Shaun le Roux, PSG Asset Management
Any review of the holdings of global pension funds, unit trusts, hedge funds, passive exchange traded funds (ETFs) and retail investor portfolios, clearly shows that almost all are heavily exposed to a relatively narrow group of securities. Today, few global portfolios are not dominated by stocks that represent the winners of the past three years: US large caps, technology, growth, and quality. At the same time, we are witnessing a global capitulation out of what has not worked in recent times – especially cheap stocks, value funds, emerging markets, and contrarian investment strategies. Chasing what has worked in the past, at the expense of what has suffered, is a predictable feature of investment markets. Yet, it is rare that consensus and the market are positioned in such a narrow range of stocks and themes. This seems to be a high-conviction view that the next three years will replicate the experience of the past three years.
It is small wonder that there is immense pressure to invest in what has worked well in the immediate past: the performance gap between the narrow group of winners and the broad universe of underperformers has been extraordinarily wide.
The ten largest constituents of the FTSE/JSE All Share Index (comprising 62% of the weighting) returned 49% (on average) over three years. The other 127 shares in the index – comprising only 38% of the weighting of the index but representing 93% of the number of stocks in the index – declined by 29% on average over the same period.
This discrepancy in performance has been replicated in markets around the world, although the JSE is more distorted by the relative size of Naspers/Prosus in our market, which masks the fact that the average South African stock has been amongst the poorer global performers.
Analysis of the top holdings of the largest unit trust funds in South Africa reveals high levels of overlap and substantial exposure to the ten largest local stocks, the recent winners. Similarly, the largest holdings in actively managed US funds are Microsoft, Amazon, Alphabet, Facebook, and Apple. Most managers are hence making an explicit bet that the experience of the recent past persists. On the JSE, this assumes that most companies never recover from their deep bear markets.
This discrepancy in recent performance by popular mega-caps can be explained by two factors: superior earnings growth but also a widening gap in valuations between the mega caps and the balance of the market. The impact of the COVID-19 pandemic on cheaper more cyclical stocks has been severe. Conversely, the lockdown measures have enhanced the relative profit performance of higher-quality businesses, especially the tech stocks that benefit from the accelerated move to digitisation.
The past few months have seen a dramatic increase in the share prices of the secular growth stocks like Amazon, Microsoft and Tencent as investors rushed back into equities after the March sell-off. As a result, we have seen tech-heavy indices like the Nasdaq, the S&P 500 and the All Share Index staging remarkable recoveries – the S&P 500 recouped all its 2020 losses in June, at the same time that the Nasdaq was making all-time highs. While tech stocks are rare beacons of growth in 2020, the rise in their share prices is almost entirely attributable to shareholders paying more per dollar of earnings.
Secular growth stocks are long duration assets – investors take a view that long-term growth compensates for higher valuations – and hence compete for capital with bonds. In a world of ultra-low global bond yields, this has had a dramatic impact on equity valuations. A company like Tencent currently trades on 49 times earnings.
What is particularly alarming to observe is how the most expensive stocks on the market, the tech stocks, have become ‘safe havens’. In recent times, bad macro headlines – such as a rise in COVID-19 infections in the US – have seen the Nasdaq rise when ‘risky’ assets like cyclical equities decline. We argue that buying overpriced assets such as developed market bonds and expensive equities is a very poor way to insure your portfolio against adverse economic developments.
At the same time, investors have capitulated out of cheap underperformers where risk is perceived to be high. They are concerned about the lack of visibility around near-term earnings in a COVID-19 ravaged world. This fear is being most acutely felt in emerging markets, like South Africa, which lack the capacity to use stimulus to counter the effects of the lockdown. As with expensive ‘safe havens’, little reference is made to price paid for cheap stocks. We would argue that many securities are discounting long-term outcomes that are overly pessimistic. Economies will eventually recover from the very visible COVID-19 shocks, even if the recovery is stop-start and if it takes many sectors a few years to reach 2019 levels of activity.
There is a growing consensus that global equity markets have moved too fast and are pricing in an aggressive ‘V-shaped’ recovery that is unlikely to materialise. While time will tell whether this is the case, we think this narrative is overly simplistic. It fails to appreciate that share price recovery has primarily taken place in stocks (like tech) that outperform in a low growth environment. In fact, cheap cyclical stocks that are more dependent on global growth have languished and have incurred sharp losses in 2020. While the tech-heavy Nasdaq is making fresh highs, the average stock on the S&P 500 is lower than where it was at the end of 2017. This discrepancy is even more pronounced in a comparison between the Nasdaq and more out-of-favour parts of global markets like small caps, emerging markets, financials, and energy. Again, most market participants are positioned in a way that assumes that this relative price-performance persists.
As contrarian investing becomes scarcer its value rises, particularly as a hedge in portfolios that are heavily weighted in crowded, expensive assets.