The purpose of this paper is to explore the potential portfolio ramifications of disruption in global equities. Specifically, what it could mean for style blending in global equity portfolios. It is our view that corporate disruption is having a meaningful impact on the fundamental performance of a wide range of companies for better and worse, to a degree never seen before. We would also argue that investment disruption is having the effect of upsetting the style balance in the asset class which has resulted in some unintended consequences.
As investors in global equities, we all need to ask ourselves the question - what does this mean for how we manage client portfolios? A key finding of this paper is that the outcome of these two levels of disruption is that Momentum has become the dominant style factor across many global equity portfolios and that the historical relationship between Value and Growth may not hold true going forward. In the context of current market levels, we feel that investors need to acknowledge the magnitude of this shift and think differently about portfolio construction in the coming years.
“This time it’s different”
According to Sir John Templeton, these are the four most dangerous words in investing. Having said that, as investors we all need to be cognizant of the changes that we constantly see in how markets operate. Needless to say that in recent years we have seen huge structural change in equity markets that could collectively change the way that stocks behave relative to historical norms. We would categorize these structural changes into two broad buckets - Corporate disruption and Investment disruption, which we will elaborate on further. In terms of the current global equity market environment, we are eight years into a strong bull market - volatility levels are low, valuations are near their highs and there seems to be quite high levels of correlation between some of the mega cap stocks. At a more intuitive level, there also seems to be signs of a bubble in the global IT sector. In summary, there are seemingly a range of disconnects that are opening up in the markets that collectively should give investors some pause.
1. Corporate Disruption
Corporate disruption is a scenario where traditional players in particular industries are being materially impacted by new business models that often come with a degree of financial irrationality. While disruption is well understood in the global equity landscape, the subsequent portfolio implications are still taking shape. If we were some summarize the current state of affairs in the global corporate landscape, we would make the point that a small number of companies - supported by strong secular trends - are inflicting considerable damage on a much larger number of companies. Needless to say that U.S. retail has become the poster child for this phenomenon.
How investors are positioned for this trend is what deserves much closer attention. As far as active investors are concerned, the perceived ‘losers’ in this trade have been sold heavily and those funds have rotated into the much smaller group of ‘winners’. The implied ‘bet’ being that a number of the losers will be put out of business and are therefore not investible at any price. On the flip side, the implication seems to be that the ‘winners’ will end up with such a huge proportion of the pie that they should be owned at any price. If we were to make the assumption that the ‘winners’ fall into the ‘growth’ category and the ‘losers’ fall into the ‘value’ category, we start to see some interesting dynamics for both style buckets. In summary, we would make the assertion that valuation risk has appreciated considerably for pure growth stocks, while fundamental risk has increased for value stocks.
Dispersion of Corporate Quality within Value and Growth Buckets
The table below provides some context around the changes in fundamental risk between the Value and Growth buckets. More specifically it demonstrates how profitability has changed over the last 5 years. While this is a relatively simplistic way of assessing the change in fundamental performance, we feel it demonstrates some interesting trends:
- Growth - profitability has appreciated quite meaningfully from 6.4% to 8.7% over a reasonably short time period.
- Value - here we have seen the opposite trend whereby returns have contracted from 4.6% to a pretty measly 3.6%.
- The profitability gap between Value and Growth has opened up materially, to the point where Growth ROC is at a 5.1% premium to Value ROC
- Quality – while profitability has picked up modestly, the sheer magnitude of Quality profitability vs the other style buckets is worthy of note. This comparison also highlights the fact that Quality and Growth are not one in the same
We feel that this diversion in profitability by style bucket is one of the more relevant reference points when looking to measure the effect of disruption. The profitability disconnect opening up between Value and Growth is in our opinion a telling indicator of the fundamental changes happening on the corporate battleground. While some may argue that the cyclical differences between the style buckets could contribute to this dynamic - the reality is that we have been in a very benign economic environment over the last 5 years that has been devoid of major economic peaks and troughs.
How Valuations have changed
Having looked at the recent fundamental change, it’s also interesting to see how this has manifested itself into valuation change. The table below shows how the valuation of the major style buckets has changed in the last few years:
- Valuations across the board have appreciated over the period
- The Value and Growth extremes have seen much more valuation expansion than the broader index as a whole.
- Growth in particular has become very expensive in an absolute and relative sense
- Value has also appreciated quite meaningfully, notwithstanding its deterioration in profitability.
- Quality valuation has appreciated at a more modest pace and currently trades at a modest discount to the broader market and a meaningful discount to Growth.
The Flaws in Style Bucketing
One of the key findings of this paper is that ‘style bucketing’ can result in a distorted perception of true value in equity markets. By focusing on Value or Growth in isolation, investors can easily lose sight of the collective risks that arise from valuation and fundamental considerations. The table below is an interesting case in point - which compares the stock specific attributes of Top 10 holdings in the MSCI World Growth and Value Indices.
Assuming the starting premise that Value should be looked at in the context of Quality, this comparison highlights some very obvious inconsistencies. While the Growth index is more expensive than Value on an absolute basis (ie. P/E), the opposite is true when you compare the two baskets of stocks on a P/E vs ROC basis. By comparing the P/E of companies to their profitability, one could argue it provides a much more realistic ‘value for money’ measure of a stock’s true value. Our research has found that Return on Capital is an excellent measure by which to measure the quality of a business. On this basis, the Growth index actually appears to be meaningfully less expensive than Value. If we were to extend this argument to the Quality bucket, it becomes clear that Quality arguably represents the best value of the three major styles with a P/E vs ROC of 1.2. The point being that by ‘labelling’ stocks in a way that they are uniquely identified with one metric in isolation, it is easy to end up in a circular argument that results in a distorted perception of true value - i.e. Is Value cheaper than Growth or is Growth Cheaper than Value? Again referring to the above table, the fact that Nestle is classified as Growth and Proctor and Gamble as Value seem ridiculous when one considers that they are similar companies with similar valuations and profitability metrics. One of the most painful lessons in recent history was when some investors made large bets on distressed financials in the early stages of the GFC, on the grounds that they ‘look cheap’. By making such a decision without consideration of the quality of the businesses themselves resulted in a series of very poor decisions.
Diversification Benefits of Value and Growth in Major Drawdowns?
One the key reasons for asset owners to blend styles within portfolios are to maximize risk adjusted returns through diversifications. The true diversification ‘test’ with any portfolio comes during periods of major weakness; hence it is interesting to see how the different styles have performed during such dislocations.
It could be argued that the aforementioned distorted perspective of true value at a stock level has historically explained why a blend of the two traditional Value and Growth styles has done little to protect portfolios from meaningful downside risk during previous major corrections. While this is admittedly a very simplistic way to look at the argument it is telling nonetheless. Especially in the GFC when Value and Growth effectively collapsed in lockstep, begging the question - what are the diversification benefits of distinct allocations? The only style tilt that outperformed in both drawdowns was Quality.
For all the reasons explained, there appears to be a growing risk that global equity portfolios with meaningful exposure to the extremes of Value and Growth will underperform should we see a meaningful market correction. As such, it is imperative that asset owners maintain an awareness of how their equity portfolios are exposed to such extremes.
2. Investment Disruption
Investment disruption refers to the changes in the way that asset owners manage their equity exposures, and the subsequent changes in market structures. The enormous move away from active management to various forms of rules based investing (i.e. Passive and Quantitative) is seemingly creating some imbalances in equity markets that deserve the attention of asset owners. In a recent report from JP Morgan, they estimated that in the U.S. equity market, Passive and Quantitative investors account for ~ 60% of equity assets compared with less than 30% a decade ago. At the same time, fundamental discretionary traders account for ~ 10% of trading volumes.^
One of the key outcomes of this shift is that Momentum has become a very powerful force when it comes to breaking down market performance. Using this premise as a starting point, investors need to consider some key questions - a) How relevant is Value & Growth for my portfolio right now?, b) How will my portfolio perform in the event that Momentum turns negative?, and c) Will Value and Growth deliver the diversification benefits that I hope? Perhaps, the most important question is – how will my portfolio perform in a downturn given that rules based / backward looking investing accounts for more than 60% of equity assets?
The next few charts illustrate the aforementioned changes that we have seen in the way that equities are managed by asset owners.
The chart below clearly shows how the net flows between Passive and Actively managed funds have dramatically changed in recent years. Since 2007, in particular there have been considerable outflows of actively managed funds, corresponding with commensurate growth in passively managed funds.
This chart demonstrates the rising Passive and ETF ownership amongst the constituents of the S&P 500. The number of companies whose collective ownership exceeds 10% has gone from 2 to 458 in a little over 10 years. Since 2012, we have seen a pretty meaningful acceleration in passive growth.
The table below shows the most widely held global stocks amongst the broad universe of global equity managers in the eVestment database. Specifically it shows the average weight across ALL managers and the percentage of managers that hold the stock in their portfolio. For example, it shows that the average weighting in Alphabet is 1.2% across all managers and it is held by 51.6% of active managers.
It also shows how ETF ownership in each name has changed in the past 3 years. The average ETF ownership of these names has increased from 10.3% to 14.0%, and has been reasonably concentrated into IT, Financials and Healthcare. While this data doesn’t encapsulate all passive ownership, it is indicative of the overall trend to passive investing. What the table does highlight is the fact that passive and active portfolios are seemingly overlapping more and more - hence the stock specific risk at an overall portfolio level is picking up. This is a very real risk that asset owners should be paying attention to.
What happens when Corporate and Investment Disruption Intersect?
One of the key findings of this report is that global equity portfolios are seemingly going through a ‘portfolio eclipse’ whereby their active and passive exposures look increasingly similar. The result being that stock specific risk is building - almost by stealth – and that asset owners can easily find themselves with too much exposure to a handful of stocks that are seemingly driven by momentum as a dominant factor. This scenario also highlights several other unintended consequences of such a phenomenon:
- Stock specific overlap
- Crowded trades
- Inability to ‘actively’ reduce exposure
- Rising concentration in mega caps
- Disconnect between Valuations and Fundamentals
- Diversification benefit of active / passive split dissipates
- Downside protection compromised
Consider Diversification by Size not Style
This observation begs the obvious question for global equity investors - how can I better protect my portfolio from major drawdowns if style diversification is ineffective? One of our key findings is that diversification by Size not Style can prove to be a more effective portfolio construction tool for the purpose of maximising risk adjusted returns. The table below shows how SMID and Small cap stocks have performed during the aforementioned drawdowns and the subsequent two year periods.
Over the course of the last two major equity market corrections, we have seen that SMID and Small cap equities haven’t necessarily done a great job at protecting value on the way down but they have outperformed meaningfully in the subsequent two year bounce. While there are many arguments that could be put forward to explain why smaller companies stock prices tend to rebound so quickly - we would note a couple of key differentiators between large and SMID cap companies:
- SMID Cap companies are not subject to negative passive flows in drawdowns
- SMID Cap companies generally have much better organic growth prospects than their larger peers which is quickly recognised by investors during recoveries. It also means those companies are less inclined to grow by acquisition at the top of a business cycle.
Upside and Downside Capture
The chart below provides some very interesting perspective around the performance characteristics of the major style and size buckets in all market conditions over the last 20 years. More specifically, it measures upside and downside capture performance against the MSCI World Index. The following points are worthy of attention:
- Downside Protection – Quality and SMID have preserved capital well, Growth hasn’t done well
- SMID is the only style bucket with the optimal blend of high Upside market capture and low Downside market capture.
Risk and Return: Global Style Buckets
It is also very interesting to look at the actual return and risk outcomes of all the style buckets over the last 20 years:
- Quality and SMID have meaningfully outperformed, with less and more risk respectively
- Growth and Value have basically matched benchmark returns, although Growth has come with much higher risk
- Risk levels of Growth and SMID have virtually identical risk levels
Investment Style Implications
This analysis brings to light some very relevant considerations for the way that global equity portfolios are managed by asset owners going forward. The multitude of changes in market dynamics that have been instigated by disruption will arguably result in some changes in the way that equity markets behave going forward – especially in the event of a meaningful dislocation. The good news for investors is that they have options to diversify their portfolios in such a way that they can optimize their risk-adjusted returns on a going forward basis.
- Traditional Style bucketing is challenged.
- Momentum has been the dominant driver of stocks.
- Risk at “Style tails” is picking up.
- Quality has been the most stable and remains good relative value.
- Investors should aim for greater diversification at a market cap level.
- Characteristic blending may prove to be more effective at an overall portfolio level rather than at a manager level.
- Investors need to pay close attention to stock concentration at an overall portfolio level.
- Negative momentum risk needs to be taken very seriously.
- Current market disconnects will create great opportunities for fundamental / active investors.
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