Many equity investors are grappling with how to invest in today’s market, when volatility has increased yet valuations are still high. For answers, we asked Portfolio Managers Lucy Macdonald and Karen Hiatt – two of our most experienced stock-pickers – to share their thoughts on active investing in turbulent times.
How do you feel about the current market environment – particularly given your focus on active stock selection?
Lucy: The environment for active global equity investing has been fantastic during the past year, and we believe it’s likely to continue. Correlations are relatively low today, meaning stocks aren’t moving in lockstep as much as they were in the not-too-recent past. As a result, there is more scope for divergent performance among different names, which plays directly into our ability to look for the right stocks in a range of areas. Moreover, technological improvements are causing huge disruptions across sectors, opening up additional opportunities for stock-pickers like us.
Karen: The growing dispersion evident in today’s market is a positive factor for us. The rising interest-rate environment appears likely to increase how much performance varies among equities, as valuations are adjusted to reflect more accurately the differences in companies’ growth outlooks, cash flows and balance sheets. This allows active managers like us to select companies that may be better-positioned to outperform in this environment.
Stock correlations have been lower overall, creating divergence and opportunity
S&P 500 Index stock correlations (January 1991 to February 2018)
Historically, when the largest stocks in an index lead the market, the environment has grown more difficult for stock pickers. Are the FANGs making things harder for you?
Karen: The major responsibility of a stock-picker is to aim to forecast future earnings when they aren’t anticipated by the broader market. So despite some fears of a market driven by the likes of Facebook, Amazon, Netflix and Google – the “FANG effect” – big is not necessarily bad. The market has a tendency to lean on the largest companies with the greatest transparency, but if these companies have the competitive advantages to drive outsized earnings growth, then it is our responsibility to capitalise on them by positioning our portfolios accordingly.
How does the recent increase in volatility impact a stock picker’s ability to outperform?
Lucy: Periods of normal volatility create more opportunities for stock selection, whereas high-volatility periods are generally accompanied by high correlations – and that isn’t the best time for stock pickers. When volatility is high, it’s a good time to buy into long-term names. Fortunately, the spike in volatility that we saw in February has subsided significantly. Still, it’s a good reminder that when the level of noise in the market clouds how performance is coming through, it gets harder to determine if underlying fundamentals are driving a stock. Over time, however, the alpha generators should become clear.
Karen: We’re seeing more players in the passive and quantitative space participating in the markets. That invites greater potential for big swings and pronounced dislocations. In times like these, we focus on trading around core positions while looking to take advantage of what happens in quant-driven volatility spikes – we look to pick off opportunities one by one as they present themselves.
Has the growth bias in the marketplace affected the ability for stock pickers to outperform – and if there’s a tilt to value, how would that change things?
Lucy: There can be sharp low-quality rallies in any market, but they don’t tend to last long. If you stay true to your philosophy, you will likely come through. Karen and I have been doing this long enough to know how to take advantage of buying opportunities.
Karen: In my view, secular trumps cyclical. Certain underlying building blocks favour growth investing – factors like acceleration of technological advancements and long-term competitive advantages – which is why we believe if we pick secular stocks, they should outperform over time. Cyclical outperformance, on the other hand, requires a perfect cyclical environment that can be fleeting over time.