Focusing On The Cash Flow

Behind the scenes with Gartmore's Pierre Castela

Originally published in the May 2008 issue

AlphaGen Tucana is Gartmore’s large cap European long/short hedge fund. It runs a highly concentrated portfolio of usually between 25 to 30 positions (although it has been known to go as high as 35) and has a mandate to invest anywhere in Europe, with up to 10% available to be invested outside Europe (including Russia). When launched in 2005 it opened and closed to investment within a matter of weeks. Up 12.7% in 2007, it now has €900 million under management. Its focused approach to European large cap investing has won it adherents with the investor community, and The Hedge Fund Journal was recently given the opportunity to speak with Pierre Castela, who joined Gartmore in 2004 in order to help generate ideas for the firm’s European portfolios.

Castela was part of the launch team that ushered Tucana into being in early 2005. He works closely with Gartmore’s other flagship European hedge fund managers, including Roger Guy, Guillaume Rambourg, and Dave Thompson, the manager of AlphaGen Velas. In late 2004 the European fund management team had felt there was a case to be made for a dedicated fund to hold some of the major stock calls they generated: there were cases where the analysts had done the groundwork already, had met with company management, had generated their models, and had reached a target price. Why not capitalise on some of that work with a highly focused European long/short portfolio?

“After we tested it out, we thought it worked well,” says Castela. “I follow a lot of companies – I have between 200 and 250 meetings a year. On top of that we have two dedicated analysts who generate more ideas.”

Altogether, the team will be typically tracking an active universe of between 75 and 100 stocks for this fund. It has a low turnover compared to its cousins in the AlphaGen range, Capella and Velas. This reflects the amount of time invested in researching the opportunities, and the fact that buy and sell signals are closely adhered to. “We’re quite disciplined,” explains Castela. “We have a two-year lock-up [for the fund] so we like to see visible growth and great top line sales from the companies in the portfolio.” This includes over 10% on top line sales over five years or more, good growth drivers, and a dominating activity within the business model that will provide the pricing power. Diverse conglomerates with their fingers in all sorts of business lines are less appealing.

Other characteristics sported by the ideal Tucana holding will be some level of upside potential, frequently a high price/earnings ratio. Good recent examples have included Synthes, the global medical device company, and Essilor, the world leader in corrective lenses. “Essilor has a dominant business line, its turnover grew close to 8% in euro terms in 2007, and it delivered 20 basis points margin improvement,” says Castela. “Its research and development spend is three times that of its closest competitor in the industry. This is a company that generates a lot of cash.”

The fund’s managers try to limit themselves to a maximum 10% of the free float in a company, particularly with mid-caps. They will frequently take a view based on the free float, factoring it in alongside target price and valuation support.

“European companies are reasonably well-managed, and unless they are utilities, if they are doing something wrong, they will tend to hit the wall quickly”

Cash is king
Cash flow is something that the Tucana managers spend a lot of time focusing on. Says Castela: “We like to look at the cash flow generally in companies, to see if they’re mis-priced, or if we can capitalise on economic changes in the industry they’re trading in. We like to take a longer term view of their prospects, say three years or so.”

A cash-flow poster boy for Tucana has been Arcelor-Mittal, which has been in the portfolio since the fund was launched in 2005, or rather, Arcelor was. Lakshmi Mittal launched his famous takeover bid for the steel manufacturer in 2006 but Gartmore was already holding the stock on the strength of anticipated future demand for steel globally. It was obvious that the capacity to meet that demand was not there, but on top of this, Arcelor as a business had plenty of cash-generating potential. Investors were becoming frustrated that the Arcelor board was not paying out dividends, but all this changed with a takeover that has had a dramatic impact on the steel industry generally. Now, the new group is offering investors price stability, and the shares are trading, according to Gartmore, five times EV/EBTDA. At the time of writing, Arcelor Mittal’s New York share price was $89, and Castela was hoping it would reach $100.

Castela has also been a fan of Daimler, another cash generator which Tucana bought when it still owned Chrysler. “We were impressed with how they sold Chrysler,” he says. “They’re another good cash generator, and reasonably visible, although compared to Arcelor Mittal it is not as focused on cash flow as the Mittal family is.”

Choppy waters ahead
As a shareholder in some of Europe’s biggest companies, Castela has mixed views on activism and feels that while sometimes it is appropriate, and can add value, at other times it doesn’t make sense. Gartmore itself is not an activist investor per se, but its fund managers do meet with other activist players from time to time to hear what they have to say. For example, the firm was a big shareholder in Suez in 2005 when US activist investor Knight Vincke was seeking to force a decision on the future of Belgian electricity company Electrabel, in which Suez was a majority shareholder. Knight Vincke and Gartmore met on a number of occasions in 2005, and Gartmore supported the US activist firm on a couple of its proposals to Suez.

But activism is not always the right solution, and Castela questions whether a fund with 3% in a given company should have quite as much influence as some activists are allowed to acquire. “Sometimes the management will get it right in the long term, and need to be given the time to do that. European companies are reasonably well-managed, and unless they are utilities, if they are doing something wrong, they will tend to hit the wall quickly,” he says.

The credit crisis, on the other hand, is much more of a concern for Castela and his team than activists are. “This could be terrible,” he admits. “The problem is so large it has to be sorted out, but who is going to take the lead? They will have to take the dirty assets and put them somewhere, because I don’t think cutting rates will provide the answer. There are two issues here – the credit crunch, and the slowing US economy. One is exacerbated by the other. If the credit crunch continues, it will spill over into the real economy.” He fears that at some point there with be retrenchment on the part of consumers, just at a time when banks are being forced to raise their prices.

First quarter numbers from the banks will, Castela feels, undoubtedly lead to downgrades across the sector in 2008-09. Price earnings multiples at six times are not good enough, with some banks likely to throw away their 2008 profits in dividends. It may, he thinks, be a case of biting the bullet, and taking the downgrades in an effort to regain investor confidence, but he still anticipates heavy casualties across the banking sector this year.

On the upside, the credit crunch and the economic slowdown means there is plenty of value around in banks, but with the lack of visibility it is difficult for the Gartmore fund managers to make accurate calls on the quality of individual banking stocks. This has led Tucana to take on a more defensive posture in Q1, with more shorts and a very reduced financials allocation. “Our shorts are very much event driven, and they’re harder to manage as they don’t have the usual valuation support we look for with the longs,” says Castela. “You have to sit on top of the news flow, exploit the worries about takeovers for example.” Tucana’s short positions are of necessity a lot smaller, usually in the region of 2-3% against a typical long of 7-8%.

“We’re not big shorters,” says Castela. It can sometimes be tough going into a meeting with company management when it is known the fund has been shorting their stock. He ruefully recalls a chilly meeting with Vodafone management following the mobile phone company’s problems in 2005-06. If you’ve been a shareholder on the long side, and have met with company management, there can be a sense that the fund manager has somehow betrayed the cause when it emerges he has gone short.

Looking eastwards
One has to ask Castela about Russia, a country which is playing an increasingly vocal role on the European stage, both politically and economically. With his 10% extra-European mandate, he has been able to acquire a couple of Russia plays, including one via a London IPO. “We’ve been impressed with the standard of their presentations,” he says.

The commodity price boom is also focusing the attention of European fund managers in an easterly direction, more so than ever before. There are a lot of investment stories in the energy sector, but there are also good opportunities in Russia in banking and finance. Russian mortgages only account for 3% of GDP at the moment, and there is also scope for some big infrastructure-related investments in a country which is still heavily reliant on an ageing Soviet-era network, including the domestic materials industry, the railways, and ports.

Investing in Russia doesn’t mean abandoning your core principles when you get off the plane in Moscow. Tucana is still on the look-out for cash generators in this market, along with the high level of visibility around where the cash originates. Believe it or not, some Russian companies do fit the bill. “We need to feel confident in the senior management,” says Castela. “When we talk to them, we need to feel comfortable about their top line growth projections. We need to get a clear picture of their history, how their market share has been built up over time. This will give us a better idea of whether we can expect solid growth from them, as well as their importance in the economy.”

A good historical perspective will allow the fund manager to assess how the company has evolved over time. An organic growth story is preferable to one that has relied on political connections, and the frantic privateering process of Yeltsin-era Russian capitalism.

Castela is not worried about the possibility of a drop in energy prices, and their impact on the Russian economy. Oil would need to hit $50-60 per barrel to really have a negative impact, and that’s without considering the massive Russian gas reserves and its role as a major exporter, particularly to Europe and China. It is a country with a population of 140 million people, who have been getting gradually richer under Vladimir Putin’s aegis, and represent a major export market for European manufactured goods. “This is not a three year trend,” says Castela, “it is a long term one.”

Meeting the management is a near-essential component of the Gartmore process (with 98% of stocks held being at least partly based on management interviews). “This is the way of the company,” Castela points out. “We don’t do much trading, so we have to listen to what company management is saying. If you have a target price, you need to know about the cost base, and the opportunity for margin development.” Corporate governance is a key factor. Back in the 1980s, such governance was lacklustre in countries like Spain and Italy, countries now considered a core part of a European equity manager’s remit. Russia is going through this process now and, in Castela’s view, the situation will improve.

Corporate governance in Europe is obviously vastly improved, but there are still occasions when eyebrows are raised at an AGM, when a poison pill is being voted on, or when the French government is allowing Arcelor to be acquired.

Another big trend affecting European large caps this year could be the increased participation of sovereign wealth funds (SWFs) in the market, particularly those from countries enriched by the high oil price seeking to gobble up assets at knock down prices. “You’ve got to ask yourself, where is the money?” says Castela. “What do these sovereign wealth funds need? What they lack is expertise, and there is a temptation, if you want to know how things are done in a particular industry, to go out and buy that expertise.”

But despite the participation of SWFs, Castela still thinks it will take 20 or 30 years for China to catch up in some sectors, even with strategic acquisitions in Europe and the US, and this is assuming that regulators and governments give SWFs free reign in their home markets.

“I don’t think there is the ability or capacity at the SWFs to buy the right company,” he explains. “They’re simply not staffed in the proper way. It will be interesting to see what they can do outside the banking sector. There is an emphasis on their part on buying the right brand names, the companies perceived to have the expertise they require.” He points to Temasek’s purchase of a stake in UBS as an example: Singapore is already a key Asian wealth management centre, but its banks are keen to learn more about the Swiss way of private banking to consolidate on that.

Castela also points to the €2.15 billion acquisition of a 50% stake in Fortis’ asset management unit by Ping An, HSBC’s Chinese insurance partner, which has raised $14 billion to make acquisitions outside China. Although technically not an SWF, Castela views this as an example of a Chinese company going shopping for foreign expertise, particularly in the bancassurance sector.

“We’re seeing a major shift in wealth and power now from the western world into the emerging economies,” he concludes.

Pierre Castela joined the Gartmore hedge fund team in April 2004, and it was his appointment that helped the firm to make the decision to launch AlphaGen Tucana. He held a number of positions at both Goldman Sachs and UBS Warburg prior to managing his own hedge fund at Bryan Garnier Asset Management in London. He then moved to become an analyst at Kepler Equities in Paris, the position he held before he joined Gartmore.