Giles Marriage: Beyond funds – why stock screens are key in DFM selection

In the past year there has been a move by some discretionary fund managers (DFMs) towards direct equity investing. It is not difficult to see why. DFMs able to hold securities as well as funds in model portfolios – be that in UK blue chips or global companies – which can offer advisers distinct advantages over a collectives-only approach.
Direct investing enables DFMs to provide advisers with lower-cost investment solutions, as holding securities is typically cheaper than holding funds and collectives that incur management and running costs. These savings can be particularly beneficial in higher-risk, high-equity allocation portfolios.
DFMs employing this approach can provide advisers with the benefits of holding securities in portfolios without the challenges associated with stock-screening and selection, allowing them to concentrate on the core financial planning element of their role.
This, of course, can be very important – particularly since stock selection is far from straightforward. A process able repeatedly to identify the best stocks in a broad index such as the FTSE 350 – or, indeed, any index – can require a significant amount of development and fine tuning.

As an example, Thesis has developed a quantitative screen that ranks a universe of UK stocks according to financial strength, identifying those worthy of further research and analysis, in order to create a shortlist of ‘best ideas’. These are the stocks we believe will outperform the wider UK market, as well as the ones we should avoid.

Investing directly requires both expertise and resource to get right. Consider company earnings estimates. The FTSE 350 has started all but one year since 2011 with downward revisions in forecasted earnings but, while these have been downgraded, the market has risen – albeit with a few blips over the course of the year. Forecasts simply do not give a full picture of how stocks will perform.

Tesco is a great example of this. In 2011, two-thirds of the broking community rated Tesco a ‘buy’. Since then the share price has declined from more than £4 to under £2 and, in the last five years, has dropped almost 40%, making it a poor medium to long-term investment.

A Different Approach

An investment manager’s job is to make decisions on portfolios. The financial crisis in 2008/09 left many scratching their heads on how they go about doing this. It reshaped the way we thought about investments, and ultimately sharpened our focus on companies that have exhibited positive fundamentals and historical trends.
We found that companies that show a good historic track record in profitability, dividend yield, growth, margins, assets and momentum are more likely to produce returns in the future. We consider this analysis a better indicator of a company’s potential than earnings forecasts from the analyst community.
Screening, of course, should only ever be the starting point. Any DFM investing directly into equities should be able to demonstrate how they perform more detailed analysis on the stocks identified from the initial screening process.

Unexpected Winners

There are many growing UK companies that, while not household names, can drive positive performance in a portfolio. For instance, software company Micro Focus International has been a stand-out performer over the last three years and gained promotion to the FTSE 100 last September. We continue to rate it going forward.
Indeed, it is worth noting the FTSE 100 will see more than half of its ‘stars of tomorrow’ come from the FTSE 250. This index may have underperformed the FTSE 100 in the last year due to Brexit, but over two, three, five, 10 and 20 years, it has produced better annualised total returns than its bigger brother (Source: Morningstar/Thesis Asset Management).
It is, however, a truism that one of the keys to successful investment is avoiding the losers as well as backing the winners and many advisers and investors will have been stung by stocks such as Tesco. By outsourcing to a DFM with a proven centralised approach to stockpicking, advisers can provide their clients access to in-depth quantitative and qualitative research for portfolios with long-term performance potential.
Giles Marriage is director of institutional sales at Thesis Asset Management. This is an edited version of a speech he gave at the Thesis Asset Management IFA conference