Robert Macrae outlines the thinking and strategies that go into the Arcus Japan Fund.
Robert Macrae, CFA, is a managing director of Arcus Investment Limited. He has spent the last fourteen years in the hedge fund industry, applying engineering concepts of robustness, reliability and problem- solving to systematic value investment. Robert has a degree in Electrical Engineering from Imperial College.
HW: What is the background to the fund?
RM: Arcus Japan Fund (AJF) has been available to Japanese retail investors since March 2005 and opened to international investors in February 2006. AJF is managed by Arcus Investment Limited whose founders are Robert Macrae, Mark Pearson and Peter Tasker. AUM for AJF is approximately USD 95 million and for Arcus as a whole approximately USD 930 million.
HW: Why should investors be looking at Japan?
RM: The long, brutal bear market has ended, leaving domestic investors suspicious of equities and holding cash and bonds. It is striking that the recent rise has been driven almost exclusively by foreign buying, which makes us bullish because the most important potential buyers are still on the sidelines.
Last year's rise of 43% is obviously demanding, but is supported by a major improvement in corporate fundamentals. Companies have cut leverage and costs, taking profitability to an all-time high, without any support yet apparent from their domestic consumers. As we come out of the deflationary effects of the cost cutting we could well see further improvement in earnings.
We have also seen a complete change in the dynamics of corporate governance, with a group of buccaneering takeover-artists shaking up management just as they did in the early 1980s in the US. Couple this with stocks that are arguably still as cheap as they were in the 1970s and the next five years should be a extremely interesting time to be in Japan. We want to be fully invested.
HW: Who are your target clients, and how do you distribute?
RM: There are lots of different reasons for investors to seek exposure to Japan, so AJF is intended to appeal to a wide variety of investors. In Japan a retail class is distributed by Mitsubishi UFJ Securities Co. Ltd. to individual investors. We also anticipate interest in the institutional class from existing hedgefund clients seeking to increase their market exposure to Japan, and from the wide range of institutions that are seeking liquid, performance-oriented investments in Japan.
HW: What is the investment process?
RM: In big-picture terms, we are bottom-up value investors, and our process has remained essentially the same since we set up Arcus seven years ago. The fund will hold undervalued stocks ranging from classic deep discount value stocks, through low P/Es through to GARP and undervalued new economy stocks. What is cheap is always changing, which is why a value approach is useful. At present many major companies appear to trade well below the value of their strong franchises. It is not that stocks like KDDI and Nissan are unfamiliar to investors, but just that they would rather pay up for riskier recovery names. In our opinion this preference is unusual, and unlikely to persist for very long. The numbers suggest that good returns will be available during any reversion towards a more normal preference for strong companies, and smallcap underperformance during the first quarter suggests that the process may already be starting.
In detail, our process has always been very conventional. We rank companies in order of attractiveness, based on the numbers. Obviously we make various adjustments, but the key elements are standard accounting ratios such as P/E and P/B. When companies appear attractive we will look in greater detail, and usually visit. Of those we research we buy approximately half.
What distinguishes our process from that employed by untold thousands of long-only managers is our willingness to back our conclusions even when they are far from consensus. We aim to make money by betting that the numbers are right and the market is wrong even when, as at the moment, most market participants are very confident that there is a new and better game in town. We are not much swayed by trends, themes and fashions. Betting against the 'Latest and greatest' is how we make money.
HW: How do you generate ideas?
RM: Ideas come from many sources. Mark Pearson, Peter Tasker and Takaaki Haruki are based in our Tokyo research office, and obviously most ideas come from them. The systems are also good at generating ideas: if a stock is cheap and getting cheaper it is worth finding out why. Often the reason appears irrational, and a trade is born. Finally, we monitor news and broker research. Broker recommendations are of uncertain quality, but reports contain a mass of good factual data on the larger companies.
However, new ideas are just part of the picture. Our holding periods are quite long, often a year or more, and just as important as the quality of the ideas is the patience to see them through. Value managers are always too early, both in and out, and we work hard to control this tendency.
HW: What opportunities are you looking at right now?
RM: We have liked the major car companies for some time, and Toyota was one of our successes last year. Now Nissan and Honda look even cheaper as both trade around half the market PE. We think that their businesses are quite promising over the next few years. JFE is Japan's largest steel company, and also the cheapest at around half the market valuation. KDDI has a PE around two thirds of the market and is an obvious beneficiary if consumer spending increases. These are substantial companies, and it a measure of investor enthusiasm for speculative and distressed stocks that we find so many large, solid companies trading cheap. We haven't seen anything like this since the early nineties.
HW: How do you manage risk?
RM: Risk control is at the portfolio level, and we do not use stoplosses. We use the same proprietary process for all our funds, which attempts to make robust forecasts of the marginal contribution that each stock in our universe makes to fund risk. In other words, it forecasts how many cents we add to our risk budget if we put one more dollar into the stock. This is a 'Day Zero' approach. Risk is a tightly integrated part of the investment process, and it happens before we ever put on a position. This helps us to size positions, to set reasonable targets for the funds' risk exposure and to reduce transaction costs.
In AJF our objective is absolute return. We see this fund as offering exposure to Japan Inc and the fund should do well if, as we expect, the market performs well over the next five years. In terms of setting overall risk targets, we are following the same mandate as Arcus Leaders Fund. From inception six years ago Leaders has returned 97% absolute, outperforming Topix by 70%.
As a guide to scale it is reasonable to think in terms of most stock positions being under 5% and most sectors being under 10%. It is always expensive to be forced onto the back foot in risk control, so we focus on the things we can do to control risk before we trade, making robust forecasts and avoiding excessive concentration.
We think and talk a lot about risk control, and perhaps it is worth explaining why because investors sometimes miss the main benefit-if you do a good job on risk control, it allows you to be more aggressive in your stock picks. When the odds look good we cheerfully hold companies that are distinctly risky, or badly out of favour. Strong control lets us run positions other managers might have to cut.
HW: How has performance been?
RM: 2005 was dull, certainly as compared to our strong performance of 2003 and early 2004. This is partly because much of the rise in the market has been driven by some companies and sectors that do not fit with our disciplined value approach. For example, we don't fall in love with positions and are happy to replace winners with more attractive alternatives. Usually this is good policy but recently returns to momentum have been unusually high. Looking back at this period we have clearly been selling winners too early but we don't intend to change. It is usually a mistake to chase last year's trade and 2006 seems to be developing a distinctly different character, perhaps more suited to our analytic approach.
The dull patch also reflects a lack of big wins in our major bets. We have made money on plenty of positions, but our currently key positions are that large, strong, well-managed, cash-generative businesses should do well. This proposition doesn't sound too remarkable, but in 2005 it was not right. Investors did very much better in some risky, over-leveraged, distressed companies with a chronic inability to make a return on their assets.
It is worth looking at recent returns in the context of our strong track record over seven years and through a wide variety of market conditions Value is a well-established inefficiency. It doesn't seem to have changed all that much on a timescale of decades so we don't anticipate making major changes over the next few years.
HW: What differentiates you from other managers in your sector?
RM: I think the first question is, what is our sector! The "Long Japan" space is vast, and within that we look like a very aggressive, very analytic manager, charging a fee structure that makes sense only if we continue to outperform. However, it is perhaps more helpful to look at the emerging sector of skill-based long funds managed by hedge fund managers, because these all fit a similar description.
Any performance-oriented manager should be judged largely on track record. Our oldest hedgefund, AJLSF, has returned 237 % since inception in April 1999. We also have a substantial track record in long-only funds. As mentioned above, Arcus Leaders Fund has returned 97% and beaten Topix by 70% since inception in September 2000. 12.9% a year is not bad for an unleveraged Yen fund.
Most of the differentiation is there in the track record. To us it suggests reasonably consistent performance through both strong and weak markets and through many different market environments. Few other managers have managed both long and long/short money in Japan as long and as profitably as we have.
HW: Do you have any plans for further product launches?
RM: No. With AJF we have a range of Japan funds spanning the large cap and small cap long-only space, as well as hedge funds. We take capacity constraints very seriously, so once we take AJF to a comfortable size we will close it. We don't plan any further launches at all.
(Robert Macrae was interviewed on 22 May 2006)