Volatility in equity markets has persisted as investors run from risk and search for yield. In times like these, we stay true to a bottom-up, value orientation.
"April is the cruelest month"—the sentiment of poet T.S. Eliot—rang especially true for managers of large-cap mutual funds this spring when they learned that during the first quarter, only one out of five of them beat the Standard & Poor’s 500 Index.
Bottom-up stock pickers are underperforming this year as yield-hungry investors snap up highdividend stocks. Meanwhile, many large, leveraged hedge funds, focused on near-term performance, quickly jettison any underperforming shares, magnifying volatility.
Investors remain on edge while coping with numerous challenges, including near-zero interest rates and reduced market liquidity.
Prolonging a two-year trend, investors seeking both limited risk and high yields pushed up the S&P 500 Utilities Index this year by 10% through May 23, compared with a 0.5% gain in the S&P 500 Index. During the same period, consumer staples, also deemed a defensive sector, rose 3%, based on the S&P 500 Consumer Staples Index. Investors are also speeding a multiyear shift into passive management, including exchange-traded funds (ETFs). During the first quarter, passive management gained $90 billion while, active managers saw an outflow of $40 billion, according to Morningstar.
Some active managers with a long-term focus have lagged in performance in recent years after investing in sectors that they expect will recover from a slump. For example, they have invested in energy companies, anticipating a rebound in the oil price, which has yet to occur. Others have invested in financial stocks, expecting interest rates will rise from nearrecord lows.
In the near term, managers who take a long view may lag passive investments, which are often tied to an index and do not overweight a particular sector. A passive approach may outperform the average active manager simply because of lower management fees, underscoring the importance of our focus on finding managers with the strongest stock selection process. The popularity of passive investing is self-reinforcing, as capital shifted from stocks excluded from an index pushes up stocks included in the index. We expect the pendulum to eventually swing back in favor of talented active managers as stocks listed in indexes decline to their intrinsic value.
Overall, we believe the market’s unusual short-term preoccupation with the perceived safety of high-yield stocks and passive investing offers opportunities for meaningful long-term gains as long as we focus on value and disregard the fads of the moment. We are staying off the market’s well-beaten path and are instead taking an approach with these characteristics:
Continue to favor equity managers who are devoted to bottom- up research and take a long-term view. In equities, we look for managers with a disciplined process who aim to buy businesses at a discount to their intrinsic value. These managers would also look for companies that hold a sustainable competitive advantage and show promise for long-term growth and profitability. Our managers do so through their own primary research, speaking to the company, its competitors, customers, suppliers and experts in the industry.
Take advantage of opportunistic investments and avoid overvalued areas. We seek opportunities to take advantage of swings in asset prices, such as our allocation to high-yield bonds after their swoon last summer. When equities with high dividend yields fell during a market panic in 2011, we “overweighted” equity income strategies, recognizing the bargain in solid companies with high yields. As the discount shifted to a premium, we transitioned back to our core equity position in 2013. The premium has now risen to such an extent that, in order to secure an above-market 3% yield, investors are buying companies that have stopped growing and that sell at higher multiples than both the broader market and some of the most rapidly growing companies you can find.
During the first quarter, our managers seized on the opportunity to buy Google, Priceline and Avis at prices well below their estimates of intrinsic value. Priceline in February plunged 23% from the start of 2016 and has since rebounded by 27%. Google (whose parent is Alphabet) fell 10% intraquarter and has risen 4% from that low. Avis in February nosedived 39% from its price at the beginning of the year. The decline was an overreaction as analysts trimmed earnings expectations by 15%. (Estimates for the broader market have decreased as well.) Concerns about U.S. economic growth and competition from Uber and driverless cars also pushed down Avis. Since hitting an intraquarter low, Avis stock has surged 24%.
Shift a portion of capital to smaller hedge funds. Hedge funds oriented toward bottom-up stock picking have suffered even more than mutual fund managers because they have lost on both long and short positions. Much like their mutual fund counterparts, many of the top funds have avoided overheated areas, such as utilities and consumer staples, focusing instead on the long-term value in quality technology, health care and consumer discretionary businesses. Many funds have been short these high-yield stocks. A number of funds have also been hurt by the rally in energy and basic materials shares that was prompted by China’s stimulus measures during the first quarter. Many fund managers believe medium- and long-term supply and demand dynamics are still unfavorable. The market, though, is reacting to the short-term news and speculating on a rebound.
Many large, fundamental hedge funds have lagged the broader industry because of “crowding” by other investors into their top holdings. Managers with exceptional track records, such as Viking, Lone Pine and ValueAct, often see their holdings purchased by copycat investors with much shorter time horizons. When the going gets tough, many of these copycats run for the exits at the same time, and the stocks underperform the market. For example, stocks that are widely-held by hedge funds fell more than 4% this year through May 16, while securities with low hedge fund concentration have surged more than 9%.
The wide performance gap underscores how many hedge funds this year have not served one of their purposes of limiting downside losses and reducing volatility. During the first quarter, our U.S. equity hedge funds proved unusually vulnerable to the downdraft in the broader market largely because of the impact from crowding. We have been reducing the average size of our hedge fund allocations for a number of years, but we, and others, wish we had done more of this before the first quarter. In our recent allocations, we have targeted hedge funds with about $1 billion in assets, compared with our current average of about $5 billion.
Broadly speaking, we believe that by pursuing a long-term strategy with the above characteristics we will generate attractive returns regardless of any seasonal shifts in the market’s mood.
The views expressed are those of the authors and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested. In addition, these views may not be relied upon as investment advice. The information provided in this material should not be considered a recommendation to buy or sell any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients or other clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients and is for informational purposes only. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication.
The Standard & Poor’s 500 Index represents the large-cap segment of the U.S. equity markets and consists of approximately 500 leading companies in leading industries of the U.S. economy. Criteria evaluated include: market capitalization, financial viability, liquidity, public float, sector representation, and corporate structure. An index constituent must also be considered a U.S. company.
The S&P 500 Utilities Index comprises those companies included in the S&P 500 that are classified as members of the Global Industry Classification Standard (GICS) utilities sector.
The S&P 500 Consumer Staples Index comprises those companies included in the S&P 500 that are classified as members of the Global Industry Classification Standard (GICS) consumer staples sector.
©2016 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information.
This communication and any accompanying documents are confidential and privileged. They are intended for the sole use of the addressee. Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, indepthanalysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.
Terms and definitions: Price-Earnings Ratio (P/E Ratio) is the ratio of the price per share of a company’s stock compared to its per-share earings. The Dividend Yield is the amount a company annually pays out in dividends per share of common stock divided by its share price. Earnings Per Share (EPS) Growth measures the annualized rate of growth in a company’s net income per share of common stock.
Alternative investments, such as hedge funds, may only be available to qualified purchasers and accredited investors.