Outperforming any index over a sustained period of time is notoriously hard, particularly when it involves equities, where the number of market participants is high and volumes are enormous. The New York Stock Exchange alone sees an average daily trading value of around USD 169 billion. This level of market participation and liquidity has made US – and therefore, to an extent, global – equities notoriously tough for active managers to beat. The numbers bear this out: the MSCI AC World Index in US dollars has returned 38.5% over the five years to the end of June 2019, while the Lipper Global Equity USD peer group of global equity managers has achieved an average of just 16.3% over the same period (Source: GAM and Refinitiv). This disheartening statistic does not signify any lack of effort on the part of either academia or investment managers in trying to find a way to consistently beat the market. The former’s crowning achievement surely came in the early 1990s when Fama and French established definitively that individual themes or factors such as value and small caps outperformed the market over time. This was a neat explanation for what happened in the past and of course gave hope for the future. Since then, however, the power of these equity risk factors has waned. The proliferation of style-based managers and the explosive growth of the exchange-traded fund market in individual factors has arguably eroded the ‘edge’ associated with identifying and holding them in the first place. Value – one of the main factors highlighted by Fama and French – has displayed no outperformance over the growth style since 1994. How, then, might investors realistically aim to outperform the equity market in the coming years?
Chart 1: The Value of Nothing: Value fails to generate a return since the early 1990s
Past performance is not an indicator of future performance and current or future trends. The views are those of the manager and subject to change.
In his seminal work “Stocks For The Long Run” Jeremy Siegel identified that over two centuries the US stock market returned 7% per annum in real terms. The ‘Siegel Constant’ essentially reflects economic, productivity and population growth captured by the listed corporate entity. The equity market can therefore be thought of as a proxy for global progress, or ‘humanity’s internal rate of return’. Improving on this natural rate of return – and Mr. Siegel found it applied over the medium term too – requires some anticipation of the structural, technical and even cultural changes that will affect the global economy. In other words, if the stock market’s long run returns are a function of structural growth trends, then outperforming it should be a matter of identifying changes affecting these growth patterns. Enter the megatrends, three in particular – Technology, Sustainability and Emerging Markets – which may contribute to a higher rate of return than the so-called Siegel Constant.
Taking technology first, Cisco estimates that at least 40% of all businesses will not survive if new technology is not sufficiently embraced. This will likely create a bifurcated world of winners and losers which offers attractive opportunities for outperformance for those listed companies providing that technology or adopting it and leveraging it effectively. Given that long-run equity returns in part reflect improvements in workforce productivity, it makes sense that innovative technology stocks will set the pace. Admittedly, this is hardly new thinking. We believe the 2001 technology, media and telecoms (TMT) unwind and scepticism around recent high profile technology IPOs in the US testify to the apparent propensity of the sector to over-valuation. But technology stocks tend to be cash rich and enjoy higher cash flows than most other businesses, suggesting that adjusted for this higher cash rate, valuations are not much higher than that of the rest of the market. Furthermore, for all the negative news around increased regulation of technology stocks, many investors seem to remain willing to add to their allocations when openings arise. Thus, while the NYSE FANG + Index (based on Facebook, Apple, Amazon, Netflix and Google) underperformed the S&P 500 this year to 7 June, it strongly outperformed when the Federal Reserve suggested it would support the economy as uncertainty rose around trade wars. Given the choice between stocks which will lead the coming digital transformation versus stocks that might or might not succeed in embracing it, technology remains a compelling megatrend.
Sustainability is the next megatrend. It is of course true that ethical investing has been around for some time. In the first five books of the Bible, Moses created rules to correct the imbalances that humanity caused, with Jewish tradition emphasising the responsibilities that property ownership confers. Islamic teaching in the form of Shariah similarly sought to prevent exploitation, with rules on proscribed investments including alcohol and usury. However, what is new today is a strong consensus around sustainability and equality, with an associated urgency to take action. Climate change is considered no less than a global emergency by the millennial generation while attitudes to meat consumption and inequality of opportunity are rapidly changing. In the investment world, sustainability is therefore moving from an investment sub-sector to the point where firms not seen to be improving on environmental, social and governance (ESG) criteria will find their stock underperforming or – worse – will be unable to list and raise capital in the first place. It is now becoming possible to buy entire indices screened for these ESG criteria in exchange traded fund form. We believe using them to create a structural long-term ‘overweight’ to listed companies scoring highly on ESG criteria may be a simple way to capture the outperformance such firms may well enjoy in the coming months and years as the investment world adapts to the demand for sustainability.
Finally, emerging markets. The International Monetary Fund estimates that emerging markets and developing economies account for nearly 60% of world GDP (and growing); yet Asia and emerging market stocks barely make up 16% of the MSCI AC World Index. The necessary adjustment that we believe will have to occur can be articulated through a structural overweight to these economies’ stock markets. Many investors will likely simply choose an established index such as the MSCI Emerging Markets Index to do this but we believe it is overexposed to ‘Factory Asia’ and underexposed to fast-growing economies found in Africa. Investors can therefore seek to make further gains by ensuring a suitable exposure to frontier markets either via selected indices or active managers. While the last couple of years have hardly been a good advert for emerging markets amid trade wars and a stronger US dollar, they do at least offer an attractive entry point in a way that technology stocks cannot. The MSCI Emerging Markets Index, for all its structural flaws, neatly demonstrates this: as at 7 June it was trading at a forward P/E multiple of just 13.0x while the MSCI World trades at 16.3x. Superior economic growth in the coming years is effectively trading at a discount of over 20%.
Chart 2: Growth on sale: EM is trading at a 20% discount to world markets
Past performance is not an indicator of future performance and current or future trends.
The megatrends described above are neither universally new, nor universally cheap. Furthermore, they do not represent a shortcut to near-term index outperformance. But what we believe they do offer is access to secular and structural growth stories which transcend near-term market histrionics. Whether it is the infiltration of technology into every sector of the economy in the coming years, the demand for a fairer, more sustainable world or the inexorable growth of emerging economies, these trends can be captured through carefully selected equity structures. Investing for megatrends is no less than a viable style in its own right and one which we feel intuitively offers at least as compelling a prospect for long-term outperformance as any other factor or style available to investors.