Matthew Olsen argues that industry experience can give fund managers a competitive edge.

Financial planners and their clients are always seeking fund managers with a competitive edge – especially in today’s markets. However, finding that fund manager is becoming increasingly difficult to achieve. It’s not hard to understand why.

Analyst coverage of Australian and international companies with a market capitalisation exceeding $2 billion has grown significantly over the past 20 years. Many buy- and sell-side analysts cover each stock, and most offer good insights that can ultimately prove beneficial to planners and their clients. But there’s an inevitable consequence of more research; there is less likelihood of the market mispricing securities. To get a competitive edge in stock selection, therefore, it’s critical that fund managers take their research to a new level. Let me explain.

In a previous role as a buy-side investment analyst, one of my tasks was to research the healthcare sector. In this task I was able to utilise the sell-side research of Dr David Stanton, an ex-orthopaedic surgeon who, armed with an MBA, had decided to change careers to become a sell-side analyst in healthcare – he was an invaluable source of industry knowledge and contacts. On one occasion, he organised a group of researchers (myself included) to attend a Cochlear implant operation at Sydney’s St Vincent’s hospital as part of research into Cochlear. One of his former colleagues was a leading Cochlear implant surgeon and had invited some of Dr Stanton’s clients to watch an operation.

That type of industry research gave invaluable background information on things such as:

• How many operations could be performed in a day?

• What were the capacity constraints on hospitals to perform operations?

• How easy was it to implant the device?

• What issues do patients (customers) face in the pre-op and post-op environment?

• What was the surgeon’s perspective on the performance of the device?

• Was Cochlear’s device the best from the surgeon’s and patient’s perspective and why?

Despite the clear value of this type of experience, the issue for a fund manager is: how do you gain an information advantage over other fund managers in the market? Because the reality is, although Dr Stanton provided me with an invaluable experience in fundamental research, he was also providing that same service to other fund managers. Two of them attended the Cochlear implant operation with me. It got a little crowded in that operating theatre!

So where was the competitive advantage? In short, it required developing industry contacts. This is what the best fund managers do – and what financial planners should be asking fund managers if they do. Attending the Cochlear implant operation was the first step – not the last. It was then necessary to form a relationship, for example, with the implant surgeon to gain differentiated insights into the industry that other managers were not getting.

In the hedge fund industry, analysts rely heavily on paid consultants to provide them with expert industry advice. This is one way that a fund manager can obtain an information advantage. It’s not unreasonable for planners to expect fund managers to pay industry consultants, given the large management fees that fund managers get from clients. At the very least, buy-side analysts need to do detailed industry studies of their own, and show an ability to isolate the crucial factors relevant to the industry sector.

Historically, global long/short equity hedge funds have a stronger long-term track record than most long-only funds (both in Australia and overseas). Unlike most long-only funds, hedge funds commonly pay external consultants and experts for advice. This makes sense, as fund managers cannot always be experts across all industries. For instance, a clothing sourcing specialist who works full-time in the retail industry is more likely to be quickly aware of changes in clothing trends or cost pressures.

Likewise, information technology experts are more likely to accurately predict changing trends across the industry. A political analyst based in Canberra is better placed to predict legislative changes across a range of industries. Indeed, experts across most Global Industry Classification Standard sectors will often be better placed to accurately predict future trends than most fund managers. Fund managers can gain much deeper insights and are more likely to have a competitive edge in stock selection if they opportunistically engage independent experts.

A good example of how differentiated industry analysis can provide a competitive advantage is in the steel sector. The factors that drive industry returns in the iron and steel manufacturing sector are diverse. Fund managers who expect to be well rated in this sector should be able to demonstrate superior knowledge in the following areas:

• Economic factors driving the industry (global demand, currency, credit availability);

• Supply factors (coal industry, iron ore industry, scrap industry, electricity industry, labour);

• Demand factors (China, non-residential construction, residential construction, car demand, et cetera);

• Competitive threats (imports, competitive landscape in industry);

• Pricing power (ability to pass on cost increases, threat of substitutes, et cetera);

• Global industry factors (US manufacturing, Chinese manufacturing, et cetera);

• Regulatory environment (for example, carbon tax, mining tax, labour laws, occupational health and safety);

• Distribution (transport issues, cost of distribution, in-sourced or outsourced).

Due to the diverse range of factors listed above, a buy-side analyst will need to develop proprietary networks of consultants and specialists in these areas. It is hard for buy-side analysts, who are more general in their knowledge, to have differentiated insights in the above areas without access to external, non sell-side specialists. Sell-side analysis, while often of a high quality, is not always differentiated, as many fund managers have access to the same research.

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