How to find the next Google: the quest for future stock stars

How can investors make the most of megatrends? At our recent virtual roundtable, several investment specialists discussed upcoming themes in the investment space and provided a glimpse into the intricacies of creating thematic indices.

Panellists:

• Chanchal Samadder, head of product strategy, Lyxor ETF
• Pierre DeGagné, head of funds selection, DBS Private Bank
• Jacob Doo, chief investment officer, Envysion Wealth Management
• Jean-Maurice Ladure, CFA, executive director and head of equity applied research, EMEA, MSCI
• Lukas Neckermann, managing director, Neckermann Strategic Advisors
• Noli de Pala, chief investment officer, Trilake Partners
• Richard Lander, director, Citywire Engage

Richard Lander: What role do thematics play in your portfolios?

Pierre DeGagné: I’m fairly cautious of being overly focused on thematics. In the 20 years that I have been doing this, I have seen many themes come and go. Reason is, many of these are driven by current “hot” topics, but may not be sustainable investment ideas for the long-term.

It is important to identify broader themes that can survive long trends in the markets, while also being flexible enough to adapt to changing trends within these themes. We generally practice a stringent fund selection process, and especially so with thematics – the fund has to give us confidence that its theme is broad-based and can evolve over time, and the team running it must have a strong track record, robust strategy and processes, specialist expertise and long-term commitment to the space.

Noli de Pala: We have been looking at thematics in the past and will continue to do so in the future, especially in the areas of cybersecurity and cloud computing. Yet, it doesn’t drive our asset allocation decision. I try to adopt a quantitative framework, which is based on correlations and reasonable assumptions on expected risk returns. Adding thematics to the mix requires you to do an ex-post evaluation on whether it did make sense to include them or not.

Jacob Doo: We increased the proportion of thematics from 15% to 25%, 5% of which are for private equity deals. The remaining 20% go into ETFs. In terms of themes, we currently focus heavily on 5G and health technology.

Richard Lander: Lukas, do you think you have to go to the private sector to find the real value?

Lukas Neckermann: That might have been true some years ago. Now, we are beginning to see much more activity on the public side. Of course, a lot of companies are still private, but if you also consider their supply chains in your analysis, you will find public companies.

For example, only slightly more than 200 out of the 750 companies in our database on shared electric autonomous mobility are public. But who supplies them? It’s public companies like Nvidia, a producer of automotive chipsets. If you dig a little deeper and do a full value chain analysis, you will find those hidden gems.

Richard Lander: Turning to the product provider side now, Chan, you came up with a series of thematic ETFs. What was the driving force behind their launch?

Chanchal Samadder: Things have changed and investors are looking at their portfolios differently today. Portfolio construction is about more than quantitative and static inputs, with an increasing number of investors now thinking about the long-term nature of their portfolios. How exposed are they to significant changes in the world?

As a rules-based passive ETF provider, we want to help investors allocate by defining the correct themes and capturing them properly. To separate themes from fads, we focused on structural, long-term and impactful forces that are both inevitable and undeniable. Structural forces are very well researched. They include changing demographics, massive urbanisation and climate change as well as resource scarcity and the fourth industrial revolution with its technology breakthroughs.

Richard Lander: Jean-Maurice, you develop and work on the funds’ underlying indices. What happens in the engine room of MSCI when it comes to creating them?

Jean-Maurice Ladure: Our methodology is based on two steps. It starts with the research phase, where we try to capture the theme by breaking it into several sub themes that give us a shortlist of key words. For example, we would break up ‘digital economy’ into online payments, cybersecurity and ecommerce. Obviously, this list is too short to select stocks, so we need to enrich the dictionary of keywords.

This is where data science and natural language processing come in – I will try to keep it intuitive. Similar to the process of googling keywords, they allow you to find other documents on the internet that are clearly related to your search terms. We analyse those documents, extract additional keywords and counter check them with the initial ones. Input from our panel of experts enables us to keep this list of keywords relevant.

The second step refers to the more rules-based index construction of identifying relevant companies. When we are selecting stocks, financial materiality is one of the main criteria. We want to get stocks that are making most of their revenue from the theme we have in mind. Our approach is two-folded: first, we analyse the filings of companies to assess what percentage of their revenue can be directly linked to the theme itself. Second, we focus on the business description of the company and try to capture the full value chain.

Richard Lander: How does that work out in practice?

Jean-Maurice Ladure: Our methodology enables us to screen over 9,000 stocks against a specific theme. For us, only companies that can link at least 25% of their revenues to the theme are eligible. This is also the case for Lyxor’s thematic ETFs, though we observe that in practice, most companies have over 75% of their revenue directly related to the theme.

After applying several liquidity and ESG filters, we end up with a number of 60 to 250 stocks, which are reviewed every six months. We put them on an equal footing before applying a tilt based on the growth of the business.

The ability to be unconstrained is key.   We’re trying to build the indices directly from the theme itself. Take the future mobility index as an example. Only a quarter of the index is based on automotive stocks, the other three quarters are coming from technology, industry and materials.

Richard Lander: Lukas, how revolutionary do you think trends like future mobility or smart cities will be in the next few years?

Lukas Neckermann: I’m really pleased about the attention they are getting. I have been dealing with topics like future mobility ecosystems and smart cities for the last seven years now and to see that the investment industry is taking such a keen interest in them makes me happy.

Future mobility is basically a shift from one old value chain and set of ecosystems to a completely new one. For example, lithium mining might not have been important for the auto industry in the past, but now it certainly is.

Unlike future mobility, the concept of smart cities has been around for much longer. There have been good and bad examples of smart cities, where someone usually took a plot of land and said, let’s throw billions and billions at it and build something new. The bigger transformation is what is happening now, with cities fighting to become more resilient. Of course, this is also a byproduct of Covid-19.

Cities compete with each other for businesses, residents and investment. To win that race, they have to get smarter and companies that are able to drive this transformation will have an advantage.