Using the example of the steel sector again, fund managers need to demonstrate superior contacts and information flow from independent steel distributors, or how they have better contacts in the scrap metal industry, or how they have a superior read on Chinese steel demand and inventory levels.
During the GFC, for example, early warnings were given to well-informed fund managers that demand for domestically manufactured steel was about to plummet, as they were getting feedback from regular meetings and conference calls with independent steel distributors that buyers could not get letters of credit. Hence the distributor, in some cases, did not have the capacity to purchase steel from domestic manufacturers. Further to this, end demand for steel was weak as the non-residential construction sector was lagging.
Analysts who relied solely on commentary coming from the listed steel manufacturers, and their prolific “company visitation programs”, were caught completely unaware. The well-informed analysts with independent industry contacts knew that because buyers couldn’t get credit, there would be a large inventory build-up at steel makers, and the cashflow of the listed companies would plummet. This would also lead to capacity under-utilisation on high-fixed-cost blast furnaces, creating a spiral of negative operating leverage. In this example, both of the largest domestic steel manufacturers subsequently had to come to the market to raise equity, at deep discounts to the prevailing market share price. These equity raisings were essentially to fund the inventory build, and alleviate balance sheet stress. Forewarned was forearmed!
Then, after the GFC had largely passed, independent, non-listed steel distributors gave good insights into how quickly the inventory build was moving. This gave well-informed analysts a read on how quickly domestic steel manufacturers would return to full capacity. The message is obvious: independent industry contacts can have a large impact on a manager’s ability to generate outperformance.
In Australia, the evidence suggests that neutral managers, on average, conduct deeper research and, as a result, are better placed to outperform the benchmark over the long term. They are more likely to frequently contact competitors, suppliers, customers and overseas listed companies in the same industry to form insights that are not reflected in consensus expectations. They appear more focused on actively analysing the prevailing themes and dynamics of the market, and by virtue of their style, are more capable of repositioning their portfolios accordingly. They do, however, have an Achilles heel – typically, they don’t engage paid independent experts, and if they did so, they could significantly improve the excess returns they generate over time.
Matthew Olsen is a senior investment analyst at van Eyk Research.
