GAM Investments’ Equity Investment Specialists share their views on factor and sector rotations and discuss how such market phases can present alpha opportunities for active investors, providing certain principles are adhered to.
“Eventually our economic fate will be determined by the economic fate of the business we own, whether our ownership is partial or total.” Warren Buffett, Berkshire Hathaway, Letter to Shareholders, 1987
In his 1987 letter to shareholders, Warren Buffett underlined the overriding principle of investment in equities. If businesses fail, so do their investors. To put it another way, equity is a theoretical claim on assets. If the assets destruct, the claims are indeed merely theoretical. Conversely it follows that the long-term determinant of equity returns for investors is the success of the individual companies. It is for that reason GAM Investments believes there can be no short cuts in equity research.
This is not to say that equity returns are constantly and solely determined by stock specifics. In the short term, share prices can be knocked around by macroeconomics, by style factors and as we have seen more recently, by social media amplification. While these moments of market irrationality could provide good opportunities for the fundamental stewardship of client portfolios, it is worth examining exactly how and why these moments can impact client wealth.
Market rotations are unavoidable but they are certainly not unmanageable
What just happened?
Chart 1: MSCI World Growth versus MSCI World Value
Starting in mid-February, we have seen a sharp rotation. Value has sharply outperformed growth and some investors have been caught out. While this rotation has been violent, it is certainly not unique. We have frequently seen these major rotations in financial markets and yet the previous ones seem overlooked as we grapple with the current incarnation. Broadly speaking the market can only ever focus on one thing at a time, but after a combined experience of over half a century of doing this, we remain perplexed at how short term the market memory can be. This phenomenon overlooks both the good and the bad, and therefore could present opportunities for the active investor.
Rotations present opportunities for the nimble active investor
Why did the rotation happen?
In a nutshell, the market rotation we have seen in the last 30 days is down to a sharp change in expectations on interest rates. Put simply, central banks around the world took the decision to stave off the likely Covid-related depression by firing up the money-printing presses. This massive increase in global money supply (aside from debasing fiat currency still further) is a partial prerequisite for increased inflation, something usually addressed by higher central bank interest rates, which makes money more expensive and therefore slows down spending.
To see it through another lens, central bank action (de facto easing through printing money) has promoted macroeconomic growth (targeting both consumption and investment). As growth rebounds, central banks will need to prevent economies overheating or inflation rising, and the traditional way to do both is via higher interest rates.
The natural victim of higher interest rates are fixed coupon bonds, whose prescheduled payment streams now look less attractive. Yields have backed up sharply both in government and credit fixed income, and investors who believed that bonds were the safe place to park their money – standard advice for investors with a shorter investment horizon and / or a lower risk appetite – have experienced an unwelcome shock in the form of a mark-to-market capital loss.
Why has the value rotation impacted equities the way it has?
The first axiom of conventional wisdom has it that the rotation occurred because higher interest rates penalise indebted companies more. Younger, ‘growthier’ companies have more debt and therefore they are most at risk. The rising tide of economic growth should lift all ships, but the heavily indebted will be holed below the earnings before interest and tax (EBIT) line, specifically via a greater deduction between EBIT and pre-tax profit.
The second axiom is that certain mature companies will also suffer under such a rotation, specifically bond-like equities, sometimes referred to as ‘traditional quality income’ or ‘dividend aristocrats.’ These companies are usually ex-growth and solid generators of cash (paid out in steady dividends, pandemics notwithstanding). Somewhat perversely, it is precisely because of these characteristics that these companies suffer. While resilient, there is limited opportunity for significant growth acceleration and therefore the pay-out profile looks similar to a coupon stream. Those more-or-less fixed future cash flows are now being discounted at a greater rate than before.
If the share prices of those two groups of companies declined, it is important to qualify what has outperformed during the rotation and why. The definition of ‘value’ here is key: Index provider MSCI uses a blend of three variables, namely low price to book value, low forward price to earnings (P/E) and high dividend yield.
The value-style sectors, which have performed well under these circumstances, include the commodity names (oils, metals and miners), banks (with positive exposure to higher interest rates), certain aspects of healthcare (more the big pharma space than the smaller, growthier biotech-type companies).
The interesting point here is that the assumption is that interest rates are rising because of inflation and higher macroeconomic growth but the market response is the outperformance of a sub-segment whose methodology does not incorporate likely growth in earnings.
Do I need to worry about the companies in my portfolio?
There is a big difference between worrying about companies and worrying about stocks.
Markets can remain irrational longer than portfolio managers can remain employed, but that is not the point. In our view, the point is that a detailed and dispassionate codified investment process is not about purely company analysis. The best quality companies are not always the best investments. A good quality company that is priced as a low quality company is a better investment than a merely above-average company that is priced as a world-leading one, providing there is a reason for the former to appreciate. To put it another way, there is a reason we are stock-pickers, not company-pickers.
The first dose of reality needs to be applied to the impact of higher interest rates on so-called growth stocks. We accept the logic of the argument above, but query its application. In other words, we are unconvinced that very many corporate treasurers chose to borrow in floating rate format when fixed rates are so cheap. This does not mean that the rotation cannot damage client portfolios by de-rating the ‘growthier’ stocks. But it does mean it is about the stock far more than the company.
The second axiom seems somewhat at odds with the first. The dividend aristocrats (the likes of Nestle and other such companies) suffer during a rotation more because of their characteristics as companies than stocks. They are not able to grow their operational results faster than the racier companies, but given they tend to have very high-quality balance sheets and limited debt, allegedly rising interest rates do not impact them between EBIT and pre-tax profit.
For the fundamental investor, these two changes to potential company fortunes need to be addressed differently. In a concentrated portfolio, there is no room for passengers and the competition for capital needs to be high. As a result, just from a company perspective, the dividend aristocrats are unlikely to be the best choices available during such a rotation. There is a place for long-term strategic holds and these dependable compounders are not without attraction, but portfolio managers understand these stocks will not be generating positive alpha during a sharp rotation.
What do I need to do about the companies that are not in my portfolio?
The careful portfolio manager knows that the wealth of clients is not just dependent on what is in the portfolio. It is also about what is not. Concentrated portfolios size their positions according to conviction, liquidity and risk diversification. A key measure of a portfolio manager’s investment process is assessing which stocks with a significant benchmark weight are not in a portfolio. To our minds, it is never acceptable for client money to be invested in a stock ‘because it is big in the index.’
As part of the portfolio management process, our managers keep a keen eye on all stocks within their universe (and quite a few that are not but which provide good read-across). There are companies whose fundamentals are excellent, but whose valuation is too rich for inclusion. There are companies with structurally challenged fundamentals, whose valuation nonetheless will dip to an entry point from which client alpha can be generated. As diligent managers of client portfolios, we would never put money in an investment thesis we did not believe in. At the same time, not every stock in a portfolio needs to be a ‘close-your-eyes-and-send-the-kids-to-college’ stock. We believe there is room in flexible, style-agnostic portfolios for tactical positions to generate client alpha as much as strategic ones.
How can you generate alpha during a rotation?
Rotations are not something to be scared of. They are a repeating and well-understood phenomenon in financial markets and to an extent, they are predictable. The sharp movement in stock prices as part of sector and factor rotations present opportunities for agile portfolio managers to invest in companies at a cheaper price than might usually be possible, and divest other investments at a higher price than normal.
The first aspect is factor awareness. In order to benefit clients during a rotation, it is our view that portfolio managers need to be aware of factors and for the formal consideration of them to be embedded in a codified and replicable investment process. To succeed, portfolio managers should know which factors are becoming cheap, which are becoming expensive, which are over-owned and which are abandoned. Some factors (like momentum) are constantly changing in their composition by definition and this also needs to be kept in mind. If the process is not measuring the valuation of factors, it is by definition impossible to manage them. Only by conscious management of them can portfolio managers generate client alpha from them.
The second requirement is for client portfolios to be style-agnostic. There is a place in the market for style-constrained active equity funds, be they growth or value or otherwise (and assuming these funds are benchmarked against the correctly-selected index, their relative performance should be a fair challenge even when their pre-determined style is suffering). But for true generation of alpha during a market rotation, we believe portfolios need to be flexible in nature, with no pre-set bias to any one factor.
This is categorically not the same as sacrificing fundamental analysis to buy company X just because it fits into a particular factor. The diligent fundamental portfolio manager invests client money in companies with sound and detailed investment theses. It is to the clients’ strong advantage if part of that thesis is based on the immediate prospects for its share price based on its factor identity (we go back to the difference between a company and a stock).
The final aspect here is agility. Factor rotations start sharply and accelerate with an element of self-fulfilment. It is critical to understand that during these moves, it is not usually company fundamentals that drive the bulk of share price movements, so a factor-unaware, purely company-analytical approach is unlikely to save portfolios. At the same time, liquidity can be challenged and for managers of very large, concentrated portfolios (or perhaps those operating as part of, and therefore constrained by a broader and giant fund team), it can be hard to move portfolios around efficiently.
To generate alpha during a rotation requires portfolio managers to be aware, agile and agnostic
What to do at the end of the rotation
As we have already mentioned, the market can only really concentrate on one thing at a time. Heightened awareness is also concentrated on what new thing to focus on, not a sudden realisation that the market is no longer worrying about X. Predicting the end of a rotation is therefore not easy, and is more feasible when trying to identify what new phenomenon might present itself.
It is critical therefore that during the rotation, portfolio managers can execute on a codified and replicable investment process, with specific and disciplined deployment of pre-determined price targets in particular. Again, rotations are rarely driven by stock specifics, so knowing when to invest and divest is key. For many of the more cyclical stocks, portfolio managers can identify trough and peak valuation points. As long as the company’s core operating characteristics do not change, client alpha can be generated by keeping a careful watch on those fundamentals and timing the entry and exit points.
A disciplined approach to valuation is key to not being caught out when the rotation ends
Is it fair to expect all funds to outperform during market rotations?
We believe the key here is being true to label and what that label says. At GAM Investments, we say what we do, and we do what we say.
Style-specific strategies (whether growth, value, income or something else) are not designed to outperform all market conditions and it is unreasonable to expect them to so. The choice of benchmark should take this into account. Funds which explicitly promise their clients a low-turnover, buy-and-hold only or unconstrained long horizon strategy should also not be expected to outperform all market phases. These accommodations do not absolve the portfolio manager of their fiduciary obligation, but it is clearly unreasonable to expect a growth strategy to outperform a value rally.
For style-agnostic, flexible portfolios, we believe it is not unrealistic to expect portfolio managers to position portfolios accordingly as rotations occur. If that is not possible due to the size of the strategy, it is not unreasonable to expect that to be included in the marketing of the product.
At the same time, if the market rotation is led up by the lowest quality stocks, possibly aided and abetted by social media-led market distortion, portfolio managers should obviously avoid investing client money into those companies. The fundamental investment process remains key. We go back to our earlier comment. If businesses fail, then so do their investors.
Long-term stewards of client portfolios know there are moments when stock specifics drive the market and there are moments when they do not. There are times when market movements allow them to bank alpha, and there are times when they can build alpha. The usual argument on sharp and violent market rotations is that these phases are times to start building alpha (and the client is advised to be patient for the cheaply-increased positions to revert to norm). However, we believe that factor and sector rotations should be viewed as a specific phase of market environment when additional client alpha can be generated. The key is being factor aware, agile and style-agnostic as part of a codified and replicable investment process.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. Allocations and holdings are subject to change. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.