The Return of the Stock Pickers – If Not Now When?
The whole trick of the game is to have a few times when you know that something is better than average and invest only where you have that extra knowledge Charlie Munger, Berkshire Hathaway, Vice Chairman.
Don’t look for the needle in the haystack. Just buy the haystack! John Bogle, Vanguard Founder
In Previous Episodes
In recent weeks, we have looked at how the UK equity market consolidated in 2022, with the largest companies increasing their dominance. This shape-shifting helped drown out the normal small-cap excess returns, a feature of developed equity markets over the past fifty years. We also observed that the traditional market for high-growth public companies, AIM, has become much less vital and that the UK has become cheap relative to other developed markets. All these observable outcomes have surfaced in a world of long-term public market de-equitisation, meaning that we have fewer listed companies as debt became favoured over equity in corporate financing decisions.
The other observable market feature over this period has been the extraordinary growth in passive investment strategies. These factors have coincided with central bank dominance, low-interest rates, and broadly coordinated international monetary policy. Some of these features have changed, and we will now learn their consequences.
This Time it’s Different
Mohamed El-Erian, in a recent FT article, said that for many years, major central banks were celebrated for being effective repressors of economic and financial volatility. We are now in a different world. The financial historian Russell Napier points out that we have moved into a world of fiscal dominance. A world that, for the first time in a long time, politics will matter most to markets. These commentators are saying that old-fashioned political economy is replacing neoliberal economics as the prime policy determinant for investors. The Chips Act, The Inflation Reduction Act and their like will be more important drivers of investment returns than monetary policy.
In recent history, ultra-low interest rates and plentiful central bank liquidity created the inflation of financial assets. Excess dollar liquidity narrowed credit spreads, and the bluest blue sky opportunities and the most indebted sovereign credits could access finance. Private equity, a business model predicated on buying assets with debt and holding on tight, boomed. In a world where a common global factor significantly determines investment performance, passive investment management could also flourish. As Merryn Somerset-Webb recently said, passive management offers a product that has provided huge benefits to consumers — after fees, passive funds have outperformed active pretty much every year for the last 20. It doesn’t cost much to do — and what costs there are mostly low and fixed. No performance-fee-demanding managers are required here. With volume, you can make investing both cheap for consumers and vastly profitable for your firm. No one loses — and if the industry is to be believed, no one will.
Until it Doesn’t
However, if today you decided to put your faith in the MSCI Global Equity index to reduce specific risks in your portfolio and get broad exposure to the world economy and its ability to recover from whatever comes its way, think again. The top four holdings in that basket of global stocks comprise 12% of the total: Apple, Microsoft, Alphabet, Amazon, and NVidia. All great companies but all widely known and celebrated as such, and all different reflections of the economic and monetary conditions of the last couple of decades. In 2021, this cohort of US tech stocks comprised 20% of the global market. (With the UK’s top five constituents Shell, Astra Zeneca, HSBC, Unilever and BP, you at least get a broader mix of industry groupings, albeit they represent 35% of the UK’s total market capitalisation).
In the 1999/2000 technology bull market, there was an 18-month period when the only factor differentiating market outperformance was exposure to technology. The Cass Business school identified that passive investors were “effectively forced” to buy bigger and bigger stakes in overpriced companies. I remember doing an equity raise for a newly anointed £ billion dotcom winner in early 2001. The amount raised in the first three meetings exceeded the IPO value of the business only a couple of years earlier. Investors who had missed the intervening boom were dangerously underweight in technology to a career-threatening extent. Their large orders to invest were attempts to play catch up. The company they felt compelled to buy was valueless within three years. In reality, passive investing is a cheaper variant of momentum investing. You get to hold lots of stuff that has done well recently. Index weightings reflect the market relative valuations of yesterday.
Ever Looser Union
Passive investing has grown such that it accounts for nearly half of all managed assets. But as passive investments predominate, markets become informationally less efficient. Bubble tendencies emanate from coordinated policies to suppress volatility and fuel a narrow cohort of stocks that dominate markets. However, the period of central bank coordination is fading. Just look at their utterings in the last couple of weeks. While the Fed sees inflation heading down to target with little damage to economic growth (a soft landing), the ECB and BoE are more worried about inflation and recession (stagflation). Meanwhile, POBC is fighting its COVID lockdown demons and property sector strains. The BoJ is changing management teams and preparing to re-enter the real world of positive interest rates for the first time in a generation. They are each fighting their own battles.
As El Erian says, we are heading into a world where clever structuring and dynamic asset allocation trump, more often, the lower fees on passive vehicles. He says we are primed for a period when active management can fight back. Napier’s view is that if we look back to previous periods of financial repression and inflation, it is obvious what has done well: stocks that have started the period cheap. That was most of the market in the late 1940s and 1950s. [What Warren Buffett described as cigar butt investing]. And it was niche bits and bobs in the 1970s; even as the wider market worked on destroying most investor wealth, small caps and resource stocks hugely outperformed.
Blessed are the Stock Pickers
As the world is coming to terms with the normalised interest rates, fiscal dominance, and the end of free money, returns should disperse as company-specific factors predominate among critical performance criteria. Companies must adapt to elevated inflation, supply chain security and the higher cost of capital. A period of re-equitisation and real capital formation lies ahead. But it is also a future where well-equipped forward-looking active investors can outsmart and outperform their passive peers programmed to drive using the rearview mirror.
I am speaking this week to two active UK equity fund managers with differing approaches to unlocking value. I will report back.
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