Tiffany Lavastida is a portfolio manager for Principal Global Equities. She is a portfolio manager for the firm's global, international and Europe +
Tiffany Lavastida is a portfolio manager for Principal Global Equities. She is a portfolio manager for the firm's global, international and Europe +
711 High Street
Des Moines, IA 15222
Q: What is the history of the fund?
The mutual fund was launched in June 2014, but the strategy has been in place in its current form for 15 years. At Principal Global Equities, we have been managing international small-cap strategies since the end of 1994 and our current process has been in place since 2003.
I joined the team in 1997 and was named co-manager in 2006. Brian Pattinson became a portfolio manager in 2001 and we are co-managers of the fund.
Currently, the majority of our assets are in developed markets outside of the U.S. We have a separate emerging market team, which handles the frontier and emerging markets, but the mutual fund focuses on international developed markets outside of the US.
Q: What core beliefs drive your investment philosophy?
A key feature of the fund is that it is a core strategy by design. It isn’t meant to have excessive style biases in terms of deep value or aggressive growth; we simultaneously deliver both growth and value.
The strategy is driven by a pure bottom-up approach. We are aware of the macro factors but we don’t have a macro-driven process, so we don’t make bold calls on interest rates, oil or gold prices. We are fully invested and the outperformance comes from differentiating companies within sectors and regions, not from sector or region calls.
We recognize that there is a distinction between a good company and a good investment, and that leads to a concept that we refer to as a ‘fundamental change.’ We are earnings-based investors who embrace principles of behavioral finance.
We believe that there are market anomalies due to the tendency of market participants to underappreciate the potential value of change. With that in mind, our stock-selection approach focuses on capitalizing on these inefficiencies. We achieve that by identifying companies with sustainable fundamental change, expectation gap and attractive relative valuation.
Finally, we believe in a strategic and a consistent approach to portfolio construction, whereby we build well-diversified portfolios with minimal systematic risk exposures.
Q: How does that philosophy translate into an investment strategy?
The goal of our process is the early recognition of positive fundamental change. We apply the distinction between good companies and good investments by identifying companies, where sales growth is increasing and/or profit margins are expanding. These features signal a potential sustainable positive earnings trend. The underlying driver of the change may come from market share gains, new product cycles, cost cutting, or even from an improved and more efficient balance sheet.
We look for situations, in which the current market expectations do not fully appreciate the magnitude of possible future change. The expectation gap is the difference between our estimate of a company’s earnings potential and the prevailing consensus expectations. We analyze recent earnings revisions and look for underlying change drivers that can deliver further positive surprise and close the expectation gap. Understanding the biases of sell-side consensus estimates gives us an opportunity to get ahead of the curve.
We consider valuation to be our anchor to reality and we focus on relative valuation, because we don’t want to overpay for the strong fundamental change characteristics. The companies that trade at unattractively high multiples often already completely factor in the expectation gap potential.
Q: Could you describe your research process?
There are two components of our process. First, we have a team of dedicated analysts and, second, we have a proprietary stock ranking tool. We start with our Global Research Platform, or GRP, which is our proprietary stock ranking tool. The GRP provides a consistent comparative framework for measuring the relative attractiveness of all the companies in our large universe.
We rank our entire universe weekly from 1 to 100 based on the key drivers of fundamental change and relative attractive valuation. The ranking process is efficient and effective; it represents an objective, unemotional tool, which helps our team to prioritize their efforts. Our analysts focus on the stocks, which rank in the top quintile, because this is where the largest alpha potential resides.
We develop multi-factor models based on regions and sectors to determine which of these stocks have positive fundamental change at attractive valuation. The analysts use their industry and regional expertise, along with company due diligence, to identify the existence and the sustainability of positive fundamental change that is underappreciated by the market.
The GRP and our fundamental analysis serve as important checks and balances to each other. The analysts look at the top quintile of stocks to pick out the companies with positive fundamental change. Conversely, when the trend in our favored companies begins to moderate or when companies we’ve been avoiding start to show early signs of life, the ranking process points in the direction where the analysts should spend their time. As new companies begin to drift to the top quintile, we are forced to look at them.
Changes in the rankings would prompt a review to make sure that the initial thesis is still in place. When a company starts to deteriorate in rank, we don’t want our analysts to get caught up in behavioral biases, such as favoring a company because they just met the management or because Wall Street is talking about that company. Our analysts would have to examine the companies to make sure that the fundamentals are in place and that valuations have not caught up with the fundamental change.
Q: What is your sell discipline? When would you sell a stock?
We would sell a company if the fundamentals deteriorate, if there are better opportunities elsewhere, or if valuation catches up with the fundamental change. We want the analysts to recognize and identify those signals, and then to assess if that indeed is the case.
Q: Is your multi-factor model based on market momentum or on the business performance of companies?
I would say both. Ideally, we look for an early recognition that something fundamentally is happening to a business or for a change that has not been factored into the stock’s performance. A good example would be a company beating expectations, when we see positive earnings revision and a valuation that has not caught up with the higher estimate. Another example would be a company that hasn’t announced earnings yet, but we see positive revisions that could signal a potential change.
An attractive valuation is a signal that the company might be worth examining, if indeed a fundamental change is occurring. Our analysts use their industry expertise and knowledge of the sector to assess if there is a positive change, a favorable product cycle, or cost cutting and margin improvement.
We have found that the sell-side tends to increase its estimates only incrementally, so our analysts leverage their industry and regional expertise, along with the company due diligence, to identify the existence and the sustainability of positive fundamental change. More importantly, they look for positive change potential that is not being appreciated by the market.
When our analysts meet with a company’s management or talk to the sell-side, they want to understand where consensus fits through sell-side expectations or valuation. If a stock looks expensive versus its consensus estimate, then the buy side is pricing it higher. So, valuation is important in terms of what is being already factored in, or what the market is willing to pay for the future earnings stream.
Q: What type of profitability factors do you use in the model?
It depends on the sector. For banks, we would look at earnings, return on equity, or price-to-book, but that approach wouldn’t make sense for technology companies. In real estate we tend to look at the cash flow metric.
It also depends on the region. For example, we would rank a U.K. bank versus other European banks because they tend to trade similarly, but we would rank a Japanese bank separately. We have found that the drivers for Japanese businesses are different and they tend to be more valuation sensitive.
Q: How do you narrow down your investable universe?
The fund focuses on international small cap but, as a firm, we are global and all cap in nature. Of the 25,000 listed equity securities, our appropriate starting point is about 10,000 of which about 7,500 are international and about 3,500 are international small-cap stocks in developed markets.
We start with the MSCI World Ex US Small Cap Index and then we augment it with about 1,000 additional companies with similar characteristics to the initial universe. That gives us a starting point of about 3,500 companies. After we overlay liquidity on these 3,500 stocks, the result is about 2,000 names.
The next step is the GRP process, which results in selecting the top quintile of that universe. So, our team of analysts has about 60 to 70 stocks per analyst on a weekly basis to look at. The ranks don’t change much on a week-to-week basis, so they have only a handful of new stocks each week.
Our team of fundamental analysts further narrows down the top quintile to a list of buyable candidates through their industry knowledge and by conducting due diligence. The analysts decide whether to meet managements, talk to the sell side, or attend conferences and trade shows to determine which stocks are best suited for the portfolio. Once they find an idea, they are looking for a fundamental change and an expectation gap. So, the analysts conduct their fundamental analysis and then model their own estimate.
If there isn’t an expectation gap, we wouldn’t buy the stock. If there’s an expectation gap for a company with an attractive valuation, they will recommend the stock to the portfolio management team. Then Brian and I discuss the buy idea with the analyst, consider it from a portfolio construction standpoint, and ultimately determine if that company is suitable for the portfolio.
Q: How is the research team organized? Do you often reject analysts’ ideas?
The analysts are broken up regionally and sectorally. I have some analyst responsibility and look at Europe, Canada and Australia, and cover financials, real estate and energy. We have analysts who focus on the Asian and European markets as well.
When an analyst brings forth a technology idea, I am not able to outsmart him on the newest technology trends, because he is the expert. But I would question and discuss the financials of the company, how it fits into the marketplace, the company risk and the analyst’s assumptions. There is a healthy discussion over each new idea. The analysts have been with the team for a long time, so they know what we are looking for and what fits our investment process. That helps to eliminate many companies and alleviates the process of me rejecting ideas because of lack of fundamental change or expectation gap.
Also, the portfolio managers have biweekly sector reviews with each analyst. We see the rankings and discuss the rationale behind new ideas or why they are not looking at a particular stock. That helps to catch something they may have missed or avoided.
As part of our annual review for each analyst, we review how the process has worked in the respective industries and segments, and if the analysts outperformed the process. We analyze if the process was blindly followed or if the analyst added value on top of that. So, while the analysts may not be correct on every single stock, they tend to do better than the process. And as a team, we must outperform our index over time.
Q: What is your portfolio construction process?
Brian and I are the final decision makers for the holdings and the position sizes in the portfolio. I am charged with bringing together the best stock ideas from the analysts and for building a portfolio that with a profile of high active share that meets our clients’ objectives.
The portfolio construction process aims to embrace company risk that we are being rewarded for and to minimize unintended, systematic or top-down risk. That means that stock selection is isolated as the key driver of return. We don’t want to put the alpha generated from stock selection at risk by making top-down calls on currencies, oil or energy prices. Our goal is to limit the top-down exposures.
We manage the country, region and sector allocation within tight bands to the index to avoid putting the alpha generation from stock selection at risk. The bands are plus or minus 5% around the benchmark, more often plus or minus 3% from the benchmark. So, the portfolio can be still be significantly overweight or underweight, depending on where we find bottom-up ideas, but macro calls are not the primary drivers.
We believe that it is difficult to correctly call the macro risks on a regular basis, so we prefer to remove that risk from our portfolio. Instead, we focus on stock selection, because that is what we do well.
On individual positions, we have a limit of 1.5% overweight. So, if a company has 1% weight in the index, our maximum position is 2.5%. On average, the portfolio holds about 200 stocks. There are no limitations outlined in this perspective, so everything is self-imposed and self-managed within our group.
Q: What is the impact of currency on your process?
Although we don’t make top-down currency calls, we are definitely aware of the impact of currency. It impacts our holdings mainly through the earning. For example, in Japan we can either invest in domestic plays, such as domestically exposed banks, or in export-oriented industrial or consumer companies. So we may have some positioning determined by the currency, but we don’t make top-down calls and we do not hedge currencies.
Our research shows that more often than not hedging costs are a big negative residual to portfolios, so we avoid hedging. Instead, we try to get the stocks right. We believe that if we get the earnings right, including the potential currency impacts, we would offset anything we could do from a hedging perspective.
When we buy a company, we invest over a horizon of one to three-years and we know that there will be some currency volatility over that time period.
Q: How do you define and manage risk?
We aim to isolate the idiosyncratic risks a stock would bring to the portfolio. These are the risks that we want to understand and embrace, because we believe that we can be rewarded for them. We minimize macro exposure risks and seek to embrace the company-specific risk instead. We are aware of our exposures and we make sure that we are comfortable with them.
We always consider stock-specific risk and idiosyncratic diversifiable risk. The portfolio consistently has an active share of more than 80%, yet we have relatively modest tracking error compared to our peers. That’s precisely because we take stock-specific risk, but don’t let the variables move around too much. We consider the systematic risk in terms of beta or volatility contribution and we also aim to have good understanding of style factors and style variation risk. The overall beta of the portfolio is close to 1 at all times.
From a portfolio construction perspective, we make sure to avoid leaning too much towards oil price beneficiaries, for example, or towards overly defensive stocks related to interest rates. Our normal neutral position is to have better growth and valuation profile simultaneously, without being skewed towards the extreme left or right of growth and value. Overall, our framework looks at risk at three levels – stock specific, systematic, and style factors.