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Europe Unit Trust Manager Q&A: 
Quality in Quotients
Author: Manish Shah
123jump.com
Last Update: 10:35 AM EST September 17 2007


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Peter J. Baughan
  “In our process, the analysis of the business comes first and the analysis of the stock comes second. We look for compelling business models globally. And then we try to value those and buy them when on sale.”
Harding Loevner Global Equity Fund

While many global funds scour the world to find the best companies in their countries, the Harding Loevner Global Equity Fund has quite a different strategy. In an increasingly global economy, the fund looks for companies with competitive advantage across global sectors. A well-defined research process and a long-term investment horizon help the fund keep its focus on quality names with durable growth.

 
Q: What’s your investment philosophy?

A: Our philosophy is that disciplined investment research yields profitable insights. We’re a bottom up, fundamental research shop. In other words, we believe in kicking the tires globally, and we do that through a consistent investment process.

Our core belief is that companies will see rising competition as barriers to entry decline around the world. We think that global research is essential in this environment. There will be winners and losers. In a nutshell, we try to identify the winners and buy them when attractively priced.

We consider ourselves high-quality, durable growth managers. High quality means companies with high returns, financial strength, low debt, and strong margins. Growth means that management can leverage structural competitive advantage to reinvest operating cash flows in the business and gain share across industry cycles.

We are an independent, employee-owned company with close to $6 billion AUM. We’ve pursued the same philosophy and process since our inception 18 years ago. The core of our senior investment team has been very stable over the years and we continually hire research staff. We stick to our style even through the difficult periods when our style was underperforming. Year after year, we retained a high-quality, growth-oriented, low-turnover portfolio because we think that these kinds of companies, bought at attractive prices, will outperform over time.

Q: Would you explain your definition of global winners?

A: Global winners are companies with competitive advantages to take share globally over long periods of time. For example, L’Oreal is a multinational player with franchises in Europe and North America, which generates 20% of its sales from the emerging markets. L’Oreal spends more than its peers on brand development and R&D and uses its global scale to amortize this investment. This spending drives innovation and product growth across geographies in a virtuous cycle, leading to more investment spending and market share at excellent incremental margins.

Cisco Systems is another company with global competitive advantages that management can lever to both take share and enter new markets as the network takes share of overall technology spending.

However, we make exceptions in specific cases, such as Japan, where some of the most attractive investment opportunities may be domestic, not global. We have Japanese commercial real estate in our portfolio, which is a domestic business by nature.

We would include companies like America Movil, the dominant wireless operator in Mexico and Latin America, which are regional winners, and its peers in the larger markets, such as China Mobile or Telekom Indonesia. We have followed wireless operators for many years, first in developed markets and now in emerging markets. We believe they have a global business model which we can understand to generate some insight.

We have a vibrant and deep emerging markets research platform, which is important because in the flat world almost any company in the developed markets can be threatened from the emerging markets. We need to be well versed in both worlds and aware of the competitive landscape as it evolves. In essence we are looking for the winners and trying to avoid the losers.

Q: What’s your strategy and process for identifying those companies?

A: There’s a lot of noise out there, and the challenge is to convert that noise to insight and then monetize the insight in the portfolio. We try to do that through our four criteria: growth, competitive advantage, financial strength and management. We approach all the companies in the various sectors and geographies through this lens, which drives our investment research process.

In our process, the analysis of the business comes first and the analysis of the stock comes second. Cheap stocks per se are not what we look for. We look for compelling business models globally. And then we try to value those and buy them when on sale.

By ‘growth’ we refer to the business, not to the security. We don’t mean the price-tobook or the price-to-earnings ratio, but the fundamental growth of the business itself. It is the combination of top-line growth, operating margin expansion, and the ability to reinvest in the business at attractive returns, that leads to double-digit earnings growth across cycles.

That’s where the role of the management comes in as we look for excellent capital allocators. Overall, the earnings growth should be a function of an attractive industry structure and clear competitive advantage. In other words, the companies should have the ability to grow faster than their industries and peers.

Q: Could you highlight your research process?

A: We have a four step process. For context, our universe consists of about 6,000 companies with market capitalization in excess of $750 million. The first step of the process is qualification, where we apply the four criteria of growth, competitive advantage, financial strength and management. That gets us down to about 800 companies. Historically, that’s been done by our analysts’ judgment but to help avoid missing something we also rely on database work to screen through that universe on business quality metrics.

In the second step of the process, we take those 800 companies and apply our Quality Quotient (QQ) analysis. This is a comprehensive evaluation of the industry competitive structure and a specific company’s ability to operate within it.

The QQ analysis has 10 components. Half of them are the well-known Porter indica tors, which include the risk of new entrants, the bargaining power of suppliers and buyers, the intensity of rivalry, and the substitutes. We spend a lot of time looking at this. The other five components are related to how the company has operated and how we think it will operate within that industry structure with a focus on the persistence and the durability of the company’s growth. These indicators include free cash flow, balance sheet strength, corporate governance, management skills, and capital allocation.
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