2021 International Equity Outlook: Finding quality in a momentum-driven market
At the height of nuclear disarmament negotiations with the Soviet Union in the 1980s, Ronald Reagan summarized his approach as “Trust but Verify.” While the ex-President made the phrase famous, our Director of Research, Igor Krutov, likes to remind us that these words of wisdom were originally an old Russian proverb “Doveryai No Proveryai”, proving that sound advice is both ageless and borderless.
2020 has been a highly unusual year, to say the least. After a brief sell-off during the early stages of the pandemic, equity markets quickly recovered despite the crippling effect of COVID-19 on the global economy. High-growth, high-momentum names have been by far the best performers. In this setting, investors should focus on stock valuations, as they may matter more for returns going forward.
When we dig deeper into recent market performance, we generally find two categories of stocks that have rallied particularly hard and thus may warrant investor caution. One includes high growth names that disproportionately benefited from a fall in interest rates, as the lowering of the discount rates mattered more for perceived high-duration assets. We believe investors should be mindful of their aggregate exposure to that group of stocks since there is a possibility of a sudden backup in rates. As bottom-up, fundamental investors, we are not making any macro predictions but are simply noting that in that scenario the biggest beneficiaries of the recent drop in rates would be most negatively impacted.
The other notable category includes the various “story” stocks, which have been on a tear even though these companies’ business models are as-yet unproven. Such speculative investments simply do not meet quality criteria.
Investing is ultimately an optimist’s game – it necessitates taking some risks in search of rewards. But we do not believe that it means blindly following the crowd or swallowing every bullish story. Investors should only make decisions based on facts, not gut instincts. In volatile markets, it is particularly worth remembering that old Russian proverb.
In this paper, we reflect on the performance of today’s high-flying stocks, particularly with respect to two critical investing considerations – valuation and fundamentals.
This year, we saw a significant divergence in performance between growth stocks and the rest of the market. Figure 1 shows that through November, the S&P 500 Index advanced 14%, while the growth component of the broad benchmark was up 28%. It was not a phenomenon confined to the US – growth stocks led the MSCI All Country World Index by a similar margin (Figure 2). Also, year to date, momentum has been one of the most powerful factors and there is a significant overlap between growth stocks and momentum stocks.
What caused this massive divergence in performance?
The lowering of interest rates that began at the onset of the COVID pandemic was a key factor. It was followed by central bank guidance that rates would remain low for an extended period of time, which in turn led to the market factoring in meaningfully lower discount rates. This benefited equities in general, but valuations of growth stocks in particular, as they are seen as longer-duration assets.
While the market’s reaction was not irrational, we think it is important to consider a portfolio’s aggregate exposure to this group of stocks. Although it is difficult to predict when rates may rise again, loose fiscal policy could produce inflationary pressures, necessitating rate increases sooner than consensus expectations. In that scenario, growth stocks would suffer a reversal of fortune, as they are more vulnerable to rising interest rates.
The outperformance of some growth stocks is also due to trends accelerated by the pandemic. Many of these stocks are technology companies that benefited from an increase in e-commerce and a shift to cloud computing. The market rewarded those stocks, which again was rational directionally. However, the magnitude of some of the stock moves may prove excessive. Investors should be careful not to extrapolate the acceleration of trends too far as some of the COVID-related changes may reverse in the short term when the pandemic fades.
Another related development has been the narrowing of the market. A limited number of tech names drove much of US equity gains in 2020. Indeed, the combined weight of the top constituents rose significantly as a percent of the S&P 500 Index’s total market capitalization (Figure 3). A similar phenomenon has been seen in other markets.
Many growth stocks that massively outperformed the market this year are good companies with attractive business models and growth prospects. In a way, they remind us of the “Nifty Fifty” stocks of the 1960s and early 1970s.
Mark Twain, the great American writer, once quipped “History does not repeat itself, but it often rhymes.” A student of market history will remember past the 2000 tech bubble to the Nifty Fifty stocks, a group of 50 large cap, high growth companies, which traded on high earnings multiples. The Nifty Fifty outperformed the market by a wide margin during the period leading up to the oil crisis of 1973, which triggered an acceleration in inflation and their subsequent crash.
Ironically, during that bull market, they were known as “one-decision” stocks because of their stability and wide protective moats. In contrast to the tech bubble of the late-1990s, when companies with great stories but no profits to show (e.g. Webvan, Pets.com, Worldcom) traded at incredible valuations, the Nifty Fifty stocks were companies with proven business models. Many still exist and even thrive today, such as Procter & Gamble, Coca-Cola, and McDonald’s, to name just a few.
We are not arguing that the FAANG+M (Facebook, Apple, Amazon, Netflix, Google and Microsoft) stocks are the new Nifty Fifty. This would be too simplistic an argument considering that despite the memorable acronym, the six companies that make up the FAANG+M have individually very different business models, valuations, challenges and opportunities.
Nevertheless, if the goal of a portfolio of quality growth stocks is to accumulate wealth with lower volatility and greater downside protection than the benchmark, then the lesson from the Nifty-Fifty era is that high growth even if it is in quality businesses cannot be bought at any price. A lack of valuation sensitivity left investors of that era heavily exposed to an external shock, which resulted in a painful and long-lasting investment hangover.
We will never know precisely what will cause the next external shock or correction to “high growth at any price” stocks. But if COVID-19 has reminded the investing world of one lesson, it is that we should always be prepared for the unexpected. One particular risk that we are watching closely is the impact that a sudden reversal in historically low interest rates might have on equity valuations. Investors across both bonds and equities, after years of heavy prodding and pushing from central banks, have been cajoled into believing that interest rates and inflation will stay indefinitely low. This has left markets and asset valuations vulnerable to a backup in rates.
In addition to valuation risk, we are concerned by how trustful the market has been of some investment story stocks. For example, there has been a recent surge in Special Purpose Acquisition Companies (SPACs) – also known as “blank check” companies. These are funds that raise cash in the stock market with the promise of investing in a private company to take it public. In contrast to traditional IPO’s, companies that become public through a SPAC are, in our view, under less regulatory scrutiny and have fewer restrictions on making rosy projections. For instance, Fisker, an electric car company that went public via a SPAC, is projecting revenues of $13.2 billion in 2025 compared to the zero revenues it generated at the time of its SPAC acquisition. There is also a potential conflict of interest between the sponsors of the SPAC and minority shareholders. As Lawrence Garfield, the corporate raider played by Danny DeVito in the movie “Other People’s Money” famously said, “There is only one thing I love more than money, other people’s money.” Sometimes life imitates art.
History is full of some of the greatest investment stories that ended in tears ranging from the South Sea Bubble in the 18th century to the US housing bubble most recently. The human brain is naturally hard-wired to communicate and to learn through stories, and every investment thesis of a high flyer has a story behind it. We think the difference between investing in real vs. over-hyped stories depends on having a clear investment philosophy, the humility to accept a smaller circle of competence and a good dose of common sense.
Another area of great story stocks today are the green technology companies that are attracting many eager investors. While the movement of the world and companies towards greater environmental sustainability might make sense and be necessary, we often find that when large amounts of capital chase a small number of opportunities, returns ultimately fall.
Consider Orsted, a global leader in offshore wind energy. While we believe strongly in the role of renewable power to reduce CO2 emissions, we are also mindful that trees do not grow to the sky. Orsted’s stock currently trades at 50x 2021 P/E, more than double the valuation of Alibaba (21X P/E), the Chinese e-commerce juggernaut with a 60% market share of a burgeoning online market in China. Orsted is a top-notch company with real know-how in identifying and developing wind offshore power plants located 30 to 40 miles from the coast. Still, in contrast to Alibaba, which enjoys a network effect and scale, Orsted has to compete for each new project in order to sustain growth without meaningful sources of differentiation – the wind blows the same for all the competing bidders.
While the opportunity for offshore wind capacity is enormous, in a competitive market, a project will earn a levered ROE of between 8% and 12%. Mathematically, Orsted cannot grow faster than 8% to 12% per year, unless it dilutes shareholders by issuing equity to fuel faster growth. Alibaba, on the other hand, can maintain a growth rate of 20% to 30% for at least the next 5 years with no meaningful capital expenditures or external capital funding. Clearly, the great potential growth in green investments do not always recycle into green dollars.
Masayoshi Son, the CEO of Softbank known for making large, bold investments based on first impressions, is another interesting potential symbol of today’s wild investing exuberance. In a Wall Street Journal interview, he said, “Don’t think, you feel it,” and indicated that first instincts are more important than precise calculations.”1 Mr. Son cut his teeth as one of the first investors in Alibaba and Tencent when both companies did not have a clear business plan. While those investments paid off, others have been less successful. His bold “instinctual” bet on Adam Neumann, the messianic CEO of WeWork, resulted in a loss of $18 billion.
Empirical Research Partners, a quantitative research firm whose reports that we regularly read, recently produced some interesting work showing that sometimes stocks demonstrating positive momentum and low volatility can be akin to a “wolf in sheep’s clothing.” According to Empirical’s analysis, investors should watch out in particular for low volatility stocks with increasing instability in company fundamentals, a large percentage of ownership by short-term investors like hedge funds, and all-around fast growth combined with rapidly increasing capital spending. These signs often foretell coming investment disaster.
This makes intuitive sense considering how hard it is to maintain supernormal growth over a very long period of time. It is interesting to note that the market volatility of some high-flying stocks like Netflix and Nvidia is below their earnings’ volatility. This sign of disconnect makes us wonder, is the market underestimating their fundamental risks?
Aswath Damodaran, a professor at New York University, sometimes known as the “dean of valuation” for his company analyses, said earlier this year that Tesla would need to generate revenues like the Volkswagen group in 10 years and margins similar to Apple to justify its valuation2. Tesla, and other high-flyers including Netflix and Shopify, are good companies with outstanding services and products and large addressable markets on paper. Unfortunately, their business models have not yet proven to lead to highly attractive economics. Ultimately, they may be just great stories, but not great investments, in our humble opinion.
Fortunately, you do not have to be a visionary like Mr. Son to make money in all young fast-growing quality companies. If you had invested in Amazon in 2007, just ten years after its IPO, when the company had a five-year track-record of profitable growth, you still would have multiplied your initial investment by 90 times.
Chuck Prince, the embattled ex-CEO of Citigroup, said before the great financial crisis, “as long as the music is playing, you’ve got to get up and dance.” Our preference has always been to be willing to miss the last song and instead get home a little earlier to sleep much more soundly at night.
We do not know when or why the market may turn. Thus, investors should favor a balanced approach to constructing high quality portfolios as outlined in our paper The Not So Secret Sauce of Portfolio Construction. This year, investors with greater exposure to faster-growth stocks would have enjoyed better performance, largely courtesy of lower rates. But a lot like the British, who are used to unpredictable weather, we believe that always carrying an umbrella when leaving home, while inconvenient when the sun is shining, is still a sensible approach.
1. One $100 Billion Tech Fund Isn’t Enough for SoftBank CEO, Wall Street Journal, May 15, 2018