Macquarie builds from the bottom up

With $20 billion under management, half of which are retail funds, Macquarie Investment Management has been staging a performance comeback over the past year. Zilla Efrat examines what has brought on the turnaround.

Little more than 18 months ago, Macquarie Investment Management's Active Equities fund was anything but active.

Hamstrung by its committee-based approach and a complicated five-factor investment model, it took some losing bets which left it languishing near the bottom of the performance tables.

Things began to change, however, at the end of 1997 when Macquarie lured Greg Matthews away from Mercantile Mutual to head its equities team.

He bounced onto the scene with a new investment model. He also restructured the investment operations, moving people around and creating a special asset allocation team. And, he launched two new funds: the Small Companies Growth Trust and the Leaders Imputation Trust.

Matthews' efforts have started to pay off. Macquarie's numbers were hammered by the Asian crisis in June last year, but since then, they have been climbing rapidly up the rungs of the performance ladder.

A key reason is Matthews' introduction of price for earnings growth (PEG), a model he previously launched at Mercantile Mutual with much success.

While not widely used in Australia, the model is big in the US where it is also known under acronyms like GARP (growth at a reasonable price).

PEG is a bottom up approach which takes both earnings growth and price to earnings (PE) ratio into account in stock selection. It is seen as appropriate at all stages of the investment cycle and is based on the belief that shares that are cheap compared to their growth prospects will eventually go up in price.

"Growth managers will pay any price for a good stock. Value managers will buy any stock just because it is cheap. I am trying to balance up the price I am paying with the growth I am getting," says Matthews, who was made Macquarie's chief investment officer in March.

The process starts by looking at about 300 stocks, or about 95 per cent of the market in terms of market capitalisation. It ranks each share in terms of how much it is worth and how much faster or slower its earnings are growing compared to the rest of the market.

Much of this entails a comparison of PE ratios against consensus earnings' forecasts of analysts from 12 stockbroking firms as well as from Macquarie's research team.

Much of the legwork, however, is done by computer, making use of what Matthews describes as "top notch" information technology from Macquarie Bank.

Indeed, one out of six people in the bank are IT people and the ratio even is higher in the equity department: three quantitative experts in a team of 16.

The result of the behind-the-scenes number crunching is a continual stream of green and red flashes - or buy and sell signals - on the computer screen.

Matthews says these are just part of the process, not the end. The signals highlight which shares need to be examined further in terms of other factors like balance sheet strength and management stability so that the Macquarie team can put together a portfolio of anything up to 100 stocks.

"Its all about filtering out the noise and trying to make sense of the myriad of things that come in every day," Matthews says.

"Everyone says that people should be buying low and selling high, but most people are naturally inclined to do the opposite, especially in a panicky market.

We try to keep a cool head by using this process."

The process has left Macquarie currently overweight in base metals and building materials with stakes in companies like MIM, Pasminco, CSR, Boral and James Hardie.

It is underweight in leader stocks such as Brambles, Lend Lease Corp, Telstra and News Corp at present.

Rating agency Morningstar has given Macquarie's PEG style a positive trend

rating.

"Although the style is comparatively new to Macquarie and has yet to prove its long term worth, the sector head has implemented the style successfully elsewhere and is strongly supported by Macquarie," Morningstar says.

Macquarie's bottom up approach is overlaid by top down economic analysis and Macquarie's asset allocation process.

Asset Allocation is done by a full-time team of five under executive director Wayne Fitzgibbon and by using a process which is unique in Australia, but similar to that used by US economist Woody Brock.

The process, which Matthews describes as "a forward look at risk", involves compiling probability trees with branches for the key drivers of each asset class.

These come up with the possible return and standard deviation for each possible outcome and enable the team to identify gaps where there has been mispricing in the market.

According to Morningstar, the process is one of Macquarie's strengths. "The style forces the house to confront consistently the question of the market versus the house view and cyclical versus structural diagnosis," it says.

Macquarie's international equity selection is outsourced to specialist regional managers.

Property investments are done via listed securities and are managed in much the same way as equities. However, instead of using PE ratios in the PEG model, Macquarie uses yields.

When it comes to domestic bonds, Morningstar says Macquarie is an active duration manager that takes advantage of trading opportunities.

"Macquarie operates to an unusually short (three months) investment horizon, believing that a longer term focus will not allow a manager to take advantage of the opportunities available in the volatile Australian bond market," the research house says.

Across all asset classes, Macquarie's investment philosophy is based on the premise that markets are inefficient.

"We also believe that we can only add value if our view is different to the market consensus. If our view is the same, we will be close to the index," Matthews says.

He adds that all investments are guided by Macquarie Bank's loose-tight philosophy.

This involves setting a tight framework with a clear philosophy and strong risk control from the top and then allowing managers to get on with doing their jobs.

"We set the outer boundaries, but within this we allow our people to own their products. We give them the power and confidence to make decisions and then make sure that they are responsible for their actions," Matthews says.

Despite all the steps already taken, Matthews still has plenty to keep him busy.

Projects under development include a quant fund and a mispriced convertibles securities fund.

A tactical asset allocation product, which could lead to a new thrust in Macquarie's business, is also being considered.

And, of course, Macquarie has set its sights on becoming a top quartile performer. "I've done it before and I plan to do it again," Matthews says.