Why global investors need to consciously seek out differentiation during the ‘big unwind’ - Angles & Perspectives

Why global investors need to consciously seek out differentiation during the ‘big unwind’

Markets are notoriously noisy and can often send contrary signals. We believe this is precisely what is happening now, with some current events obscuring the long-term secular shifts we believe are taking place. This creates the danger that investors are lulled into a false sense of security, and continue to favour strategies that have worked in the past – at the expense of their future portfolio growth. In such an environment, differentiated managers bring important benefits as part of a diversified portfolio.

Investors have faced an eventful start to the year
In his article Capitalising on the ‘big unwind’ – picking stocks that are fit for the future, Shaun le Roux references how the unwinding of several market distortions will give rise to risks and opportunities in coming years. However, the first six months of the year have been a tumultuous period.

After a strong start to the year, cyclical sectors such as materials and energy joined the global market sell-off in June, largely driven by fears that rampant interest rate hikes, particularly by the US Federal Reserve (the Fed), will lead to a sharp slowdown in demand and possibly a recession. Many may view the potential of an imminent recession as confirming previously held views that the global economy will revert to its post-Global Financial Crisis (GFC) period of below-trend economic growth, and that the stocks to own going forward will likely be the same as those of the past. However, we would caution against this view and would argue that using the playbook of the past over the coming decade will set investors up for poor returns (Kevin Cousins and Shaun le Roux elaborated on our reasoning in their respective articles What if secular growth, and not stagnation, is the new normal? and Challenging the seven narratives embedded in current portfolios from our previous edition of Angles & Perspectives.)

Market participants not positioned for the ‘new normal’
We believe the areas of the market that will deliver for investors and which will be perceived as ‘quality’ in the future, will be different from those of the past. Given the expected unwinding of several major market distortions and weaker returns expected from major index constituents, differentiated positioning will become critically important going forward. Importantly, as the analysis below shows, the majority of fund managers still aggregate around consensus positions, and are thus not aligned to the changing landscape.

Unpacking concentration in investment markets
Given the market dynamics over the past decade, indices have become enormously skewed towards the winners of the past, most notably the mega-cap technology platform companies such as Apple, Microsoft, Amazon and Alphabet, while longer-term underperformers such as energy and materials companies have seen a significantly diminished share in major indices. Diverging sector weights in the S&P 500 Index between the IT, media and telecommunication sectors and the energy and materials sectors since the Global Financial Crisis, are testament to this (as seen in the graph that follows). One could argue that the current composition of major indices carries a significant growth stock bias.

In an attempt to better understand market positioning, we analysed the universe of global equity unit trusts available on the Morningstar database, which sum to a total of 2 891 funds and US$1.4 trillion in assets under management across four key global equity categories (large cap blend equity, large cap growth equity, flex cap equity and large cap value equity). Interestingly, yet unsurprisingly, large cap and growth equity funds account for the bulk of assets (88%) while flex cap and value equity funds are only approximately 12%.
(Note: Funds in the flex cap category, which is the category of the PSG Global Equity Fund, invest across a wider market cap spectrum.)

While the above only tells us that investors far prefer large cap growth over a wider value universe, we then ran over 400 of the largest global funds available on the Morningstar database through the Morningstar holdings-based style analysis tool, which maps unit trusts according to investment style (from value to growth) and the size of companies held by each fund. We also included the PSG Global Equity Fund for this analysis. As can be seen in the following graph, the bulk of funds are invested in the largest global companies and ranked as core and core growth, with only a small minority of funds scoring as value funds. While these results shouldn’t be surprising, it is highly indicative that the vast majority of funds are positioned for a continuation of the investment environment witnessed over the past decade (i.e. a continuation of the status quo). As alluded to earlier, the skewing of indices to large cap growth companies also means that the bulk of funds have likely become closet index trackers.

Most South African-based investors cannot easily access hundreds of the largest global funds. Performing the same analysis on the key global funds available for distribution in South Africa yields similar results, with only a handful of funds positioned towards value and invested across a wider range of market capitalisation.

Considering the current set-up of the market, some of the key questions investors in unit trusts should ask themselves are whether their active managers are just hugging the index, and how they would perform, if the next decade were to look substantially different to that of the past. Given the expected unwinding of several major market distortions, we believe differentiated positioning will become critically important going forward.

How our globally integrated investment process enables us to find differentiated opportunities
Our team of investment professionals manage a total of R11 billion in global assets across our domestic South African and global funds. We have been investing globally since 2008 and use one globally integrated 3M investment process to filter down the large global investable universe of around 3 000 companies to our buylists. This process intentionally downplays our ability to predict macro outcomes, and instead focuses on longer-term supply-side dynamics and company fundamentals. We are benchmark agnostic and allocate capital to the best risk-adjusted opportunities identified globally.

We have a track record of getting into the right areas and our global stock picks have been highly additive to the strong performance of our domestic funds. This is evidenced by our large allocation to technology related shares in 2016. As valuations and share prices rose, we recycled capital into other parts of the market offering better value, and in recent years increased our allocation to energy and materials shares, given the major dislocations and supply-side constraints observed.

Globally, value investing has faced severe headwinds over the past decade, but the major inflection points we are seeing in markets should provide a favourable environment to benchmark agnostic, valuation-focused investors going forward.