Since 2003, there has been a positive but globally benign environment for both the economy and equities. Post the equity declines of 2001/02, fiscal policy had fostered an environment that featured low interest rates and inflation. Companies that had become lean and mean through repeated downsizing began to see profits; subsequently demand grew, and markets began a recovery that both lifted corporate profits and stock prices for the best part of five years. This, coupled with burgeoning demand from emerging markets, meant that confidence grew and investors signalled belief that economic recovery was both robust and sustainable.
Challenging times
However, this wasn’t necessarily good news for everyone. For fundamental or active managers, the combination of a benign rising tide and confidence that it would last a long time (ie, low volatility) led to very little differentiation in stock price performance. Thus, we saw poor-quality stocks with questionable business models and high levels of cheap borrowing trading at valuation levels that would suggest investors were giving them every benefit of the doubt. There were fewer ‘star’ stocks, but also fewer disaster stories.
Volatility sets in
This environment worked well for passive and index-like strategies; from 2003 to 2007, the benchmarks were the stars. In the UK, the FTSE All Share index between 2003 and 2006 outperformed 81 per cent of managers. Thus, if you bought the benchmark you enjoyed top quartile performance.
Unsurprisingly, investors began to question the value added by active managers. Part of this related to the benign economic environment that offered readily accessible liquidity and paid more attention to momentum than fundamentals. However, this continued good news led to a degree of complacency and meant that the market continued to take on risk.
We are beginning to see a reversal of these trends. Earnings growth is decelerating, and we continue to hear a flow of negative news from financial companies. There are indications that risk is being re-priced and volatility has returned to levels more in line with long-term averages.
Fertile opportunities
As trends continue to reverse, we see the reappearance of idiosyncrasies at a stock and industry level. Put simply, this means that not all stocks will do well and thus the environment now favours fundamental stock pickers who can seek out those that perform well, despite macro market environments.
Quality of management, sustainable cash-flow generation, balance sheet strength, capital allocation discipline and differentiation of business model are all characteristics that can make all the difference in a challenging economic environment. Stock level research and thoughtful valuations have a tremendous opportunity to add value.
Who will succeed?
The case is stronger than ever to unconstrain your manager from the benchmark and to give them the broadest opportunity set. Thus, a bottom-up equity manager who can form a differentiated view based upon knowledge and insight gleaned from experience should be a good bet.
This isn’t about having more information than everyone else; it’s about having someone who can spot opportunities away from the consensus view. All managers have biases, but it is important to accept this and to be vigilant in the pursuit of objectivity and simultaneously to profit from the biases of others. Basically, there is no substitute for doing one’s homework.
