How to be a fund manager

Editor’s Note: Eduardo R. Banaag had worked for big local and regional financial institutions as a professional fund manager for 25 years before retirement. As an equity portfolio manager for one of the largest institutional investors in the Philippines, he managed over P60 billion worth of funds and consistently ranked No. 1 in equity funds, particularly in the categories of one-, three- and five-year returns.

These days, he is an independent investment advisor who has made it his mission to educate the small investors.

In a question and answer interview at the podcast program of First Metro Securities Brokerage Corp. (First Metro Sec) on March 24, Banaag discussed with Royce Aguilar, First Metro Sec head of retail research, some tips on how to be an effective fund manager. These are excerpts from the interview.

Question: [How can small investors be] resilient when financial markets are performing poorly?

Answer: Let me define “resilient” this way: It means achieving a positive investment return even when stock prices, in general, are down. You’d want your portfolio to be positive. In the short run, it’s reasonable for investors to expect a loss; at any point in time, stock prices are the result of supply and demand. Those who are selling stocks today probably believe that inflation will not fall very fast or that the economy will slow in a big way.

There’s also momentum. Mood or expectations and momentum—these influence demand and supply. And, yes, it’s important to make money over an acceptable period and it’s not you or me who determine what acceptable is. We know that it’s the investor who determines what is acceptable or not acceptable.

Q: In the United States, there are a lot more assets that are not correlated to equities that investors can use as a hedge. There’s also “shorting” so that when the market is trending down, you can still make money off it. In the Philippines, how do you hedge risks?

A: It’s going to be more complicated if we had shorting in the Philippines. So, I’m not sure I welcome shorting. But, for now, I think if you have a portfolio and because there’s no shorting, you could do it in a specific way. We should emphasize that before you invest, you need to know a lot of things and I will enumerate them.

First, you need to know which companies earn, out of their capital, 15 percent a year. I say ‘15’ because, as we know, if you have 15 percent or 14.8 percent [return] a year, in five years, you’d be able to double your initial capital, and you’d hope that you’re with the company that can double its capital sooner rather than later. We know that these companies have “moats” around their incomes. They have high barriers to entry, a sizable share of the market, probably the lowest cost of production, if not, at least, a very competitive cost of operation, and a high cost of switching. All these prevent others from getting into their market or limit the competition. And importantly, these are companies that have moats. They’re able to increase their revenues without compromising their return on invested capital or ROIC.

We observe that higher ROICs are not always accompanied by positive investment returns —that’s not always the case. However, we know that companies with high ROICs—the simple definition or formula for ROIC is your net operating income after tax as a share of your operating assets or invested capital—are more likely to create value than companies with low ROICs. You want to be with a good company. Hence, you want to prioritize or focus on companies with high ROICs.

The second is you should like companies that report rising operating incomes most of the time. In reality, it’s not all the time that companies report rising operating incomes. But we know that the operating incomes add value to stocks and, especially, when incomes are greater than the cost of capital, the values of these stocks increase and inevitably, sooner or later, their market prices follow. Noteworthy, rising operating incomes shorten the acceptable period—we mentioned earlier —that investors want to make money. The more often operating incomes rise, the sooner stock prices follow.

Third, you need to know which companies have cash left after paying the banks and reinvesting in working capital or fixed assets. We are common shareholders. When we buy stocks, as common shareholders, we have the “last priority” over income. The priority belongs to banks, bondholders and preferred shareholders.

Fourth, you need to know which stocks are trading below or above their intrinsic or monetary values—this is not easy. The simple reason is not everyone would have an estimate of the monetary value of a stock. You need to know what you are buying or selling. If you don’t, the seller from whom you are buying or the buyer to whom you are selling may have an advantage over the price at which you are buying or selling. And finally, you need to know which benchmark is appropriate. If your investment objective is to make money, the appropriate benchmark is that which is positive all the time—that can only be inflation or interest from fixed income instruments, whichever is higher.

Q: How do you prepare before executing a trade? Do you have any to-do list?

A: When you’re buying stocks, you are taking a risk. It’s a small risk if it involves little money and it doesn’t alter or influence your lifestyle. But you want to make money just the same. You should know that of the 285 stocks that trade at the PSE, only nine report ROICs of at least 15 percent year in, year out. Of the nine, eight recorded positive investment returns versus the 4-percent loss, on average, of all shares in the last five years. Sadly, the ROIC of all shares, on average, is just 4.2 percent. Know that there are 20 companies only whose operating incomes grow 75 percent of the time. There are as many as 40 companies that need to pay interest above or greater than operating income—they are not financially healthy. And, the offer prices of six out of every seven stocks are higher than how much is needed to capitalize or fund the companies’ operations, meaning, you’re most likely buying them at a premium. As you are buying common shares from the secondary market, the shares got there through an initial public offering. You’re taking risk from someone who had invested before you. He may have acquired the stock at a lower price; you’re buying at a premium because the company doesn’t need that much money to fund its operations, or, [the price is] higher than the book value or net worth of the company.

The to-do list can lengthen but it cannot shorten. But it should include, one, invest in companies that are likely to create value. Stock prices rise as value is enhanced or increases. Two, invest in companies whose operating incomes are likely to rise… especially if you want to shorten your holding period. Three, invest in companies where there will be “free” cash left for the common shareholder. This is rather easy to ascertain as there are metrics like interest cover, etc. Fourth, invest in companies where the intrinsic values are higher than their market prices.

Q: Do you have strict rules to follow in terms of stocks that you invest in – such as earnings must be double-digit per annum, reputable management or ESG (environment, social and corporate governance) metrics?

A: What I know about stock markets — how they work and how they don’t work — has helped formulate these rules. It’s likewise important to be aware that if one decides not to follow a rule, the risk is higher. They are strict rules because they serve as the “boundaries” within which you want to operate. If you decide to operate outside of it, you simply need to be aware that you are taking more risk. In relation to earnings, these need not grow double-digit per annum if they are growing fast enough and creating value. A simple example would be if interest rates are falling, even if earnings are rising less than double-digit, it helps that the cost of capital is falling; hence, the value of the stock is rising. But, yeah, we love double-digit growth. Reputable management, yes – that’s a must. I have nothing against ESG but companies need not prioritize if doing so will destroy rather than create value.

Q: How do you best gauge if an investor is successful in terms of performance? Do you have to beat inflation or a local index as a benchmark?

A: Yes, we must emphasize this – to me, at times, it’s surprising that the current benchmark, the most popular or what appears to be the most important benchmark is still used by many investors. We should remember that if the investment objective is to achieve a positive investment return, I think, the better gauge, as mentioned, is the higher of inflation and yields from fixed income securities, simply because it’s advisable to avoid using a poorly-performing index as one’s benchmark.

Q: How much you utilize technical analysis before buying or selling?

A: I use technical analysis too. A to-do list should include knowing at what price most buyers and sellers are willing to buy or sell a stock. It’s really where supply meets demand. I think that’s the use of monitoring, watching and figuring out where the price will go in the short term. Yes, I use technical analysis to know what users of technical analysis are seeing or incorporating into their decision-making.

Q: Do you have any sector picks in this kind of market environment?

A: If I were to refer to the stock portfolios where I help, I see broadcasting, banking, financial exchanges/data, distillers/ vintners, marine ports and services. These are not the result of picking or liking the sectors where they belong but of satisfying my to- do list. In other words, I don’t pick sectors; I pick companies with moats around their incomes and can satisfy the objective of generating positive returns over an acceptable period.—CONTRIBUTED