Asset owners examining whether to set up long-term mandates should look for fund managers with business skill, not financial skill, an expertise not commonly found in asset-management firms.
Two Dutch authors, Jaap van Dam and Lars Dijkstra, who have written a paper on long-term investing, call for managers who can truly analyse industries and companies, because they say intrinsic value is the key to wealth creation, an essential ingredient of long-term investing.
In the paper, Long Term Investing in Public Equity Markets: What does success look like and how to organise it?, published by The 300 Club, van Dam, who is head of strategy at PGGM, and Dijkstra, who is chief investment officer of Kempen Capital Management, outline steps for shaping a long-term mandate and measuring its progress.
“The investment process of asset managers should focus on long-term industry trends, and building a concentrated portfolio of companies within those,” the authors state. “The development of intrinsic value of these companies over time is one of the most important metrics, in our view. By intrinsic value, we mean one or more measures of the value creation by the company. Hence, focus on the quality and the operating metrics of companies, instead of their share price metrics.
“To improve the long-term value creation of companies, portfolio managers need to maximise their impact through engaged active ownership. This means portfolio managers must act as engaged owners of the companies they invest in.”
The authors point to the culture and skill set of a manager that would be well equipped to achieve this. They say the people who run the mandate should be seasoned, innovative, patient, passionate and long-term committed professionals.
“Hence, we strongly prefer people who are experts on industry trends [and] know how to run companies, above people who know how to trade securities,” the paper states. “This requires a fundamentally different set of skills than most people in the financial industry have.”
Dijkstra says there is too much focus on finance skills, not business skills, within funds-management firms.
“Within asset managers, we need active owners who are in a dialogue with the chief executives of companies, so they need to know a lot about the industry and have strategic dialogue,” he explains. “This is a very different skillset to looking at a Bloomberg screen in your office.”
Van Dam and Dijkstra spoke at the Focusing Capital on the Long Term conference in New York last month. At that event, Dijkstra said it was evident that chief executives of companies thought analysts with spreadsheets were irrelevant to the strategic outlook of their company.
How to monitor mandates
The authors’ paper proposes a number of metrics that provide a better insight into the risks to operational development for the companies in a portfolio, and asks the question: What is the probability that this intrinsic fundamental value development and the expected cash flows will not materialise as predicted? The paper states that scenario analysis of a number of important profit and value drivers is important.
“In addition to all sorts of quantitative measures, the story that goes with the portfolio is also an important aspect here. Why is the company in the portfolio?” the paper explains.
The monitoring of these mandates should be less frequent and less focused on market prices or share prices than in traditional reports. The authors say it should also provide insights into:
- The realised progress on the objectives
- The activities and turnover that have taken place in the portfolio
- The current characteristics of the portfolio, to show the logic of meeting your objectives in the future
- The attribution of the portfolio return over a long period/the reporting period (at least seven years), to show that the building blocks of the strategy ultimately achieve the intended goal.
“The long-term value creation can, in our view, be well summarised by the concept of intrinsic value. If the price of the share differs strongly from the intrinsic value development of the company, a patient investor will also have good opportunities for the long-term value creation.”
The authors say monitoring of a long-term mandate requires a different approach because its nature and structure are so different from a traditional active mandate. It requires trust between the asset owner and manager, and a constant building of shared insight into process and results.
A close relationship between the manager and asset owner is essential, and may require shortening the length of the investment chain.
“We need to shorten the distance between manager and asset owner, and perhaps get rid of some of the other players,” van Dam says. “Once the mandate is in place, do away with consultants and allow for a very intense dialogue between the investment committee of the asset owner and the manager. Trust between the asset owner and manager is very important, something to fall back on in difficult times.”
Long-term investing is not for every asset owner, nor every asset manager, he says.
“If you don’t have the conviction and beliefs, and the governance budget, for really understanding what you’re trying to achieve [by getting] away from short horizons, then you shouldn’t start this,” van Dam says.
The paper also outlines some guidance on incentives and alignment through various fee models; however, the authors point out that “incentives can never compensate for the lack of the right people in the right culture. Financial incentives are, at the most, a means of strengthening the already agreed-upon alignment in goals and approach.”