The Fed shifts on inflation – What does it mean?
The Fed unveiled a revision to its monetary policy, allowing for higher inflation to help support the labor market. We believe this action could keep interest rates low for years.
Large-cap growth has been a style that has continued to lead the market. The Russell 1000 Growth Index, the Fund’s benchmark, is down 3% year to date through May 5, 2020, compared to the Russell 2000 Value Index, which has lost more 30% over the same period. On a year-over-year basis, the large growth index is positive by 8%. Why have these businesses been rewarded so favorably relative to the broader market?
Klapmeyer: Our universe has treated investors well not just during the last year, but really over the past decade. During that time, growth has been scarce and some significant global macro concerns have surfaced. The large-cap growth space has been successful due to the strength of the business models that comprise it. These companies have returned large amounts of capital to investors and generated incredible free cash flows. We believe these characteristics have been desirable and rewarded. Value-oriented businesses, which can be characterized in many ways, have had some difficulty generating enough momentum and cash flow to disrupt incumbents or innovate in a slow-growth world. These companies need faster gross domestic product growth to compete.
For example, Amazon reported paid unit growth of over 30% and Microsoft reported year-over-year sales growth in the mid-teens. These are massive companies with huge revenue bases. The numbers suggest these business models are unique, enabling them to grow at this scale and continue to dominate the marketplace. The Fund’s process is based on bottom up fundamental research. It starts with the business model. From a risk management perspective, if we notice our portfolio is becoming skewed to some of the largest companies, we either need to justify that exposure or adjust accordingly. Ultimately, our goal is to have stock-specific risks drive the portfolio, not industry- or factor-style exposures.
April’s rally was one of the best on record for a single month with the Russell 1000 Growth Index returning nearly 15%. Across the investment landscape, some of the lower quality, cyclical businesses bounced the hardest like those in the energy and materials sectors. What's your view of the environment now?
Klapmeyer: It is a fascinating time, and no one really knows the short-term investment playbook for COVID-19. I can comfortably say investments made for a very specific environment like COVID-19 don't define an investment philosophy. It may represent a strategy for a moment in time, but it should not be used as a long-term investment approach. Emotion has been driving the market recently, as volatility and correlation of company returns have both been high. We expect the market will revert to a more sustainable investment framework as the year progresses, and we will take steps to ensure emotions don’t drive our decision making.
Stock-specific expertise has not been rewarded during this environment. Certain baskets of companies, on the other hand, have worked very well. For example, companies clearly benefitting from the pandemic and shutdown, or those that perform well in a 0% interest rate environment, fall into this category. In our opinion, this says little about the long-term sustainability of these individual business models. Other companies have suffered due to lack of human mobility. Industries like restaurants, brick and mortar retailers, hotels, cruise lines, and other travel-related areas have been punished. Like a defibrillator for a stopped heart, recent stimulus has revived many companies that were near death and their share prices have recovered sharply. Many of these businesses are still challenged.
If we take a longer view, I expect a big divergence within some of the most impacted industries. High-quality travel businesses will continue to add value for hotel partners, rental car partners, and airlines. Other industries like optometry that are having trouble executing their business models, will eventually normalize. For example, as consumers run out of contact lenses, they will need to schedule eye exams to reorder new supplies Strength of the best business models should shine through on the other side of this pandemic situation.
As part of the Fund’s high-quality growth strategy, we avoid hyper-growth business models as many of these companies often fail to meet investor expectations. Price multiples reflect investor expectations, and many of the recent top performers have seen significant multiple expansion, reflecting even greater expectations. We believe this just introduces more risk in those types of companies. We also avoid questionable business models, like those mentioned earlier that have benefited most from government assistance. Our philosophy doesn’t lend itself to owning businesses whose share prices rise 30% in a month, or 360% on an annualized basis. In order to generate those types of returns, we believe investors need to accept significant amounts of risk and return volatility.
Some are debating the shape of this recovery. Will it look like an L, a V, a W, a backward checkmark, or a Nike swoosh? We don’t know, and we certainly don’t want to build a portfolio designed to outperform in a very specific recovery. Our goal is to build a portfolio of companies with a long-term investment horizons, capable of performing in a wide variety of market environments.
A quality growth philosophy is a function of understanding how a business operates. What is your view on companies with environmental, social and governance (ESG) considerations in place, particularly as it relates to current circumstances?
Klapmeyer: The ESG component is highlighted even more in the current environment. Companies with favorable ESG characteristics have performed relatively well during March and April, and governance and social issues have seemed the most relevant during this downdraft. Many companies have proactively allocated resources to handle their individual pandemic responses. Corporate directors and managers have been freezing or reducing their compensation, choosing instead to support employees. We believe these businesses are acting as good stewards for stakeholders and behaving in a socially responsible manner. On the flip side, companies with poor working conditions, or those that are treating their workforces poorly, are being called out in the media and held publicly accountable for their actions. This can have a long-term impact on goodwill, both with employees and customers.
What are some of your initial reactions to first quarter company earnings reports and calls with management teams?
Klapmeyer: There is a great deal of information to digest right now. The data can lend itself to many narratives, which we think can be dangerous. It seems clear China is recovering quickly. I doubt many investors expected a company like Coca-Cola to indicate sales are reverting to relatively flat in China as activity increases. Also curious are strong travel retail sales in airports in Hong Kong and Macau for a cosmetic company like Estee Lauder, a company that is seeing sales now growing year-over-year in these locations during this time. These are promising data points indicating eventual normalization is probable. The bigger question is whether the pandemic will have a more lasting impact on companies in the U.S. and Europe?
The broader bounce in stock prices since late March appears to be related to price-to-earnings multiple expansion. We expect very significant negative earnings growth for the second quarter so expanding multiples appear to be reflecting better expectations from investors. If the fundamentals don’t follow through over the next few quarters and earnings fail to meet those expectations, we think we’re more likely to see disappointing returns in the future.
Past performance is not a guarantee of future results. This information is not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through May 6, 2020, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This information is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.
Top 10 holdings (%) as of 03/31/2020: Microsoft Corp. 9.6, Apple, Inc. 6.4, Amazon.com, Inc. 5.4, Visa, Inc. 4.8, Alphabet, Inc. 4.2, Coca-Cola Co. 3.3, Motorola Solutions, Inc. 3.1, Adobe, Inc. 3.0, Cerner Corp. 3.0 and NVIDIA Corp. 2.7.
The Russell 1000 Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. The Russell 2000 Value Index is a float-adjusted market capitalization weighted index that measures the performance of the small-cap value segment of the U.S. equity universe. It is not possible to invest directly in an index.
All information is based on Class I shares. Class I shares are only available to certain investors.
Risk factors: The value of the Fund’s shares will change, and you could lose money on your investment. Investing in companies involved primarily in a single asset class (large cap) may be more risky and volatile than an investment with greater diversification. The Fund typically holds a limited number of stocks (generally 40 to 60), and the Fund’s portfolio manager also tends to invest a significant portion of the Fund’s total assets in a limited number of stocks. As a result, the appreciation or depreciation of any one security held by the Fund may have a greater impact on the Fund’s NAV than it would if the Fund invested in a larger number of securities or if the Fund’s portfolio manager invested a greater portion of the Fund’s total assets in a larger number of stocks. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Not all funds or fund classes may be offered at all broker/dealers. These and other risks are more fully described in the Fund’s prospectus.
The impact of COVID-19, and other infectious illness outbreaks that may arise in the future, could adversely affect the economies of many nations or the entire global economy, individual issuers and capital markets in ways that cannot necessarily be foreseen. In addition, the impact of infectious illnesses in emerging market countries may be greater due to generally less established healthcare systems. Public health crises caused by the COVID-19 outbreak may exacerbate other pre-existing political, social and economic risks in certain countries or globally. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.