Monika Skiba is senior managing director and senior portfolio manager, Manulife Asset Management. She is lead manager of the Manulife Canadian Equity Balanced Fund and the Manulife Canadian Stock Fund.
What’s your investment process?
My funds are built through bottom-up, fundamental analysis. Experience has taught me the market always changes and you need an edge in analyzing companies because almost everyone in this business is bright. And with technological developments that provide instant access to information, it’s even more difficult to set yourself apart.
Buying companies with low P/E ratios and selling those with high ratios is the traditional approach everyone else is using. These opportunities are easy to arbitrage away, so they’re not a consistent way to gain an advantage over the competition.
Three elements are critical to our approach:
01 Accounting interpretation
Financial statements are the product of accounting assumptions and management interpretation. A lot of judgement goes into almost every line item and the result is an accruals-based net income that doesn’t necessarily represent what the company truly earns.
We want to know the company’s cash-based earnings, which are the amount of cash it can earn every year.
To this end, we use a proprietary version of the Direct Cash Flow methodology. In this approach there’s much less management discretion in producing the numbers, allowing us to arrive at a clearer understanding of the company’s underlying economics.
Everyone can see what’s officially published in financial statements, and the market values companies based on reported earnings. These numbers sometimes prove correct on deeper analysis. But we often come up with more accurate figures, giving us an edge.
By reconstructing financial statements with our own formulas and metrics, we’re able to generate private information from public documents.
02 Capital efficiency metrics
People typically focus on Return on Equity (ROE). We take this figure into account, but we’ve also come up with our own metric: Cash Flow Return on Invested Capital. It’s based on our calculation of cash flow-based earnings, which isn’t related to accounting assumptions.
Instead, it ties into how we think of competitive advantage. It isn’t just about market share because a company can buy it up and still be unprofitable. True competitive advantage means the company is generating positive returns on capital. Our metric allows us to identify firms that do this.
We prefer free cash flow yield over price-to-earnings and price-to-book. An attractive company is an efficient user of capital at a good price, and free cash flow yield helps us determine whether the price is right.
Our valuation method also relies on a discounted cash flow model, which is different from the one they teach in business school. The growth rate assumptions we use are far more realistic; our discount rate is based on forward yield curves.
This three-element process is only the first step. It’s the model-driven part of the process that digests the broad universe of companies and screens out those that don’t meet our criteria.
Once we have our list of possible candidates, we do the manual fundamental analysis. We go back to financial statements to ensure the results of our screening process are 100% correct.
Then we look at sector drivers; the company’s product offerings, competition and management team; and broad economic data to get a picture of the company’s outlook. It’s not a mechanical process—you have to think in ways a model can’t.
We use buy and sell targets, as well as individual weighting constraints. Portfolios have 40 to 80 names, and single positions cannot exceed 10%. Sector positioning is an outcome of stock selection and our goal of maintaining diversified exposure to the market.
How do you evaluate a firm’s management?
Discussions with company executives tend to be biased. What matters is how managers think about capital allocation, and how they’re remunerated.
If their compensation is tied to a certain metric, it usually gets overemphasized in their strategy. For instance, gold companies have enjoyed an incredible run over the past decade, and CEOs were incented to make acquisitions. But so many committed the sin of buying at the cyclical peak. They’re now paying the price—a whole slew of CEOs have been fired in the past year because their strategies were detrimental to value creation.
I don’t want to tell companies how to run their businesses, but as a shareholder I provide them with capital and I want to see it allocated effectively. This should be an overriding goal, and it’s a good sign if compensation is tied to it.
What’s your outlook for the equity markets?
There’s been a gradual pick-up in growth, especially in the U.S. We’re also in a low-inflation environment and have seen a highly accommodative Federal Reserve. But given the significant run equities have enjoyed the past several months, we need to look closely at valuations.
Across the developed world, markets are fairly valued. Since we have closed the gap on what used to be a cheap market, there are fewer interesting investment opportunities.
What are some key risks?
Interest rates rising rapidly. The housing market is an important component of the U.S. recovery, and higher mortgage rates would negatively impact affordability.
Slowing growth in China is another risk. It wasn’t so long ago we were talking about 8% GDP growth, but now we’re looking at less than 7%, which is probably the new normal.
China is a difficult market to understand because of the lack of transparency, especially in their banking system.
The key for Canadian investors is to figure out how much of China’s growth is driven by commodity consumption.
Over the past decade a large share of the growth in commodity demand has been fueled by China; if it drops off considerably, then Canada’s resource-based economy, as well as its markets, will suffer.
What advice do you have for advisors?
Advisors are in a difficult position because clients might be running after the hottest managers. But they’re chasing yesterday’s numbers and don’t understand how those returns were achieved relative to the risks taken. The core of the portfolio should be a well-diversified basket of products with steady returns. On the edges you can add sector-specific funds or some hot manager.