Equity Roundtable

Investors in equity markets are still adjusting to new and evolving conditions. Last year’s sharp downturn put an end to a decade of generally upward-trending equity markets, fueled by zero-interest-rate policies. In early 2023, stocks have advanced, though markets have been increasingly volatile, as investors grapple with challenges including sticky inflation, high interest rates and banking sector turmoil. We asked three of our equity portfolio managers to share their thoughts on investing in the current environment.

Q: There’s still a lot of uncertainty about the possibility of recession. To what extent do you think about macro considerations in your research and portfolio construction processes as you identify new names? 

Ben Ruegsegger, Portfolio Manager, Sustainable US Thematic and Senior Research Analyst, Sustainable Thematic Equities: Macroeconomics of course shapes central banks’ outlook and actions. Their decisions affect the real economy with a lag and, more immediately, affect equity valuation multiples in the market. You can’t ignore the macro environment. However, the themes that our Sustainable Thematic portfolios invest in are largely macro independent or macro agnostic. We believe that these themes should persist regardless of the interest-rate environment or the market’s growth level. We focus on durable themes—climate change, healthcare and empowerment—that we think will persist in a variety of different macroeconomic scenarios. But within those thematic opportunities, we have a diverse opportunity set that provides us with flexibility over a market cycle. For example, we can prioritize more defensive names in our research agenda, perhaps, if we see more pressure on overall market earnings. That's one way that macro may influence the portfolios. 

It also presents opportunities. Because other investors have a different time horizon than we do, they tend to overreact to short-term macro data points. That creates opportunities to invest in high-quality compounding franchises at better valuations. 

Q: In the first quarter, high-beta stocks that are generally seen as riskier outperformed lower-volatility stocks. Since we’re expecting earnings and economic growth to slow as 2023 unfolds, do you think high-beta stocks will continue to outperform?

Kent Hargis, Co-Chief Investment Officer, Strategic Core Equities: It's surprising that we're talking about high-beta stocks rallying along with cryptocurrencies this year. Coming into 2023, we were on alert for a possible recession while interest rates continued to rise. Then three US banks collapsed, including two that ranked among the biggest bank failures in US economic history. So how can we explain market behavior? First, economies are actually in better shape than markets expected; for example, lower natural gas prices have helped mitigate some of the downside risks in Europe. Second, the end of China’s zero-COVID policy has made the Chinese economy more robust. Finally, the US economy is stronger, with employment better than we expected when the year began.

We've also moved from a period of expecting rising interest rates, to expecting more significant rate cuts over the course of the year. Clearly, that's helped some of the technology stocks and some of the longer-duration stocks. For now, at least, it feels like the worst of the contagion effects might be behind us.

Q: In the first-quarter earnings season, what were you looking for when engaging with companies to determine whether or not we're seeing any earnings degradation or broader concerns around the macroeconomy or consumer? 

Vinay Thapar, Co-Chief Investment Officer—US Growth Equities, and Portfolio Manager—Global Healthcare: We like to interrogate businesses on fundamental drivers including capital efficiency, reinvestment rate, barriers to entry and durable competitive advantages, including pricing power. In a period of higher inflation, can they pass on pricing without having a deleterious effect on volumes? We’re starting to see that in consumer staples, where some companies are taking aggressive price increases with a corresponding decline in volumes. You want to find businesses, in our view, that are resilient through periods of economic turmoil and that give you the confidence to re-risk your portfolio if the macro environment provides that opportunity.

Ben: Earnings are very uneven in this environment, where we are seeing a normalization on several fronts. Pricing is normalizing, and this has been a tailwind for many industries and businesses. We’ll probably see a normalization in backlogs and in excess inventories, which have been growing on balance sheets. It really depends on where a company lives in that ecosystem; is the company a provider of those critical components that were overstocked, or is the company a consumer of those goods, which means they will now enjoy some relief from that pressure. Trends like these are influencing earnings.

Kent: I agree with those comments. I’d add that after the events we’ve seen in the banking sector, credit conditions are getting tighter. We’re looking for signs that any companies we hold or their competitors are facing higher financing costs or additional problems in terms of reinvestment opportunities.

Q: Your portfolios all focus on quality businesses—but you have different perspectives on quality. How do you define quality when researching investment candidates? 

Vinay: For us, it's about how efficiently a company uses its capital. We care about return on investment capital (ROIC). We want businesses to reinvest and to grow their asset base. And it's not only about whether the company is growing, it's really about how it’s growing.

Ben: We look at quality along a few dimensions. First, we want to see companies with clean balance sheets that aren’t overly leveraged. We also like companies that can grow above their cost of capital consistently over time. Strong or improving cash flows are important too. One other dimension that we look for is a stakeholder-aligned management team. These managements are running the business not just for shareholders or to meet next quarter's earnings expectations. They’re considering the environment of their employees, their communities and customers, and managing the business with this broader set of constituents in mind. We believe that companies like these will build more durable businesses that can generate consistent economic returns over time.

Kent: I agree with these points. When companies have very strong ROIC, the market often misprices the sustainability of those cash flows. And the sources of sustainable cash flows differ from company to company. Some may have a platform with network effects, which creates a stickier customer base. Businesses with a hard-to-replicate service, innovation advantages or a beloved brand can also offer quality cash flows that are more sustainable than the market might perceive.

Q: Where are you finding some of the most attractive opportunities across sectors? 

Kent: It might be counterintuitive, since my Strategic Core Equity Portfolios invest in low-volatility stocks, but we think technology is one of the best areas to find defense in today's market. The industry has many characteristics we've been discussing, such as strong pricing power, strong cash-flow generation and low leverage. These features work well in today’s environment. Within technology, we like companies that operate behind the scenes, which you might not see in the headlines. These types of companies tend to offer steady, compound growth potential. Examples include companies with mission-critical software or service or better data and analytics than rivals. 

Ben: We look at the world through the thematic lens. One area that we find especially attractive is sustainable infrastructure. We're seeing a lot of momentum globally and a lot of funding that's already been approved. In the US, for instance, the Inflation Reduction Act provides significant spending for these opportunities. The Chips Act, which aims to bring manufacturing back to the US, and the bipartisan infrastructure bill provide support for sustainable infrastructure. In Europe, the Green Deal has been approved, and in individual countries, such as the UK, additional stimulus is being provided. There's a huge backdrop for infrastructure.

What's the goal here? It's about decarbonizing economies, energy security, and localizing and securing production. The US IRA will provide an estimated $370 billion in the coming years to support these opportunities in wind, solar, biofuels, hydrogen and carbon capture, etc. That's just federal government support; more is coming from the private sector. That's several trillion dollars of spend that's going to be at work in this market. At the same time, costs of these technologies are declining dramatically. Taken together, stimulus and declining costs improve the economics of these opportunities. 

Our portfolios are exposed to this theme in several ways. We hold consultant firms that are helping to manage, design and implement these projects. We also own water equipment firms that benefit from infrastructure spending by installing critical systems to bring water to new factories and buildings. Utilities and renewable energy firms also benefit from this trend. This isn’t a one-year phenomenon. It will play out through 2030. Revolutionizing the power grid will continue through 2050, creating significant opportunities across the US, Europe and Asia.

Vinay: We think healthcare is an interesting area. It’s often seen as being purely defensive, but it's not, in our opinion. There are many really exciting growth opportunities in companies with high levels of profitability and impressive reinvestment rates. This spans everything from insurance companies, where we expect the rise of technology to continue to dampen healthcare costs and create better outcomes, to medical device companies that are working on innovations such as surgical robotics, which will have a major meaningful positive impact on the healthcare system. Other companies that aren't often thought of in the healthcare space include animal health companies, where we've seen a rising trend toward pet adoptions and people willing to spend more on their pets; these companies have very little exposure to risks like healthcare reform or pricing regulation, which makes for a solid industry structure with strong growth rates and high levels of profitability.

Q: The next decade isn’t going to look like the last decade, when zero-interest-rate policy drove the outperformance of equities. Today, bonds look more attractive in higher-rate environments, and investors can actually get paid for cash deposits for the first time in years. So why should investors still consider equities in a broader allocation given the alternatives available today? 

Ben: There are disruptive forces at work in the world, and perhaps the most liquid and most direct way to get exposure to thematic opportunities is through equities. Interest rates are certainly up and central banks are active, but they're not going to change whether ChatGPT is adopted in the market and how that will play out. If you think about how drugs are developed and how often they come to the market, whether it's a small-molecule drug or a complex biologic, these are market evolutions that will persist. We think the best way to get exposure to that is through equities.

It's not just about investing in the broad market, having exposure to equities or owning a single-theme fund. You need to pick a manager that has the ability and skill to identify opportunities within sectors and find companies on the right side of change that can provide direct access to these thematic opportunities. Large-cap stocks in the benchmark often dilute exposure to these transformations under way. That's where manager skill comes in—and we think this is what's going to help drive returns for clients over time. 

Vinay: It's hard to time the market. Professional investors and other investors will always find it difficult to try and figure out whether they should go full force into fixed income or money market funds or equities. Our view is: own companies that we believe will create value over time and maintain exposure to those characteristics to increase the probability of compounding.

Kent: When markets get volatile, it is hard to stay invested. One of the benefits of a low-volatility equity strategy like ours is that it can reduce the pain of the downturns, making it easier for you stay invested and enjoy all of the long-term benefits that we've been discussing here.

Q: What have you learned from the last decade of managing your strategy? Has your playbook changed? And what is still relevant today?

Kent: Our playbook really hasn't changed. We think that defending capital and delivering returns are as important as they have been over the course of the past decade. Our core investment convictions have not changed. I’d point to three key lessons that we have learned from managing our low-volatility equity portfolios. The first is to balance conviction and adaptability: we stick with our core investing convictions, but humans have thrived because of their adaptability. Though we are not swayed by recent headline grabbers and we don’t chase trends, we should evolve in response to fundamental structural changes in successful business models and take advantage of advances in quantitative tools in data science.

Second, portfolio managers must challenge conventional wisdom. You need to be different. We’ve redefined what we think of as investment success, and the characteristics of offense and defense. Instead of looking at conventional industry definitions, we’ve developed our own views on the underlying business models and characteristics to capture return and risk. Third, steer clear of unpredictable forces. Be focused on mitigating the unintended noise that may come along with some of the companies you’ve invested in.  Make sure the portfolio is focused on the insights you have and capture those in the portfolio.

Ben: I think today's environment is quite applicable for what we do. Sustainable themes will persist. They offer good growth and resilience. The positive macro environment, which has provided support for all businesses, is starting to fade away. Sustainable themes have their own set of growth drivers and will become increasingly important. When I think about some of the lessons we've learned over the last 10 years, I think about data science and new tools that are available. Data science is incredibly important for building a robust investible universe, which is attached to our themes. How do we search for companies that are exposed to these themes and figure out who will be the winners and losers? Do the themes have momentum? We can check that with data points gathered from the real world. 

We also have new tools to help us manage risk. We want to make sure that we have a diversified portfolio with idiosyncratic risk—that is, stock-specific risks rather than broader macro bets. We've also been reminded about the importance of taking profits in your winners. Investors should never fall in love with a theme or stock, but stick to a robust disciplined process, take profits when the time is right and get involved again when the risk/reward tradeoff is more favorable. 

Vinay: The last 10 years have reinforced the importance of having a philosophy that makes economic sense. What's the anomaly you're trying to exploit? Why does it work? Being grounded in a philosophy is really important and you must look for specific characteristics to amplify that philosophy. The second is process. It’s important to be disciplined about a process that executes on that philosophy so that you're actually doing what you say you are doing, and you can measure it objectively. The third is discipline. There will be periods of underperformance. In my experience, managers tend to go awry when they completely change the portfolio to fit what is working in the moment. We don’t do that. Our portfolio stands for something, and we believe in this philosophy and process. Having the discipline to continue executing that philosophy through good times and bad is how you make money over the long term.