MARKET COMMENTARY

Four Portfolio Themes Entering 2021

02.10.2021 - Douglas Cohen, Portfolio Manager

Having already shared our outlook for 2021, we’ve put together a short list of portfolio themes that, in our opinion, offer attractive upsides for the coming year.

1. Don’t Give Up on Quality Equities

The marquee mostly tech-related, large-cap growth stocks that dominated 2020 and the entire post Global Financial Crisis era[1] seem vulnerable to some form of reversion to the mean, at least in the short term. What better time for that transition than the likely dawn of a new era of post-COVID economic growth that could revive interest in value-oriented cyclicals and the financial stocks that have long underperformed due to super-low interest rates and a flattish yield curve?

Many value stocks have attractive profiles and may be well positioned to outperform this year. However, as one famed value-investor remarked “value investing doesn’t have to be about low valuation metrics. Value can be found in many forms.”[2]

Fortunately, we can be flexible on style. The growth versus value debate is somewhat of a sideshow relative to how core long-term equity investments should be positioned. We believe the focus ought to be on quality, meaning companies that can generate cash, show above-average growth, have low levels of borrowing and are led by management teams who can effectively invest in their businesses. These companies can often produce returns on equity[3] that are durable and higher than their competitors, and usually operate within industries that offer potential competitive advantages.

Quality tends to correlate more closely with growth than value.[4] When the COVID crisis first emerged in the US, many investors flocked to quality stocks, then headed the other way en masse following the November elections and vaccine news. We think that investors will likely gravitate back toward quality as markets and the broader economy recalibrate to a new normal of steadier growth but still-elevated macro uncertainty. Once a high-quality business is found, the key is to allow it to compound over time, while still being disciplined about paying a fair price as a means of providing a margin of safety.

2. Rely less on traditional fixed income.

In a December article on the traditional 60/40 equity/fixed income portfolio, we suggested that prospective fixed income returns are likely to be so low over the next several years that investors can probably generate some extra returns by reducing traditional fixed income exposure even if they give up some perceived ballast in the process.

3. Increase exposure to overseas stocks

Wall Street strategists have seemingly been saying “go international” since the New York Stock Exchange was created in 1817 under the leadership of the somewhat aptly named Anthony Stockholm. Calls for more overseas diversification have increased over the last decade, during which the S&P 500 returned 267.0% versus the 69.2% for the MSCI All Country World (ACWI) ex US Index. [5] The enthusiasm only increased in 2020, when the S&P 500 again outpaced the ACWI ex US.[6]

It’s hard to believe the US has a near-monopoly on high-quality companies with good growth prospects, strong free cash flows, high returns on invested capital and management teams that are effective stewards of capital. But, given how wrong the calls for overseas outperformance have been, why take action now? We see three key reasons: 

  • Relative valuations gap between the US and other regions[7]: This disparity appears to be about as large as we can recall. Our long-standing view has been that valuation means little in the short-term, but a lot over time in terms of framing risk and reward given the tendency of markets (though not necessarily individual stocks) to eventually revert to normal trading ranges.
  • Some lagging sectors seem poised for a bounce back: To the extent we believe the surge in the US large-cap tech darlings has largely run its course, most overseas markets tend to be dominated by financial and resource-related stocks that have generally lagged but appear poised to benefit from a global reopening trade. We think these stocks have been trading at discounted valuations and offer attractive dividend yields—they may offer unusually attractive reward-to-risk prospects as economic conditions normalize.
  • Overseas progress on the virus: Many foreign countries are ahead of the US on the COVID-recovery front. These economies, particularly China and many of its nearby trading partners, should lead global growth in 2021. Such growth does not always go hand in hand with equity market performance, but the starting point for valuations compared to the US should lead to better overall performance over this year.     

There are two caveats, however. First, we don’t expect the US dollar to fall sharply during 2021, although its weakness could favor more overseas exposure. Second, while company domicile is relevant, the composition of each holding is probably just as important. For example, foreign sales accounted for only 29% of the $12 trillion in total S&P 500 revenues in 2019.[8]       

4. Limit exposure to potential investment bubbles.

Our team has little doubt that there are signs of what Alan Greenspan might term “irrational exuberance” out there. Examples include recent IPOs from relatively low barrier-to-entry, moderate profit margin businesses such as food delivery and lodging to high-growth, high-margin markets such as cloud-related software. The tendency seems to be that perceived financial bubbles grow bigger and last longer than skeptics expect. We believe, though, that there can be “mini-bubbles” in small pockets that are unlikely to trigger wider contagion when they inevitably pop. That sure seems like the best-case scenario as it pertains to the recent Reddit-inspired frenzy in several relatively small market-cap companies.  

As fears of a deflationary spiral and surging dollar hopefully diminish, our focus remains on the economic rebound and high-quality businesses at attractive prices.  

 

[1] Source: Bloomberg. For the year 2020, the Russell 3000 Growth Index returned 37.9% versus Russell 3000 Value Index’s 2.9%. From 1/1/2009 to 12/31/2020, the Russell 3000 Growth returned 18.5% per year versus the Russell 3000 Value’s 11.6% per year.

[2] Source: Oaktree Capital Management, L.P, “Something of Value”, Howard Marks, 1/11/21.

RReturn on equity (ROE) measures the financial performance of a stock by dividing its net income by shareholders' equity.

[4] As defined by the MSCI Quality Index.

[5] Source: Bloomberg, as of 12/31/2020. Cumulative total return shown.

[6] Source: Bloomberg, as of 12/31/2020. Total return for S&P 500 and ACWI ex US was 18.2% and 11.0%, respectively.

[7] Source: Bloomberg, as of 2/4/2021

[8] Source: Goldman Sachs, as of 12/1/2019.





This communication is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. You should seek advice based on your particular circumstances from your tax advisor.

MARKET COMMENTARY

Looking Ahead: What Follows Unprecedented?

02.24.2021 Ronald J. Sanchez, Chief Investment Officer

Looking Ahead: What Follows Unprecedented?NEXT POST

MARKET COMMENTARY

White Paper: The Evolving World of Bitcoin

02.05.2021

White Paper: The Evolving World of BitcoinPREVIOUS POST