As the saying goes, for things to stay the same there will have to be change. Fund managers and investors will feel this way after 2022.
All fund managers want to deliver positive risk-adjusted performance and outperform their benchmarks, and the way to do this in the 12 years following the financial crisis of 2009, was simple: buy growth stocks, and preferably in the technology sector. This is the strategy which has underperformed the most this year, and for those with exposure to the more speculative areas of technology (not us, thankfully) it has been particularly painful. Has this strategy reached the end of the road? And if so, what comes next? Our answer to the former is probably, and the latter is evolution.
Markets change direction
To understand the outperformance of growth investing in the last decade, some perspective and historical context is helpful. No investment style or asset class has a divine right to deliver investment returns. Investment returns are derived from the operational performance of the underlying asset and the price paid to own it.
In the 2000s, the best combination of operational performance and valuation was in areas such as mining, due to the emergence of China and its need to build infrastructure. Equally the global economy had much less ongoing technological disruption than seen today, which meant that buying underperforming businesses on the basis they could be turned around by new management teams was also profitable. This was known as 'reversion to the mean' investing and often would be classed as 'value' investing.
These trends came to an end in the 2010s, however. After the recession induced by the financial crisis, interest rates were reduced on an ongoing basis to levels which were highly favourable to valuations of long duration growth stocks. At the same time, technological disruption and innovation accelerated – creating the large technology companies which now dominate society. The best combination of operational performance and valuation was therefore in growth and technology investments.
These evolutions are not coincidental. Both happened after bear markets, the first after the bear market of 2000-2002, following the technology bust of the late 1990s, with the second seen after the Great Financial Crisis. Bear markets change leadership, and it is a bear market we are going through now. Where should investors be looking to for the next decade?
This is a debate which should be treated with a degree of caution. There were many theories of how markets would evolve post the financial crisis, and some were wrong. One example of this was the idea to buy high dividend yielding equities in a low interest rate environment, which proved to be an underperforming strategy. That said, there are some observations which we think are useful.
The last decade has been an aberration in many ways which are becoming more apparent now. First, it is the only decade in recent history with such low levels of interest rates and inflation. Second, it was a time of extreme narrowness in markets, with only a small number of sectors delivering investment performance. Finally, it was a time when the valuation of assets was not important, it was simply the ownership of them that mattered.
It would seem sensible to plan for an investment environment more like decades prior to the 2010s. One where interest rates and inflation are more in line with historical levels, like in the 2000s when inflation was in the 3-4% and interest rates were 5%. One where a broader exposure to a range of industries is better than a narrow focus on a few. And one where valuation reasserts itself as an important part of any investment decision.
Back to the future
Of course, none of this is particularly revolutionary. Indeed, these were the skills that many investors and fund managers were taught when joining the industry, they have just been quashed by multiple years of cheap money and a prolonged bull market. This is the essence of our view that what is needed going forward is more evolution than revolution, a reassertion of what fund management should be about rather than a reinvention, and that there is nothing to fear about what the next decade will hold for investors so long as we accept it may be different to the last.
When we apply this to our portfolios, which have been significant beneficiaries of the major market trends of the last decade, it does create some evolution of what we are choosing to invest in. Higher valued investments, particularly in the equity market, look increasingly asymmetric, with minimal share price upside should they operationally continue to deliver, but material downside if they don’t. This is an area we have been gradually reducing exposure to when opportunities allow.
The technology sector will remain a critical part of any investor portfolio, given it is one of the truly innovative sectors. However, as we saw in the 2000s after the technology bubble of the 1990s, it is unlikely to be the sole driver of markets and adding diversification into areas alongside it – which we have always had to some degree – is sensible.
Finally, looking at historically more lowly valued areas of the stock market, ignored for many years, is a good use of time. Areas such as banks, which have improved sustainably and financially in the last decade, look much more interesting to us in a higher interest rate environment and one where finance will play a key role in the transition to a more sustainable society.
Any changes we make will be consistent with our core principles of investing in sustainably positive, value creating businesses. After all, it will be the operational performance of companies we own and the price we pay for them which will determine our success. If we can do this effectively however, it will allow us to maintain what has made our funds successful over the last decade whilst enhancing them with new and interesting areas.
As the last blog of 2022, it does seem appropriate to reflect on the year. Here are three observations we have:
- The future is unpredictable – when an unforecast event like the invasion of Ukraine can so fundamentally change investment markets, it reminds us that predicting what will happen in the future is difficult
- Reward happens slowly, risk happens fast – fundamentally flawed investments can look good for many years and lose all their gains (and more) abruptly. This is the lesson of all booms and busts, of which speculative technology investments is the most recent example
- Bear markets are the price of long-term returns – bear markets happen infrequently enough for investors not to get used to them as part of the process of delivering long-term investment returns. Very few things have permanence in markets however, and this too will likely pass
As we move through 2023 we will get the answer to many of the questions vexing markets currently. Some of these answers will be good, some will be bad. However, we believe that the premise of sustainable investing remains strong and we remain invested in a range of attractive companies which we believe will thrive in the long term, whatever the future may be.
This is a financial promotion and is not investment advice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice.