With more than a century of history behind it, Merrill Lynch has a string of firsts to its financial – as well as moral – credit. From hiring the first woman bond salesperson to being the first on Wall Street to issue a financial report, to naming Stanley O’Neal as the first African-American president of a bulge-bracket financial services company. Perhaps relevant to these testing times, Charles Merrill was noted for bucking the tide of euphoria leading up to the 1929 crash. Merrill Lynch’s global reach was enhanced when it became the first major financial services firm to enter China, following its entrance as the first foreign firm on the Tokyo Stock Exchange.
Merrill Lynch manages over $1.6 tn in total client assets. Its asset management arm, Merrill Lynch Investment Managers (MLIM), has a worldwide staff of nearly 4,000 (including over 900 investment professionals in 22 countries) who manage over $533 bn in assets for individual and institutional investors. Clients include 31 central banks and government institutions, half of the top 100 UK corporations, 28 of the top 50 Japanese corporations and 133 of the 500 largest corporations in the MSCI World Index.
‘This has been a very good period for us,’ confirms Hannah Grove, head of marketing for MLIM Americas. ‘Barron’s has us in their top quartile of fund families and more than 74 percent of equity assets under management have beaten their Lipper median.’ Grove has no reason to doubt continued success: ‘Our product range is wide enough to allow us to shift focus towards funds more suited to market conditions. So, for example, the last five years have been a growth market. But we can now shift our focus towards the range of value products, if that’s appropriate for a client’s portfolio.’
MLIM’s global CIO, Bob Doll, and Brian Fullerton, head of risk management, have spent the last few years integrating various research and risk-management processes. ‘They are in constant touch with all our offices about what’s happening in portfolio construction, benchmarking and research, so there’s a real sense of integration about what we do. Each portfolio manager manages their fund with a style and discipline that’s all their own,’ Grove explains. ‘But they partner with the risk management team to ensure that the fund is operating as it should against a peer universe and its stated objectives. For instance, a relative value fund would be analyzed against peer funds, using characteristics appropriate to relative value investments.’
Small cap hunter
Ken Chiang is one of MLIM’s asset managers with citations for his global small-cap fund ranging from Forbes to Barron’s to Valueline. He explains how stocks change hands under the MLIM umbrella: ‘Each group determines what and when they want to buy. One may be buying as another is selling the same security. But we do confer, and spend time with each other. We see the runs on what people are buying and selling, so we can double-check why a growth investor may be interested in buying something that we find very dear, or why value investors are buying something that we think is about ready to explode. It creates a nice intellectual and creative environment for people to compare notes and make their best investment decisions.’
After spells with IBM and Wharton, Chiang began working with MLIM ten years ago as a research analyst in emerging markets. He left for a year to start up a mutual fund company – a hedge fund in the Far East – which, he candidly confesses, was badly timed because of the Asian crisis. That helped him make up his mind when MLIM invited him back to take over the global small-cap fund in which he currently nurses some $550 mn in assets. ‘You have to be idiosyncratic to be a fund manager,’ he claims, adding that he is in the bearish minority on the overall economy. That is, except for emerging markets, where he’s more in the bullish camp. ‘In fact I’m not aware of anyone else out there talking about emerging markets. To most people it’s a horror show they escaped from four years ago.’
On the macro side, ‘The world is clearly slowing down, and we’re coming off the hangover from a severe asset bubble created off the internet boom and off the stock market boom that started in the 1980s. We feel that may be a problem in the future, since there’s not that much more room to cut interest rates.’
In a difficult period, most corporations usually look to make further cuts, to streamline, Chiang notes. But times have changed: ‘At this point, operating margins are already high at many companies because of aggressive cost-cutting over the last decade, so there isn’t much room for reducing expenses in this part of the down cycle.’
Chiang has no sectoral preferences, but he does have biases against weak managements, companies that don’t have leadership positions in their peer group, and companies that are trading at very high valuations. Describing his fund as Garp (growth at a reasonable price), he fine-tunes the definition: ‘We tend to buy on the higher side of value, sell on the cheaper side of growth.’
Land of opportunity
Despite his bearish outlook on the global economy, Chiang is optimistic about investment opportunities: ‘We can always find companies that are growing in any type of economy, especially since our universe of investable companies comprises a large group. There are some good opportunities in the emerging markets, which have experienced the equivalent of the Great Depression for the last four years, particularly in Asia. And just from a normal recovery – even if the world economy just muddles along – markets like Thailand, Indonesia, Korea are undervalued and have substantial appreciation potential.’ To that list he adds Latin American markets such as Mexico, Brazil and Argentina which, he admits, are heavily leveraged into the US. ‘But the good news is that they have been hit badly because of Argentina’s problems. So you are coming from a very low base.’
Nevertheless, Chiang tends to focus more on the best companies he can find around the world, rather than making investment decisions based on geography. ‘Our geographical dispersion is more a by-product of the quality of the companies we find around the world.’
In the US he sees some opportunities with companies involved in transaction processing, outsourcing and human resources. The reason? Big corporations will increasingly try to off-load their less profitable back-office functions, such as systems management and accounting. He also sees prospects in the cyclical companies, pending possible economic recovery.
To identify stocks, Chiang’s first stop is Bullseye, MLIM’s in-house research tool which pools third-party and in-house research from all over the world into one centralized computer system. ‘We spent a lot of money developing it,’ Chiang admits. His team of four analysts, who, he says, scour the world for small-cap opportunities, can also leverage research from other MLIM analysts worldwide.
The US proportion of the fund varies within a 30-60 percent range, depending on market conditions. It’s a big variation, Chiang cheerfully concedes. ‘But that’s what I’m paid to do, right?’ he says, putting the current proportion at around 43 percent. For his purposes, ‘Small is between $100 mn and several billion dollars in market cap,’ but he identifies the fund’s ‘sweet spot’ as between $500 mn and $2 bn. ‘America’s historical legacy of entrepreneurship presents a constant flow of innovative small companies, like Microsoft two decades ago.’
Globalization means the fund does not worry much about whether to go for ADRs or overseas purchases. ‘Our preference is to look for the most cost-effective way of gaining access. We prefer to buy an ADR if it trades at a discount, since the commissions are less and there are no foreign exchange costs. However, if the local shares have much better liquidity, then we prefer to buy on the local board.’
Chiang on IR
There are 15,000 companies in Chiang’s investment universe, so that leaves him plenty of room to be picky, and he relies on good investor relations skills at the companies in his portfolio. ‘The quality of IR has improved on a global scale, especially in most of Asia and Europe,’ he comments. ‘The concept that shareholders are very important has taken root even in many emerging markets. Firms which may not have placed an emphasis on shareholder communications in the past have now hired in-house IR professionals or taken on consultants.’
‘We try to get to know management and understand them, which is a critical component of our investment style,’ Chiang continues. ‘Smaller-cap companies are very dependent on the quality of management compared with larger-cap ones, given their stage of development and the influence that management has on their success or failure,’ he explains. ‘Larger companies have institutions and procedures that typically stop any single manager from destroying the company, while in our size range it can make or break the company,’ he explains.
Hence, the importance of ‘establishing a relationship with the management, understanding what drives them, and seeing whether or not that fits into our parameters,’ notes Chiang. He says he prefers to talk to a company’s chief executive or chief financial officer, but finds that a call to the IR department usually provides the basics and helps set up the meetings.
‘Essentially what we are looking for are managements that know how to create economic value higher than their cost of capital. We steer away from management that is driven by news and events and what they perceive the market wants to hear.’
This is not a comment on IR departments, he explains, ‘but on the managements themselves, who establish the criteria by which they improve their stock performance.’ Chiang radiates a strong degree of skepticism about current trends, warning that shareholders and managers are so completely aligned in their focus that the manager/owner interests outweigh the creation of value. ‘In theory, most of the time, management will create value, which will increase earnings and increase shareholder value. But I think we have come off an era where manufacturing earnings, or creating a perception of positive information flows, also drives stock prices.’ He does not blame management, but the investors who have rewarded such behavior.
Cold analysis
Ken Chiang looks carefully at his investment choices. He goes on site visits, meets management at conferences, and ‘once in a while management will come through and visit us. After a visit we’ll stay in touch through quarterly conference calls as needed, and we will call them if we have issues.’
He is responsive to cold calls, which come especially from Europe and the US. ‘The most important aspect of our business is to have an open mind. Before seeing a company we’ll take a quick look at the financials, and if the fundamentals look awful, or the basic business is not one we’d be interested in, then we’ll probably just decline the offer. However, most of the time, it is very worth our while to hear what they have to say.’ However, as he adds laconically, ‘The second go-round, we may not be as open.’
The calls come from IR departments or third-party IR service providers, and of course from brokers. But not all IR firms are equal. ‘Often the smaller companies can’t afford the quality IR or PR firms that the larger companies have, so sometimes we have less qualified consultancies come through, or less qualified PR. If the pitch material was presented better, companies would be better-served overall.’
He is also wary of IR overload. ‘Often information flow is too heavy. The IR department should provide enough information for the investors to make an informed decision, but I don’t want them to be overly proactive and bombard me with e-mails and faxes all the time.’
Chiang concludes: ‘The better IR departments have a senior IRO who has been involved in the business and had a prior life in either the financial controller’s office, strategic planning or at the board level, rather than a hired gun they’ve brought in from outside with little or no industry background. And his next job will be a promotion.’ Amen, say the IROs.
