MARKET KNOW-HOW | 2020: Edition 3

The Coronacrisis is a generational event that stands to transform how economies function. To navigate the shifting environment, investors need to adapt to a new framework consisting of three overlapping phases: preservation, consolidation, and innovation. Preservation is key in periods of high uncertainty, as companies focus on funding and survival. Consolidation depends on business strategy, not circumstance. Lastly, innovation creates the potential for both massive disruption and superior returns. Successfully managing through these phases potentially lies in the ability to identify sustainable competitive advantages emerging out of the crisis.

In parallel, this pandemic has also exacerbated key investment challenges, ushering in a world of episodic volatility, lower yields, and scarcer growth. To better cope with volatility, we believe that balance sheet strength and competitive positioning remain vital in this recovery. To combat yield compression, cash flow enhancers may be effective in providing diversified income growth. And as the number of faster-growing companies continues to decline in major markets, we believe the opportunity set is becoming more idiosyncratic and global. The post-COVID world may mean investing without borders.

The COVID-19 pandemic has driven an acceleration in the adoption of countless technologies and consumer behaviors, chief among them, ecommerce. What started at first with panic buying and hoarding has turned into an array of adaptations that have driven ecommerce from 15% of retail spending in the US in 2019 to over 40% temporarily in May 2020 and is expected to be 30% sustainably by 2024. Evidence from other countries suggests that the online migration has been global. We anticipate that many new adopters will stick with this medium even after economies reopen, and that the ecommerce acceleration may continue to reshape the retail landscape.

In this new normal, we believe that businesses able to survive, and perhaps even thrive, are those with scalable online business models that can cope with those new “stay at home” consumption patterns. Indeed, Millennial consumption and lifestyle habits are shifting to the broader population. Older generations, some of whom may never have previously used ecommerce may have had to adopt such technologies out of necessity; millions of children have had classrooms replaced by online learning; and business operations, have moved online. In our view, the COVID-19 crisis has accelerated the secular adjustment that was already underway, with agile, tech-savvy businesses most likely to benefit.

Attractive equity returns of the last few years have reflected shifting demographics, social preferences, and consumer behaviors that translate into powerful earnings growth. While the US technology sector has been well-positioned for these trends, the US market’s compositional advantage has begun to shrink as global economies invest in more profitable industries. Additionally, the market’s willingness to pay a premium for more consistent profitability may extend to areas such as Med-tech, Fin-tech, Ed-tech, Green-tech, and Environmental, Social, and Governance (ESG), which could begin to balance out the global opportunity set.

The top-performing companies remain well-represented in the global landscape, despite overwhelming US performance. Of the top 50 performing stocks each year, on average, more than 75% have been domiciled outside of the US over the last decade. Even in the Coronacrisis, where macro and market conditions have been challenged, global opportunities have remained plentiful. So far this year, 92% have been domiciled internationally. Investors who can identify high-quality companies with strong balance sheets, earnings potential, and profit margins may benefit from expanding their portfolios’ borders.

Recent months of equity performance have shown an unusual dynamic of growth dominance during periods of significant market volatility. Historically, this has occurred only 41% of the time. In our view, this rotation in outperformance can be explained by the evolving characteristics of growth companies. They tend to be 1) more defensive because of balance sheet strength and ample liquidity, and 2) more insulated from negative earnings revisions due to less cyclical business models. We believe the outperformance of growth will likely persist given modest GDP growth, low inflation, and single-digit earnings growth potential.

The growth opportunity is expansive as you move down in market capitalization. The index composition of small- and mid-cap growth stocks is heavily weighted toward information tech and healthcare, which comprise ~60% of the index. Even within growth sectors, these companies are tilted toward industries most transformed by the digital revolution, including semiconductors in tech and biotech in healthcare. We think the next decade ahead will increasingly be disrupted by technology. Small- and mid-cap growth stocks are poised to benefit from this secular trend as they are both innovative and nimble in evolving business strategies.

Over the past decade, investment grade fixed income has changed from both a characteristic and composition perspective. The Bloomberg Barclays US Aggregate Bond Index has lower yields, higher duration, and more exposure to Treasuries relative to 10 years ago. As such, investors who rely on a passive investment strategy may unintentionally take on more interest rate exposure as well as lower yields. We believe there are ample opportunities to boost income and seek more attractive risk-adjusted returns by diversifying into high quality spread sectors of the core fixed income market.

When it comes to fixed income, investors are often tethered to the Bloomberg Barclays US Aggregate Bond Index. However, not all bonds are created equal, even within the same core fixed income space. Sub-sectors have a wide range of characteristics across yield, volatility, return, and correlation to equities. In today’s yield-challenged environment, we believe selectivity is critical not only within the benchmark, but also across the entire investment grade universe. A dynamic approach in core fixed income may allow investors to fully capitalize on the benefits in their portfolios.

The US middle market is made up of the “businesses next door” that are the backbone of the economy. These companies range from $10-$100 million in annual EBITDA and have strong growth potential, but are often underserved by traditional providers of capital such as banks and the public markets. Instead, their funding often comes from local banks and private markets. In our view, today’s tailwinds of targeted fiscal stimulus, renewed investment in domestic supply chains, and the longer-term trend of companies staying private longer, all make the middle market an attractive opportunity for investors.

Middle market direct lending has held advantages over other public fixed income markets resulting in stronger risk-adjusted returns. In the post-COVID world, these aspects of the private market may be particularly attractive. Bilateral negotiations can result in better terms (e.g. enhanced due diligence, higher credit spreads, and tighter debt covenants). Relatively conservative capital structures and longer deployment horizons can lead to lower default rates and less fluctuations in yield. As such, direct lending can be an interesting source of returns for investors seeking to manage portfolio volatility. Imperative though is partnering with companies with healthy balance sheets and sustainable cash flows.