With the financial system nearly collapsing and the recession reaching unprecedented levels, it is something of a challenge for the investment community to find returns in a very uncertain market. One style of investing well placed in the current turmoil is thematic investing. It builds an investment portfolio and ‘theme’ from analysing the political, economic and social environment. For example, ‘more government’ is a major theme currently within thematic investing because of the on-going involvement of government in the market.

Philip Collins, investment director of the private management arm of Newton Investment Management, explains: “How I define thematic is: a change in economic behaviour.We try to identify changes in economic behaviour and then that is what we term a theme.”

Stewart Newton chairman of Veritas Asset Management, adds: “To decide on thematic investing you have to look at the key drivers in the world economy. It comes from a strategic outlook, which will generate capital appreciation or added value through higher dividends.” “It is the identification of dynamic global trends which stimulate corporate earnings growth, and drive stock price outperformance over a business cycle,” comments Christopher Lindsay, head of thematic research at Sarasin.

Filtering process

The themes, not the investments, come first. Charles Richardson, chief executive of Veritas Asset Management, says: “We seek to identify, as companies themselves do and as fundamental investors do, the future drivers of growth and performance. These we call tailwinds. One example would be our theme of ‘serving the national interest’. In the current environment, commitments by governments to support development through fiscal spending will become highly relevant.

“In this respect there is no better example than China with the fiscal firepower and policy intent to continue to drive growth forward. China’s urbanization programme and infrastructure spending may suffer short-term challenges but is an established medium-term trend.

“We seek to get ahead of these tailwinds and have a number of companies we follow closely to gain entry points to their equity. It may also be the case that when analysing economic, capital market or industry context we identify serious headwinds. These in themselves can help our filtering and investment focus by ruling out opportunities that face adverse change, creative destruction in their way, a disappearance of their ‘moat like’ characteristics or new competition.”

Growth of thematic

Twenty years ago, coming out of the major stock market falls of 1987, Richardson identified themes as a central part of his investment approach. He says: “However, in using that sort of terminology you were asked to explain yourself. It was not part of the accepted lexicon of the asset management business. At that time, typically, many prospective clients or their advisors wanted to know about the four Ps: philosophy, people, process and performance.

“They expected some peg to hang you on, value, growth, regional focus and so on, and they were being preached [at the time] the religion of passive indexation. There were some clients who saw the wisdom in being less influenced by index driven thinking and more by themes in the business world: it made intuitive sense to them.”

Today ‘thematic’ appears everywhere: common usage but still, not necessarily a common language or interpretation. “Once again, one is obliged to explain oneself to clarify the fog of marketingspeak: and rightly so,” says Richardson.

Importance of research

Narrowing the investment universe and using focused research is a key part of thematic investing.

Richardson says: “As Keynes pointed out, investment is an activity of forecasting the yield on assets over the life of the asset; speculation is the activity of forecasting the psychology of the market.”

Collins explains how research fits into the thematic approach. “We do thematic research, looking at this and that and then we say that is the theme done and then give these to our investment analysts who start from the investment side.We then say: this is how the world is going to change, and our observation of trends is as follows, so you Mr Banks analysts should go away and tell us which banks to buy and not to buy, based on that view the world,”.

Sarasin’s Lindsay adds: “The power of our approach is more in the process than in the theme. By this we mean that selecting a share that passively expresses a core theme is not enough to ensure outperformance. Instead, considerable alpha is added by the way we identify the most robust candidates, with the best potential, from within each opportunity set.”

On this basis, a number of themes can be developed. Newton Investment has 15 themes at the current time. There are two investment themes Newton started at the beginning of the credit crunch. The first was ‘debt and credit’; which focused on the unsustainability of the growth of credit witnessed in developed economies in recent years. The view being that the decline of inflation and interest rates over the last quarter of a century triggered what Collins calls a ‘super cycle’ of credit growth which boosted economic activity in the west. It extended the economic cycle, but left developed world households, corporations and administrations increasingly indebted. This contrasted with the developing world, where households and, increasingly, corporations took on significantly less debt.

Theme two was ‘becalmed’ which focused on financial market behaviour, observing that developed world borrowers, lenders and investors had begun to behave as though the economic cycle had been abolished. This gave rise to new excesses in risk taking which pointed strongly to the likelihood that the credit cycle was nearing its peak in the western world. “That was more of a warning theme: to avoid certain things, rather than go towards certain things,” says Collins.

New themes

What is coming out of the recession now are four new themes. The first, ‘all change’, is a concept that the last five to ten years have not been normal. Thus, the crisis in credit markets is marking an important turning point in a number of areas: the growth in credit in general, asset prices, concepts about balance sheet efficiency, financial earnings, consumption trends and economic growth. The broad question implied by the theme is what a world with less and more costly credit will look like. “We are now back to normality: a move from leverage to thrift,” says Collins on this theme.

The second theme being ‘more government,’ says that the capitalist system has been under a lot of stress and even failed in a number of cases. “The government is expected to step in and spend money on infrastructure resulting in a government that employs more people, and steps in and almost runs the system. It is set up for the government to be involved in the running of the economy,” says Collins.

Lindsay agrees, and Sarasin are following this approach. “Government will loom larger in the economy, and will direct national savings toward national projects, hence our new focus on ‘national champions’. Nurtured by the Government, and given preferential access to capital, the national champions will be the instruments of job creation and the development of new national core skills. Names such as Petrobras, Gazprom, CCC, EdF and Areva stand out.”

New environment

This trend combines Sarasin’s recent work on a new core theme, the ‘strong get stronger’, which values sector ‘gorillas’ which also have an ability to selffund and display a superior degree of control within their business system. The trick is to find companies, favoured by government, who also have the strength and freedom to price their business correctly.

In the new environment, Sarasin are nervous of any businesses which it feels governments will seek to milk: banks and telcos, or hijack as auxiliaries of national policy in order to supplement the tax base. The third theme for Newton is ‘uneconomic growth’ relating to the distorting effects of currency pegs, price controls and subsidies on key global prices. The view being that a significant proportion of global economic activity is currently being distorted by the fixing of key prices, such as exchange rates, energy, food and utility prices, and by mispricing of others, such as environmental inputs, principally in the developing world. Fourth is ‘constructions and reconstruction’ highlighting the “megatrend” in global infrastructure.

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