Should investors buy the dip?
Despite this week's dramatic decline in the major stock indices, markets remain within 5 per cent of their all-time highs. Now, as the long running bull market in stocks approaches 11 years some investors may be wondering what to do next. Should they still consider jumping in during this week's correction, or possibly even take some profits if fully invested? This bull run, however, has been rather quiet and some are referring to it as “the most unloved bull market ever.”
Perhaps one the reason is because household ownership of stocks is still below prior market peaks. Last year, retail investors bailed on a record amount of equity investments and ploughed the money into bond funds.
Another explanation may be that all categories of equities have not fully participated in the decade-plus rally. Large-cap growth stocks have been the clear winners in this cycle, while many old economy stocks tied to commodities, basic industries and energy have been left far behind. Meanwhile, international markets have provided much less return than America's main bourses while emerging markets continue to struggle.
Investors highly exposed to the S&P 500 or Nasdaq have seen strong gains, but some of the largest mutual funds continue to hold substantial positions in old economy sectors, causing them to underperform.
Even many index funds have failed to keep up with the broader averages despite advertising lower costs. Indeed, success in recent years has been largely determined by a rather narrow group of stocks which are overly represented in the market capitalisation weighting of the main indices.
Market followers will remember how the so-called “FANG” stocks: Facebook, Amazon, Netflix and Google (now Alphabet) had been responsible for a large percentage of the broader market gains in recent years.
The definition of FANG itself has morphed into newer acronyms which include Apple and Microsoft. Last year, 21 per cent of the S&P 500 index's gain came from just four of these mega cap tech stocks. The trend continues into 2020 with the tech-heavy Nasdaq outpacing the S&P 500 by over three per cent so far this year.
As I stated in my last article for this column, market gains are still possible in 2020 given a somewhat more constructive macroeconomic backdrop. However, selectivity is the key to staying ahead of the curve. In that respect, it's worth a deep dive into those equity characteristics, or “factors” which have been working and those which are likely to work in the months and years ahead.
Factor investing has been growing in popularity over the last several years as a plethora of new smart beta exchange-traded funds hit the market. According to a report by Morningstar last year, factor-based products now number about 1,500 and total assets have grown by $200 billion to approximately $800 billion over the past two years.
Relevant factors include profitability, size, value, momentum, growth, dividend yield and quality. Factor-based ETFs employ a disciplined approach to selecting securities which meet certain measurable levels of each criteria, or sometimes a predetermined combination of them for multi-factor models.
Looking back over the past seven years, profitability as a factor has led to market outperformance. According to a Bloomberg analysis, share prices of those companies with the highest return on equity have outperformed those of the least profitable by 6.5 per cent annually over the past seven years within the universe of the top 3,000 companies globally.
Another winner has been the level of positive earnings revisions by sell side equity analysts. Those companies experiencing the highest percentage level of past three month's earnings revisions for the current quarter have outperformed the lowest quintile by 81.8 per cent over the past seven years. During the past one-year period the market outperformance, or “alpha”, was 11.5 per cent.
Value is a factor which shines on a longer-term basis, but has confounded equity strategists in recent years. Over the past 20 years, value as defined by a company's free cashflow to enterprise value has shown total positive alpha of 116 per cent. However, the value style has actually underperformed by 6.99 per cent during the past seven years as investors continue to flock to growth stocks. Factors which may have worked over the long run can disappoint in the short term.
Leaning on one factor creates an important investment discipline, however, better results are often achieved by combining them. A strategy of value combined with momentum has been shown to achieve better results than value by itself, for example.
Over the past seven years, momentum and growth have been positively correlated with outsize market returns. Growth companies with “capital light” structures, such as internet-based businesses are likely to continue to their outperformance in the current macroeconomic environment defined by lower growth.
While growth stocks remain in the spotlight, investors should also consider funds which adhere to value and dividend disciplines. Income yields around the world remain extraordinarily low and are likely to stay down for an extended period of time. Dividend stocks could begin to shine in this environment.
Growth and value, opposite sides of the same coin, have swapped the spotlight at different points in each economic cycle. For example, when technology growth stocks began to crash in early 2000, high-dividend paying value stocks massively outperformed the market during the ensuing months.
At LOM, we favour a “barbell” equity strategy of high growth companies with strong and rising earnings momentum coupled with defensive dividend plays trading at value prices.
• Bryan Dooley, CFA is the senior portfolio manager and general manager of LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority
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