Lonsec has recently completed its Global Equities Sector Review, where a rating/recommendation has been ascribed to each fund formally reviewed. These ratings reflect Lonsec’s view on each participating manager’s investment and management capabilities within the sector, with the Viewpoint reports also summarising their particular strengths and weaknesses. During this review cycle, there were 37 rating changes – with 20 upgrades and 17 downgrades. All ratings can be viewed / filtered via the Managed Funds page within the Members Research Portal.
While 2020 and the advent of COVID-19 brought the world to a grinding halt in many ways, it accelerated many structural trends. The pandemic forced society to adapt and move beyond past traditions, resulting in an increased reliance on and embedding technology to a greater extent in the way we live, most notably through the way we work, transact, and communicate. Below are a few key market themes and fund manager observations from the review cycle.
Our ever-increasing dependence on technology has led to an immense amount of data being captured and stored on the cloud which is at the control of only a handful of companies. This inevitably brings about tremendous power and influence which has naturally caught the attention of numerous regulatory bodies. The major technology and internet platforms in the US face several challenges ranging from privacy issues and content moderation to antitrust regulatory pressures which are incredibly complex and difficult to predict. While fines and earnings potential may be under threat with reformative measures, in some cases regulation may strengthen the moats of the largest platforms since these companies often boast deep resources and have established a plethora of polices pertaining to privacy and legal matters. Nonetheless, the rhetoric of regulation has been growing increasingly louder, particularly since the Democrats took office, which the market has attempted to price. How consensus estimates differ to reforms motioned will be a key catalyst for sentiment and returns for the key players and the industry more broadly.
Sentiment for Chinese stocks among foreign investors experienced a meaningful pullback through 2021 and most notably in July. The Chinese government stepped up its desire to “take back control” of the new economy data goldmine and has significant concerns about the potential of critical data being leaked to the US via US listed Chinese companies following several years of geopolitical conflict between the US and China. The unwinding of ADR listings could severely halt the flow of foreign investment as China looks to scale back the reliance on western capital and promote Hong Kong listings. Further, China has clamped down on its principal of prohibiting any economic interest group or company from yielding monopolistic powers over its society. Chinese regulators escalation of activity began against some highly successful ecommerce companies, most notably and visibly beginning with the cancellation of Ant Group’s IPO in 2020. This was followed by heightened scrutiny of Meituan and regulatory action taken against Didi Global on user data and security concerns alongside others (e.g. JD). The most recent regulatory action resulted in effectively dismantling an entire for-profit after school learning industry, forcing operators to essentially become non-for-profit companies. In conjunction with actions taken around the takeover of Hong Kong and other posturing by the Chinese government these actions have spooked markets and led to large losses for investors in the specific cases as well as more broadly material underperformance of Chinese markets. Investors are therefore proceeding with caution with some experts pointing to other sectors being next in line for regulation such as online gaming.
As alluded to earlier in the market overview, the growth versus value style debate has been percolating for over a decade but market commentary has heightened in recent years due to the dispersion of outcomes reaching levels not previously seen. There has been a plethora of rhetoric released that value investing was ‘dead’ and likewise counter arguments discrediting the notion and the logic of valuations being paid for prospective growth. While value finally had its day in the sun via the ‘re-opening trade’ in late 2020 and into 2021, much to the relief of its pundits, the style continues to lag its growth counterpart. The reasons for value’s blunders are wide ranging but some of which include extraordinary central bank intervention leading to historically low interest rates, generally lower growth, higher cyclicality and asset heavy characteristics of traditional ‘value’ sectors (i.e. energy and financials) have all contributed to the dynamic. It was particularly noteworthy during Lonsec’s annual cycle reviews that those in the value camp were under increasing pressure to either ‘stay the course’ or ‘adapt’.
In Lonsec’s view, some subtle adaptations were observed and the determination of what constitutes ‘value’ was in some cases very much in the eyes of the beholder. Lonsec observed that valuation sensitive managers increasingly adopted an ‘intrinsic value’ approach which is more akin to mispriced quality or growth to expand their opportunity set and in some cases join in the ‘FOMO’ trades of higher growth peers. The traditional value approach of stocks trading at discounts to their tangible net assets (e.g., book value) or stocks trading at low multiples of reported profits in Lonsec’s view has been a contributor to the narrowing of the investment universe and potentially the deterioration of quality represented in valuation sensitive approaches.
An increasing consideration observed by fund managers when valuing a company has been the explicit inclusion of intangible assets such as brand, proprietary software/databases and innovative property (e.g., patents, trademarks, copyrights) in valuation analyses. These assets have distinguishing characteristics over their tangible asset counterparts such as scalability, network effects, synergies and spill-over applications which have driven much of the value depicted in share prices over the past decade. This point is best illustrated by the tangible assets of the S&P500 Index equating to just ~20% of the market’s value. The tremendous expansion of the value of intangible assets has been the dominant driver of returns, with some top constituents such as Amazon and Microsoft intangible value’s representing over 90% of their total enterprise value.
Through the cycle, currency impacts tend to wash out albeit currency movements had a meaningful impact on returns for Australian investors through 2020-2021. Unhedged investments generally provide better protection against domestic currency debasement and a weak Australian economy. An unhedged approach also tends to perform well during market risk-off events, such as the COVID-19 market crash in 2020, helping to cushion or offset the severity of the stock price declines in foreign currencies. That said, valuation or ‘fair value’ matters, with a sharp valuation reversal ensuing in 2020 which was supported by risk-on sentiment and/or strengthening Australian economy relative to our foreign counterparts that eroded unhedged foreign currency returns. For the calendar year of 2020, hedged returns outpaced their unhedged counterparts materially (11.23% vs. 6.04%) using the MSCI AC World ex Australia NR Index. This is a considerable rotation given unhedged returns materially outperformed through the risk-off period of Q1 2020 (-9.41% vs. -20.91%). This has since stabilised in 2021 with unhedged returns taking the baton (15.46% vs. 13.23%) to 30 June 2021.
Despite all intuition, the market environment has not been overly favourable for managed volatility strategies to perform as they have in previous market downturns. This was due to multiple factors though given the speed and nature of the crisis. While traditional defensive sectors such as Consumer Staples did provide some degree of protection, defensive performance was not widespread with indiscriminate selling and tilts to Utilities and Real Estate detracting from returns. A significant factor which drove underperformance was the strength and narrowness of the subsequent rebound. The narrow subset of COVID winners such as those in the Technology, Communication Services and Consumer Discretionary sectors are also those that managed volatility strategies tend to be heavily underweight. Further, the approach has some crossover with value investing, whereby future growth is largely foregone in preference for steady earnings and share price volatility. Given the market’s strong desire for growth generally over the period alongside the heightened earnings risk, the natural selection universe of the strategies faced significant market headwinds. This was particularly pronounced given the quantitative based approaches employed are predominately backward looking. Additionally, the small cap bias generally exhibited by the approach also contributed to unfavourable returns in the early parts of 2020 albeit staging a strong recovery since.
Dividend strategies were generally challenged during COVID-19 with many companies pausing or reducing their dividend payments through 2020 which drove poor aggregate sentiment for the style. From a regional perspective the approach tends to lead to an overweight to Europe and the UK, with an underweight position in the US relative to the Benchmark which exacerbated performance differentials. This is driven by the investment approach targeting companies with above average dividend yields that tend to be more pronounced in Europe relative to the US. Further, the approach is closely associated with value investing, whereby future growth is largely foregone in preference for a more secure/steady form of cashflows from high dividend yielding companies which are typically more mature given this common metric is used in traditional value investing. Given the market’s strong desire for growth generally over the period alongside the heightened earnings risk and therefore uncertainty of income the sentiment for the sector faced significant headwinds. The small cap bias generally exhibited by the approach also contributed to unfavourable returns in the early parts of 2020 albeit staging a strong recovery since.
Momentum continued to accelerate on both the product manufacturing and client demand side over the past year for sustainable oriented investment solutions. Lonsec welcomed a handful of new thematic oriented approaches at this year’s review while more broadly ESG has become a significant area of investment for incumbent managers. It has been strongly evident that it is a strategic initiative by many major firms to develop and refine their policies, build dedicated ESG teams to drive their approach, engagement and communication to the market. Lonsec has observed several existing offerings introduce greater exclusion policies over the course of the review cycle with a majority of managers enhancing their depth and breadth of the ESG stock and portfolio analysis via external data sources and/or complementing this with proprietary data and analysis. Lonsec expects this to be an area of ongoing process evolution as data quality improves, approaches are bedded down and more generally the heightened awareness and focus of such issues by shareholders which is likely to derive more alpha opportunities.
Direct investing is not new phenomenon within Australia with the advent of self-managed superannuation and the ease of online brokerage accounts. This trend however has accelerated with falling brokerage costs, technology platforms, ease of access and information availability alongside the rise of product availability, most notably ETFs to name a few. While this trend is more pronounced in passive investments, Lonsec continues to observe greater actively-managed funds being offered as an exchange quoted managed funds, active ETFs, listed investment trusts or mFunds to service a growing pool of direct investors. Lonsec considers this to be a structural trend that is likely to continue which is disrupting the traditional investment advice model (i.e. platforms).
More broadly, the incredible rise of smartphone investing applications such as Robinhood and lower cost brokerage have given a significant voice and power to retail investors, especially when acting collectively. The use of online stock forums such as Reddit played host to retail investors buying so called ‘meme-stocks’ including GameStop, AMC Entertainment, Blackberry, and Nokia in early 2021. In the case of GameStop, the stock was heavily shorted by hedge funds as a brick-and-mortar shop during a global pandemic selling physical games in an increasingly digitised market and therefore the company was under duress. Through social media, retail investors weaponised their involvement in stock markets to negatively affect hedge funds who had taken short positions in companies. Co-ordinated buying drove unprecedented trading levels which sent the stock price of GameStop and similar companies soaring, forcing a short squeeze and therefore short covering. The GameStop share price climbed over 1000% in just two weeks. Financial regulators now face a conundrum on what constitutes market manipulation and how to regulate such activity, if at all.
Asset managers are now more wary of such asymmetric risks within the market and have updated their risk models and processes to account for ‘meme-stocks’. Locally, applications such as Superhero has lowered the barriers of entry and is servicing the local appetite for brokerage free offshore investing while micro-investing investment managers appealing to the next generation of investors such as Spaceship Voyager have attracted over 200,000 active users and over $1 billion in assets in a relatively short period of time, all of which again disrupts the traditional investment advice model.
While Lonsec typically prefers stability of investment teams, turnover is a natural order of the labour market and can also bring about new perspectives, skills, and experience. Given the uncertainties thrust upon us in 2020, a lot of the turnover that might have naturally occurred in 2020 simply didn’t, due to either the job market tightening up, heightened job security and/or difficulty of changing jobs in a largely remote working environment. As the pandemic matured, Lonsec observed a latent build-up of turnover in early 2021. Other factors were also potentially at play which include breaks of routine from lockdowns being a catalyst for employees to reassess their priorities and seek a change in a new direction. Further, the desire to return home and be closer to family were common desires that led to internal transfers or departures. The financial hubs and mega cities of old may never return to what they once were as we are likely to continue to straddle a hybrid office and remote working structures for the foreseeable future.
Dealmakers are scurrying to do deals on the back of improving optimism and economic prospects which is supported by the strength of vaccine rollouts in key economies. M&A activity is being fuelled by the low cost of financing, market stimulus, significant cash reserves sitting on corporate balance sheets and record amounts of private capital dry powder, most notably SPACs. Global M&A activity hit an all-time high in the first half of 2021, with 479 announced deals worth more than US$2.6 trillion (up from US$926 billion H1 2020) and well above the five-year average of US$1.6 trillion according to EY. More than half of the activity was recorded in North America followed by a quarter of deal values in the Asia-Pacific region. Most notably, China saw a flurry of domestic M&A as geopolitics with the US saw an inward shift of deal making supported by China’s economic strategy to boost domestic demand. Despite many travel restrictions, cross-border transactions represented approximately a quarter of transaction deal values. Technology-related transactions led the way while media and entertainment sector had seen some of the largest deals announced as streaming giants look to attract and retain customers. Elsewhere M&A activity in the renewables sector has almost tripled (US$35.7 billion to US$96.5 billion) in the first half of 2021 as companies look to meet environmental targets and appease investors.
Author: Lonsec Global Equities Research Team
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