Our Strategy

  • Investment Philosophy

    Profits, not quality or cheapness, moves share prices

    Argonaut has a distinct “earnings surprise” investment process. We believe that stock prices move up (or down) on the basis of rising (or falling) market expectations of future corporate profits. We therefore focus our research efforts on finding companies where consensus is significantly over (or under) estimating future profitability. We believe that if we invest in stocks with superior earnings momentum this will lead to superior investment performance.

    Our belief in the primacy of “earnings surprise” distinguishes us from the vast majority of fund managers who categorise themselves either as “growth” or “value” and believe either that investing in the best companies will generate superior returns or that the cheapest companies will generate superior returns. Although “growth” and “value” styles are capable of generating periods of significant multi-year outperformance, the obvious flipside of this is periods of significant multi-year underperformance (see Chart 1). We also believe that this outperformance of “growth” or “value” stocks is primarily linked to corporate profits, not quality or cheapness, and that any periods of outperformance are purely coincidental with superior earnings momentum.

    Chart 1:
    “Performance of growth vs. value stocks” - traditional “growth” or “value” investing produces inconsistent returns

    Performance of growth vs. value stocks

    During periods of anaemic economic growth, for example, more often than not, only high quality “growth” companies are capable of generating the earnings growth upon which equity valuations are so sensitive, leading to their outperformance. By contrast, in periods of more robust economic growth, the average (or below average) company can generate profit growth, thus negating any reason to pay a premium for higher quality companies, and leading to the outperformance of “value” managers. We believe that both “growth” and “value” managers are equally deluded and that our “earnings surprise” style has demonstrated more consistent and superior outperformance. This is our competitive advantage.

  • Investment Process

    Simple, but not easy

    Although our process is simple, it is not easy to execute. A successful professional investor must be a combination of stock-picker, economist and risk manager.

    We are often asked whether we are “bottom up” stock pickers or “top down” macro investors. In practice, our investment decisions are derived from a mix of analysing data gathered on individual stocks in the context of prevailing macroeconomic trends.

    We spend most of our time engaged in individual security analysis: meeting company management, industry analysis, building spread-sheets to analyse company data and crucially producing our own research with our own conclusions.

    Often fund managers are dogmatic about only investing in certain industries or in businesses with certain characteristics. We will invest in any company, industry or sector as long as we are convinced that its future prospects are better than the market currently anticipates .Our only dogma is profit and specifically earnings surprise.

    However, we also believe that the blinkered extrapolation of “bottom up” trends is extremely dangerous if the macro-economic environment suddenly changes. Investors’ expectations for individual stocks can be wildly inaccurate if their assumptions for the economies in which the stocks operate are also wrong. This was most obvious in 2008 when too much “bottom up” emphasis on meeting company management who did not see a slowdown was disastrous; equally in 2009 in listening to company management who were too timid in identifying a recovery.

    Economic activity has always been and will always be cyclical. This means that booms normally go bust and economies recover from even the deepest recessions. There is a strong reversion to the mean in all economic activity. It is important to bear this in mind when assessing whether any company’s profit margins are unsustainably good or alternatively unsustainably bad.

    Supply of capital is also cyclical. When capital is too freely available it tends to be abused: governments, individuals and companies over-expand their balance sheets thinking that boom times will last forever. In any “growth” industry, supply will eventually catch up and erode super-normal profit margins. No one industry is therefore likely to generate consistent above average returns. Investment returns will therefore mean revert.

    Often just when a particular type of investment has recently proven very successful and has subsequently converted general opinion to its superiority, it suddenly stops working, producing spectacularly poor results. The stock market, however, is unlikely to be so predictable in the attributes it rewards – if it were it would be much easier to consistently beat.

  • Risk Management

    Assessing what constitutes appropriate and inappropriate risk

    Risk is often always viewed as undesirable. But without risk, active fund management can never generate the necessary superior performance to justify its existence: no traditional long only manager could beat the market; no absolute return manager could beat cash. Diversifying away all risk is therefore never appropriate for an active fund manager: without risk, we are condemned to perpetual mediocrity. If every active fund manager needs to take risk, management of risk should be about isolating and diversifying away only inappropriate risk. This means that we must define what constitutes desirable or appropriate risk. Since every active fund manager should have an investment philosophy which explains, in their opinion, what moves share prices and therefore what they always look for as desirable characteristics in stocks, diversification away from this style bias is also never appropriate: the value manager should always invest in cheapness, the growth manager in quality and the earnings surprise manager in stocks with superior earnings surprise potential. As such, it is always appropriate that volatility emanating from a fund manager’s style bias is diversified at the fund selection level rather than through an individual manager’s style drift.

    We should also note that style drift is most likely to occur when the manager is unable to attain immediate reward for their investors. In order to avoid style drift it is better that the manager sets expectations at realistic levels. Although we believe (although others may not) that our investment religion - earnings surprise - is a superior and more consistent investment philosophy than its obvious peers, value and growth, and this is what both distinguishes us from and diversifies our returns from our peers, this does not mean we expect to be permanently rewarded: in fact, we accept that through taking risk, it is not possible for any active fund manager, unless engaging in a fraud, to never suffer periods of underperformance or drawdowns; though clearly we would expect these to be more than offset by times when our funds are delivering out-performance and attractive positive returns. We have high conviction in our ability to generate performance for our unit-holders, but this is very different from a belief that we will do this all of the time. Even when their style of management is out of favour, the professional investor is - somewhat ironically - managing risk appropriately by always adhering to it: in their opinion, it should always give the best chance, though not a guarantee, of future outperformance.

    It is however always appropriate to diversify away inappropriate risk and as such the biggest undesirable risk in our portfolios - given our style bias - is always the failure to correctly identify earnings revision trends, either through faulty analysis of individual companies or of wider macro-economic factors. As a result our biggest concern is always whether our views on particular stocks are legitimate. Given human imperfection it is impossible that we will ever perfectly execute our process: to construct a concentrated but diversified portfolio of companies that will over the near future subsequently uniformly see superior earnings surprise. We will also make mistakes believing in potential in stocks that transpires not to exist. As such it is always appropriate to diversify our investment risk across industries, countries and stocks, but only to the extent that superior earnings surprise can still be identified in all of our investments.

    Diversification for its own sake is never desirable. By contrast, conviction in earnings surprise potential in an individual stock in a sector or industry where the catalysts are stock specific is always more valuable. However, although we will invest in any industry we can understand and identify potential, it is a fact of life that earnings surprise potential is unlikely to be equally spread at all times across industries, countries and stocks. As such indirect biases to sectors and countries are always a risk that can be managed, without ever being fully diversified away.

    We also believe that running concentrated portfolios with stock specific risk is usually a desirable risk. The identification of earnings surprise is not easy: it involves significant labour intensive research and often contrary thinking. We want to be able to focus our research efforts on our “best ideas”. When we find these opportunities we want these stocks to have a meaningful impact on the portfolios and not be diluted by inferior opportunities.

    Some of our funds have different objectives: this is important in assessing what constitutes appropriate and inappropriate risk. Most obviously, our traditional long-only Alpha fund will nearly always be fully invested with an aim of beating the market, whilst our long/short Absolute Return product has an explicit mandate to manage the risk profile of its return and will therefore always have a more modest market exposure.

    But far from being a uniquely undesirable characteristic, risk – where taken appropriately in accordance with a coherent and proven investment process - is in fact the raison d’etre of the active fund management industry. Risk management involves exposing the fund to desirable risk characteristics and diversifying away undesirable risk according to the underlying investment process. It does not guarantee or promise permanent reward but it should always maximise the chances of future success.

  • Active Fund Management

    Cost effective solution to investing in the European stock market

    The performance of our funds is always quoted after all fees. We also compare our long only funds’ performance to the market benchmark index even though it is a common misperception that the benchmark index can be bought for free. Efforts to replicate an equity index will always involve a degree of tracking error and therefore returns will never be exactly similar. Equally, every passive fund has management fees and trading costs that will be charged to the fund after which performance is usually quoted. Conceptually a “free” replication of the benchmark is therefore impossible. It is entirely logical that passive funds should consistently underperform the market.

    It is also commonly argued that the industry has become polarised between active and passive funds. We would disagree on the basis that we believe that the average active fund is becoming more passively managed. Truly actively managed funds are therefore becoming scarcer. This is another unique selling point for Argonaut funds.

    Purchasing units in our funds, instead of the direct purchase of the underlying individual shares, can also significantly reduce underlying transaction and holding costs for individual investors. Active funds such as ours are therefore in our view the most cost effective solution for individual investors wishing to invest in the European stock market.