people will be familiar with, whether it's balance sheet, financial leverage, operational cyclicality, governance and management risk, regulatory country risk. All of these are fundamental factors at the stock level. 

We think that growth investors often get it wrong by not understanding the riskiness of companies in which they're investing. We, as well as focusing on the upside in our earnings growth gap, we focus on the risk that we're taking in every individual investment and make sure that our understanding is good. If we are investing in a more risky situation we appropriately size the position or we avoid those situations that we feel are too risky even if we have a strong growth gap on the upside. 

We have developed a framework where we have seven main categories of fundamental risk, we give a rating score to each of them: financial, operational, industry risk, management, country, transparency and governance are the factors. That adds up to an overall risk rating for each of our stocks and it is very important. It's bottom up and it's dynamic; it's developed proprietarily on our team for each of the companies we invest in and it gives me as a portfolio manager a really good bottom-up tool for understanding the risk of the stocks I'm investing in on behalf of our clients. Often it comes up with quite different conclusions than the statistical models that everyone uses. Nokia Oyj would be an example. 

It's one of our largest holdings in the classic sense. Research models going back over five years of history and volatility of the stock calculate a risk that goes back to a time when Nokia had a levered balance sheet and a highly cyclical mobile handset business. That situation is completely different today. 

Within our fundamental stock risk model we adjust for the current balance sheet, we adjust for the current business mix and our assessment of the quality of the management and governance of the company. There are examples the other way where we feel a traditional statistical model underestimates the risk of the company and our model suggests the fundamental risk is higher and if we are going to continue to hold it then we have a lower position or we sell out.

Q: What lessons have you learned and internalized after the financial crisis of 2008-2009? 

The work that I've just been talking about on fundamental stock risk is something that we feel that we have learned. It was necessary because of the inadequacy of available tools to us externally and has been developed to really help with the downside capture as well as the upside capture, which has always been good with this strategy.

We believe that's what we now have in place to have a strong downside as well as upside capture in the portfolio. If we go back to 2008/9/10 period, with our strategy focused on growth and companies that have real growth prospects, there are times of extreme risk aversion where everyone in the market is just flooding for defense and low duration assets. That is an environment in which we expect to struggle because we are focused on longer term growth which has a higher duration and can be more sensitive. 

What it's incredibly important to do in those situations is to stay consistent to one's investment process and philosophy and we used that opportunity in 2008 and early 2009 to really build positions in companies we had confidence in for the long run. We didn't know what was going to happen in the next few months but we did feel we had great conviction in the long term viability and the earnings prospects of many of the good global franchises and we positioned the fund accordingly. It set us up for a very strong 2009 and 2010. 

In summary, we reaffirmed and learned the importance of being true to one's investment philosophy even in a period of short term underperformance to set oneself up for the long run. We also learned the importance of really understanding the risk of stocks in which you're investing.

Growth investors focus so much on the upside, so often we want to make sure that we are giving as much consideration to the downside and to the risk management.