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Europe Unit Trust Manager Q&A: 
The Probability to Outperform
Author: Manish Shah
123jump.com
Last Update: 10:09 AM EST August 08 2007


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Joshua Byrne
  “We want a portfolio where every name has the probability to outperform, with no name overwhelming the performance. That means that we do not like to take a make or break bet on any one stock. The fund reflects a broadly diversified portfolio of our best investment ideas.”
Putnam International Equity Fund

Scouring a large universe of international stocks to find the ones with best chances to outperform, is indeed a difficult task. Joshua Byrne, the manager of the Putnam International Equity Fund, relies on a long-term view, a disciplined process, a team of 20 sector analysts, and a blend between quantitative and fundamental analysis to find multiple points of confirmation that the stocks in his portfolio have all it takes to outperform.

 
Q: How would you describe your investment philosophy?

A: Our investment philosophy has remained the same for nearly 20 years. It is based on the belief that each company we invest in has an intrinsic value and its share price will fluctuate around that fair value, creating buying and selling opportunities.

I believe that our competitive advantage is our ability to estimate the fair values of the individual securities along with the key variables driving that value. Those variables might be the growth rate, or the amount of capital needed to finance the growth, or the company’s ability to expand its margins through operating leverage, market share, or innovation. We focus on understanding those critical variables, which is crucial for building conviction and identifying potentially mis-priced assets in the marketplace. It is also important to note that we approach buying the stock as if we were buying the entire company.

This is an international fund and we’re looking at all the non-U.S. markets with a focus on the developed markets in particular. Our benchmark is MSCI EAFE, which includes most developed countries in the larger international universe.

Q: What is your valuation approach and why do you believe in it?

A: A primary valuation tool is discounted cash flow analysis, which we do on every single company we invest in. One of the reasons for choosing discounted cash flow analysis is that it represents a common language. Allowing us to cross compare investment opportunities despite all the non-cash accounting differentials in each individual country.

Also, since each stock is a financial asset, the discounted cash flow analysis allows you to derive the value of the underlying company. If you are investing in bonds, you consider the expected dividend stream and its worth relative to the opportunity cost of investing in another asset. If you are looking at a rental property, you would look at the yield and the potential price appreciation of the underlying asset. So we use discounted cash flow analysis because we want to know the underlying worth of the asset.

With the discounted cash flow analysis, you can take a longer-term view and take advantage of the mis-pricing opportunities. Because the short-term view often prevails in the market, many investors are looking at the most recent piece of information. For example, the sales and the margins of an automotive company may go up today. As we know, automotive manufacturers go through model cycles, and sales pick up when a new model is rolled out. If sales accelerate and top line growth leads to margin expansion, people might be willing to pay more for that stock. But a competitor might be coming out with a better product six months later, which cannot be captured in static multiples like the price-to-earnings ratio or the price-tobook ratio.

Overall, we take a longer-term and holistic view and focus on trying to understand the critical variables that allow us to analyze how short-term events affect the underlying worth of the company, and potentially, if future returns may not be recognized by the current static multiples.

Q: Do you establish a hurdle rate for the return on invested capital?

A: Yes, we have a required rate of return for every company, above which an investment makes sense and below which it does not. This is largely determined by where the company does the business. In Japan, for instance, a company can borrow in yen and its hurdle rate is going to be lower in nominal terms than for a company that’s doing business in the United States. So you have to look at companies in the appropriate currency, and then apply a rate to that investment. We also look at their capital structures and their ability to generate cash before applying an appropriate risk premium. For multi-national companies, we blend the hurdle rate for the different businesses and geographical areas.

Q: Would you walk us through your investment process?

A: We believe that blending quantitative and fundamental tools allows us to build a higher degree of confidence in the names that are likely to outperform going forward. Our process starts with scoring every stock in our universe, which consists of more than 2,000 names, on a quantitative basis.

The universe is broken down by individual sectors and we use historic metrics to decide which names look attractive in terms of valuation, earnings quality, and potential catalyst metrics, such as price and earnings momentum. In that way we decide which names potentially might outperform or look attractive relative to the rest of their sector.

Then, our team of 20 dedicated analysts looks at the names on a fundamental basis. Through discounted cash flow analysis they evaluate the most attractive stocks in the sector from a valuation standpoint. This fundamental analysis is entirely forward looking because it’s a projection of their future cash flows versus the amount of capital they have to invest to generate those cash flows, while the quantitative approach is primarily backward looking.

Q: What is the rationale behind combining the historic with the forwardlooking view?

A: With over 2,000 stocks in our universe, we believe, this approach actually increases the probability we can identify a specific selected name that will outperform going forward, and that is our ultimate goal. We want a portfolio where every name has a reasonable probability of outperforming, with no name overwhelming the performance. That means that we wouldn’t take a significant bet on any one of those stocks. In our process, every stock goes through a process examining the investment thesis and the probability it will outperform over time. The more points of confirmation we have, the more likely it is we are to select that name for the portfolio. So it’s a series of probabilities.

Q: How is your research process organized?

A: We have analysts located in Boston, London and Tokyo, as well as emerging market analysts. They all have their sector expertise, which means that we have technology, healthcare, consumer, and financial analysts. Each of them has a fundamental framework and looks at factors that typically lead to outperformance within the specific sector. They score all the names they actively follow within their sector on their fundamental framework, and then do more analysis on the most attractive names.

We actually have analysts managing about 10% of the portfolio through sector sleeves, and the analysts are incentivised and measured against their performance within their sector. They are motivated to own the performance of the portfolio and to make the same determination about the best risk-reward returns in their sector as a portfolio manager does for the overall portfolio.
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