Investors around the world have been scrambling to increase their holdings in popular stocks. It looks like they are giving up on the cheap underperformers.
A high-conviction view of the next three years
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.
Unfortunately, the consequences are also predictable: individual investors are selling low and buying high. This will have a detrimental impact on long-term returns, as we believe the prospects for contrarian investing have been enhanced. Most investors have thrown in the towel on contrarian style at just the time that portfolios need them most.
We have seen the rise of a narrow group of winners and a wide universe of underperformers
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. Table 1 shows that 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 assumption that the experience of the recent past persists. On the JSE, this assumes that most companies never recover from their deep bear markets.
A focus on relative earnings growth but not valuations
This discrepancy in recent performance by popular mega-caps can be explained by two factors: superior earnings growth (which gets all the attention) but also a widening gap in valuations between the mega caps and the balance of the market. To be fair, we have written a lot about this discrepancy in valuations over recent years and discussed our conscious decision to rotate our portfolios towards cheaper stocks that were out of favour. The impact of the latest coronavirus pandemic on cheaper, more cyclical stocks has been severe, having a negative effect on the relative performance of value managers such as PSG. 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.
Tech stocks have driven the recovery in index performance
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 Microsoft – a business that we have owned in the past – currently trades on 36 times earnings. It is a fabulous business, but if you bought it the last time it traded at this kind of valuation level (in 2003), you had to wait a decade for the share price to start appreciating.
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.
Locally, Naspers and Prosus dominate portfolios
Closer to home, it is difficult to find a domestic manager that doesn’t gush about the investment merits of Naspers and/or Prosus. In fact, the combination has become such a consensus holding that most managers seem to view a holding of below 20% of portfolio value – in effectively one stock – as overly conservative. This is a function of the extraordinary distortion that has been allowed to manifest in the JSE indices, with Naspers/Prosus comprising 26% of the Top 40. With an ever- growing proportion of capital being allocated to benchmark- heavy investment styles, Naspers has become a victim of its own success, or, more specifically, Tencent’s success. Because, whichever way you slice it, an investment in Naspers/Prosus is primarily an investment in Tencent as the balance of investments are currently loss making. Just like the tech stocks on the Nasdaq, most market participants are positioned in a way that assumes the future will mimic the past. With the current Tencent rating – at 45 times earnings – close to the highs of the past decade, having 20% of your portfolio in one stock is a high-conviction view that not much can go wrong from here. This kind of conviction and concentration is playing out in portfolios around the world.
A fantastic business – what could go wrong?
A discussion with fund managers that are long tech stocks will typically focus on the fantastic economics of these businesses and superior long-term earnings power. Here you will find little disagreement from ourselves. What is less frequently discussed are: the price paid, the expectations that are embedded into that price, and what could go wrong. A lot could go wrong with an investment in tech. When expectations and valuations are this high, they do not allow for any disruption to the current status quo. Possible disruptions include: regulatory intervention (likely), higher bond yields and lower P/E ratios, a rotation in fund positioning, unforeseen future competition, and declining returns on invested capital as a result of the law of large numbers. In addition, an investor in Tencent also needs to consider the very real risks associated with Chinese corporate governance. This combination of aggressive positioning, very high expectations and very little attention being paid to what could go wrong is a clear indicator of how investment markets are currently perceiving risk. There is material complacency as far as expensive stocks are concerned.
Many securities are discounting long-term outcomes that are overly pessimistic
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 the 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. We view this as very fertile ground for long-term contrarian investors. As our article Obscured quality – the market is pitching classic 3M opportunities discusses, we have invested in a number of out-of-favour businesses at incredibly attractive prices. These companies are of above-average quality and the long-term returns look compelling.
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. As graph 2 shows, 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.
Sharp profit growth off low valuations could set the stage for excellent returns to come
We often get asked what would result in outperformance by the contrarian investments that we currently favour: the cheap unloved stocks. Our non-consensual view is that the environment is conducive to the next three years being very different to the prior three: the extent of the crowding in popular sectors sets the scene for aggressive future rotation. 2020 earnings are going to decline sharply for most companies, but this sets the scene for a sharp recovery in 2021. Sharp profit growth and very low starting valuations tend to give rise to excellent returns as stocks emerge from a deep bear market. A stimulatory environment, which the COVID-19 pandemic has induced, has also typically been kind to cyclical industries, commodities and emerging markets and less favourable for developed market bonds and ‘bond proxy’ stocks like defensives and tech.
These factors favour increased exposure to cheap contrarian investments at a time when most investors are reducing their exposure to these counters. As contrarian investing becomes scarcer its value rises, particularly as a hedge in portfolios that are heavily weighted in crowded expensive assets.
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