Taking a systematic approach that relies on company valuations allows investors to combine active and passive elements into a well-diversified, cost-effective portfolio, Avantis’ Eduardo Repetto says
As more superannuation funds merge and fewer but larger funds emerge, these organisations are starting to think about their next phase of growth. What will their portfolios look like when they are double or triple the size they currently are?
For some funds that means planning for a future where they are more than $500 billion, while some will nudge $1 trillion. Will they run into capacity issues? Are they priced out of certain markets?
Portfolios will have to change, but going fully passive or investing everything in unlisted markets is not an option that will suit many funds.
Eduardo Repetto, Chief Investment Officer of Avantis Investors, an asset manager owned by American Century Investments, believes there is another way. What if you could develop an approach that combines elements from both active and passive investments?
“We are trying to bring a way to systematise active management, bringing data, processes and systems – everything what you call science-based [methods] – into a process of security selection, weighting, rebalancing and management of portfolios,” Repetto says.
But unlike the systematic asset pricing and factor models of the past, Repetto says investors shouldn’t look at security prices, but at valuations. Valuations lie at the heart of most active strategies, he says.
“If you think about the price of the company, then what is it? If I want to buy American Century Investments [the parent company of Avantis], for example, then how much do I pay for it?
“Well, American Century has a lot of equity because they have a lot of buildings in Kansas City. So the price that I’m going to pay is at least the price of that equity. But American Century is a profitable company that has good cash flows, so I also have to pay for the cash flows. But those cash flows are money in the future, not money today.
“I’m not going to pay a dollar today for a dollar in the future. I’m going to discount it by some discount rate. So the price is the equity plus expected cash flows divided by some discount rate. That’s how we think about the company.
If you have good cash flows, good balance sheets, and low prices, that means high discount rates, high expected returns. That's a typical portfolio for us
“Now, If I was an active guy trying to buy a stock, I’m going to set a target price. Let’s say the target price is $100 and the company is trading at $50. That’s a good buy. But all that is a lot of work because I have to analyse a lot of things at the company level, across the industry level, across the country level, in order to come up with a discount rate.
“And, at the end of the day, it’s kind of arbitrary because it’s my own opinion,” he says.
A better way of looking at valuations is by estimating what is already priced in the market and taking exposures based on this metric, Repetto says.
“What we do is turn it around; the market is giving me the price. I have the proxy for equity and the proxy for cash flows, and so I can infer the discount rate that the market is giving us. Suddenly, I can find what is attractive, what is priced with a big discount. And if something’s priced with a big discount rate, that’s a very attractive investment.
“If you have good cash flows, good balance sheets, and low prices, that means high discount rates, high expected returns. That’s a typical portfolio for us,” he says.
Looking at valuations should also help investors avoid value traps, Repetto argues, because these situations often occur when investors look merely at book-to-price ratios, or other traditional value metrics. But companies that are value traps almost never look good on a discounted rate front.
“A value trap in general happens because you’re buying something at a low price, not a high discount. The company can have a low price because it’s making no money, and it’s never going to make more money.
“So I’m putting a lot of money in that with the hopes that it’s going to go up, but there is no real [hope] because the company’s price is at the normal discount rate,” he says.
The opposite is true as well, Repetto says. If you look, for example, at Meta, the parent company of Facebook, or Apple, then these stocks look quite expensive purely on price. But looking at the discount rate and the cash flows reveals another picture.
“We own Meta and Apple, not because the price is low, but because they make so much money that even despite having a price that is not as low, they are still attractive. And so by focusing on things that are trading at a discount, you have better odds to produce higher performance than just thinking about low price,” he says.
Repetto says as an investor you should not think about the balance sheet or income statement alone. Instead, they have to think about the company as a whole. “The only thing that gets you there is valuations,” he says.
“By switching how you look at the company valuation and using information from the market to get a good fundamental information, you’re able to do it faster with up-to-the-minute information across more companies at a lower cost,” he says.
Investment Philosophy
Avantis was established in 2019 and has grown rapidly ever since. It currently manages almost US$30 billion in assets. But Repetto wasn’t always planning to embark on a career in investing. At university, he studied civil engineering, did a Master’s degree in mechanical engineering, and ultimately wrote his PhD thesis about aeronautics.
Although today he is a spectator rather than a contributor to the field of aeronautics, he still has a keen interest in the area and keeps track of current development through his board position at the California Institute of Technology (Caltech).
Caltech founded and manages the Jet Propulsion Laboratory (JPL) for NASA, a laboratory that is dedicated to the robotic exploration of the universe.
“I have the pleasure of listening to all the scientists speak when they present what they are doing at JPL, at the Caltech board meetings. It’s quite fascinating,” he says.
In a recent discussion, JPL scientists were explaining that they can measure the presence of underground water via satellites.
“They can measure it from satellites because of gravity. If you have a lot of water, it’s more mass, and if you have more mass, then you have more gravity. And so they can measure the variations in gravity and infer how much underground water is in different aquifers. It’s just unbelievable,” he says.
This love for science has followed him in his investment career. He began his career at systematic investment company Dimensional Fund Advisors in 2000, when it was still based in Santa Monica and managed about US$25 billion.
Dimensional is well-known for having its roots in academic research, being founded by David Booth and Rex Sinquefield, who both studied at the University of Chicago under Eugene Fama and Kenneth French.
He ultimately became the firm’s co-Chief Executive and Chief Investment Officer and helped manage US$530 billion in funds.
Asked to what degree he is influenced by Dimensional’s research, he says that it still informs his thinking, but that, ultimately, he has moved beyond the factor framework.
“Like everything in science, it is about pushing the frontier. There has been a humongous amount of work done by a lot of people, who have all contributed to this [body of work],” he says.
“It started with asset pricing models that are trying to see how securities are being priced in the market, then came factor models that are a way to think about the expected returns based on certain characteristics. But if you look at the cutting edge [today], it’s going back to valuations.
It started with asset pricing models that are trying to see how securities are being priced in the market, then came factor models that are a way to think about the expected returns based on certain characteristics. But if you look at the cutting edge [today], it's going back to valuations
“We are using all the knowledge that we got from asset pricing models, all the knowledge that we got from factors, and putting it back into a valuation framework. And that’s where we are,” he says.
The heritage of Dimensional is still found in the fact that Repetto incorporates ideas such as value and momentum, but where his old firm regards these largely as separate return drivers, Repetto combines the ideas for practical implementation tactics.
For example, understanding how momentum works can help investors maintain better buy and sell practices when investing in value stocks.
“When you look at securities that are extreme underperformers, they tend to continue to underperform [for some time]. Not for a long period of time, but for a short period of time. If you jump into that underperformer too soon [based on value metrics], then I’m going to suffer underperformance because of the momentum. And that’s something that they really don’t want,” he says.
“But this is also true for upward momentum, because if you have a company that is doing extremely well, then it is also expected to continue to do better for a short period of time. And so if you have a company that is in an upward momentum, and it’s in your universe of eligible securities, then you don’t want to let go so soon [even when prices change].
“So this concept of momentum is very much integrated in our portfolio management process,” he says.
Although his approach is a systematic one, Repetto says it should not be mistaken for a passive strategy. “If you think about considering company valuation and are willing to deviate from the benchmark then that is an active management decision,” he says. “Being willing to rebalance when you need to rebalance, not artificially waiting for the rebalancing or reconstitution date, that’s a concept of active management.
“So all these concepts of active management are really, really valid,” he says.
Disclaimer:
References to specific securities are for illustrative purposes only and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.
The opinions expressed are those of American Century Investments (or the fund manager) and are no guarantee of the future performance of any American Century Investments fund. This information is for educational purposes only and is not intended as investment advice.
American Century Investment Management, Inc. (“ACIM”) (CRD#105778/SEC#:801-8174) is a US registered investment adviser pursuant to the Investment Advisers Act of 1940 of the Securities and Exchange Commission.
ACIM relies on the Australian Securities & Investment Commission (“ASIC”) relief provided for under Class Order [CO 03/1100] for U.S. SEC-regulated financial service providers in relation to the provision of financial services to Australian clients. ACIM has an Australian affiliate entity, American Century Investment Management (AU) Pty Limited (“American Century”), that holds an Australian Financial Service Licence (Number: 518417) issued by ASIC. The information is directed and available to residents of Australia only deemed to be Wholesale Clients under Section 761G of the Corporations Act of 2001.
This article is sponsored by American Century Investments. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
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