Grab those life jackets and get your clients off the party boat
The New Year got underway with the usual smattering of asset manager outlook presentations. In fact, over the first five weeks of 2023 this writer attended a handful of webinars in which all and sundry shared their views on asset allocations; developed versus emerging markets; and offshore versus onshore to name a few. There were also countless discussions about inflation and interest rates and the possibility of global recession.
The depth, duration and impact of recession
“Everyone is talking about Europe, the United States (US) and even South Africa going into recession,” said Justin Floor, a Portfolio Manager at PSG Asset Management. He added that portfolio managers were consumed by questions like when countries might enter recession; how deep these recessions would be; whether countries would experience a hard or soft landing as the exited recession; and what the impact of recession would be on asset classes and prices. Although it is impossible to answer these questions on a short-term view, Floor was prepared to share data from a recent Bank of America survey of global fund managers which suggested that “markets may have moved past peak fear”.
PSG Asset Management has long differentiated from its competitor firms on the basis of size, claiming that smaller asset managers are able to side-step some of the risks that go hand-in-hand with investing in the big stocks that everybody owns. To illustrate, a fund with ZAR150 billion assets under management is not going to be able to stay fully invested in SA equities without loading up on shares in the Top 40. And portfolio managers with that much capital to allocate cannot dive in and out of positions in the small- and mid-cap shares that numerically dominate the JSE All Share Index. “We see some big risks sitting at index level in the large stocks that almost everybody owns; but there are pockets of the market that look really interesting,” Floor explained.
The compelling ‘two boats’ narrative
To keep an audience of advisers and investors engaged, you need a compelling narrative. This presentation earned its storytelling ‘stripes’ with a tale of two boats: one, a superyacht with a crowd of partying passengers; the other a sailing boat, with a more reserved clientele. The party boat, it turns out, is an analogy for the last decade, especially in US markets. Throngs of partygoers (aka stock market investors) revel in the liquidity on offer on this boat, chasing prices higher based on the notion that quality is always worth any price. Over this decade, benign inflation plus low interest rates meant that money was practically free in investors’ hands. “You had the central bank stimulating [via] the Federal Reserve ‘put’; every time equity markets wobbled, the Fed would get in there and buy the hell out of the market [in an attempt to] support everything,” said Floor.
These conditions proved perfect for a run on the large cap growth shares that are often found in the technology sector. So, over the decade, the so-called FAANG stocks made up of Facebook (now Meta), Amazon, Apple, Netflix, and Google (now Alphabet) all shot the lights out. Other technology stocks, accelerated perhaps by the two-year-long pandemic, did well too. “It was an absolute roaring party, and the passengers were having a great time,” noted Floor, before observing that a few astute investors on the boat had noticed choppy waters ahead and started nervously eyeing the lifejackets.
We already know what happened next: almost overnight, the decade-long US equity market rally that was carried on the back of loose fiscal and monetary policy decision making seems to be nearing its end. That explains why Lumen Technologies (down 58%); Meta (down 64%); PayPal (down 62%); and Tesla (down 65%) all featured on the list of 20 worst-performing S&P500 shares last year, while the S&P index contracted by a fifth. “We do not know the future, but the evidence is building that we might be in a new cycle,” Floor opined. This cycle revolves almost entirely around the Fed refocusing on its mandate of fighting inflation rather than protecting growth, meaning that the free money era, and the age of the Fed ‘put’, are over for now.
Price actions perpetuated by frenzied investors
To be clear, there are many investors who still believe that technology will deliver growth over the coming decade; but PSG is not so sure. “If you look over history, there is always a bear market that seems to mark the divergence or transition from the winners of the past to the winners of the future,” said Floor. Examples include the 1987 stock market crash; the dotcom ‘bust’ in the early 2000s; and the global financial crisis of 2008-9. The argument is that many equity market trends begin with a seed of truth that is over watered by frenzied investors, eventually overshooting fair value by quite some margin. According to Floor we could be witnessing a painful normalisation in which the over heatedness in segments of the US markets cool, whereafter the next cycle will commence.
It is worth noting that asset managers often get caught offside during these cycle transitions by stepping off the party boat too early… “We are not able to time the market exactly [which means that] this part of the cycle is typically quite painful for us,” admitted Floor. Indeed, it was painful for asset managers that eased out of their technology positions at what, on any sensible valuation methodology, appeared to be the right time. The only consolation is that investors’ funds were off risk at the height of the speculative bubble that developed around technology shares during 2020, 2021 and part of 2022. Going into 2023, there are real concerns that investors are still backing the winners of the last decade, hoping that the 2022 market correction was just a temporary blip.
A practical growth versus value example
Floor commented that the last time the spread between very expensive and very cheap parts of the market was as severe as we see today was just prior the dotcom correction, before concluding his presentation with a ‘blind test’ of three companies labelled A, B and C. All three companies were considered quality investments and widely held in global equity portfolios, but the key metrics could not be more different. At end-December 2021, company B and C were considered expensive, trading on PE multiples of 30x or higher and promising 6-8% earnings growth over 2022. Company C, meanwhile, was trading on a 9x PE multiple and promised earnings of around 10%.
Wind the clocks forward 12-months, to end-December 2022 and company B (Nestle) and C (Moody’s) had fallen 15% and 30% respectively versus company A (Shell), which appreciated by 33%. Surprisingly, B and C remained expensive on a forward PE measure, while A remained cheap. This exercise supports PSG’s thesis that cheap stocks are where the value is. “To make the argument that there is low growth and low quality in value is factually incorrect; there is growth and there is quality in some of the value pockets of the market,” concluded Floor. “It is our job to go and find those pockets”.
Writer’s thoughts: This growth versus value tug-of-war is as old as the financial markets, with one or other methodology getting the upper hand, often for decades at a time. At first glance it does appear that the value team is in line for a few winning years; but the outcome is never certain. Do you get caught up in the growth versus value debate, or do you leave your client’s asset allocation and stock selection decisions to the professionals? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts editor@fanews.co.za.
