A large cap renaissance
Europeans may have good reason to feel irritated that the frequently criticised US political actions in Iraq are contributing to a global economic scenario where some large US companies have much to gain. Even more galling may be the fact that this has happened through disastrous incompetence rather than a Machiavellian approach to economic and political strategy.
However, instead of some major US construction companies benefiting from the initially hoped for peace dividend through the reconstruction projects in Iraq, it looks instead that other large defence orientated US companies may well end up benefiting from the war dividend from the more dangerous world that has arisen out of the disintegration of Iraq as a nation state.
But, disregarding the economic side effects of US political action, there are still strong arguments to suggest that US large caps may now be a more attractive asset class, both in absolute terms and when compared to US small caps. In a more dangerous world where credit is more rational, it is large companies that have an advantage. But despite the problems, global growth is still looking strong. "The growth of the world economy is not a zero sum game, less reliance on the US is healthy and US large cap companies can benefit from it," says Colin Morris, the managing partner of GoodHope Advisers, a partnership with Arnhold & S. Bleichroeder.
Heather McGoldrick, senior portfolio manager at State Street Global Advisors (SSGA), expresses similar sentiments. "It is time to look at large caps because growth outside the US continues to be quite strong and large companies get a lot of their sales from outside the US, especially with the dollar as weak as it is," she says. Morris goes on to add: "We are at a major inflexion point with regard to US large cap stocks. Instead of looking at the world as US versus non-US, it is now one giant playground where US companies are well equipped to compete."
What approach should be taken to invest in what is probably the most heavily researched marketplace in the world? Bob Turner, CIO and cofounder of Turner Investment Partners, a manager specialising in US growth stocks with a recently opened London office, admits that it is difficult to add value in large cap stocks. "Our neighbour is Vanguard and its founder, Jack Bogle, has always said that active managers can't add value everywhere, especially in large caps," he says.
Despite this, Turner is clearly a keen advocate of active management and investors would do well to consider both the shortcomings of passive approaches relying on indices that have strong sector biases not necessarily reflecting the most attractive current market opportunities. They should also consider the impact of style cycles following the huge outperformance of value stocks since 2002 following the crash of the TMT bubble.
"As much as the US is ridiculed for its military stance in the Middle-East and Asia, any signs that the US will withdraw will in fact cause more concern and heightened risk premiums," says Morris. Whatever the merits of the argument, and many would see it as inevitable that the US will withdraw sooner rather than later, he says: "Worldwide military infrastructure spending is on the rise with US large caps like Raytheon Company poised to benefit from its leading technology."
It is not just the development of a more dangerous world driving defence stocks that may be of benefit to US large cap companies. "Worldwide infrastructure is by far the largest opportunity and US companies will provide plenty of the expertise and technology to developing economies. In the US itself, an ageing baby boom generation will require a vast amount of services, providing plenty of investment opportunities," Morris continues.
During the last few years, the boom in US small cap stocks has hugely overshadowed US large cap stocks. Richard Jacobs a founder and director of Altis, an investment fiduciary firm based in Switzerland, explains: "US small caps have done well since 2002, outperforming large cap by 70%. As a result, what you do see, especially in more unconstrained managers, is that most successful managers have done well and scooped assets because of their small cap exposure. So a manager has done well through exposure to small caps rather than picking stocks."
Quantitative management approaches often have a small cap bias, Jacobs continues. "European institutions are heavily invested in quantitative fund managers with many quant boutiques. But European institutions are now struggling with quant and they now see that it is risky to be heavily exposed to small cap. They are uncomfortable with it and are trying to reduce it. Everyone realises that small caps are relatively expensive." It is not surprising that there is now increasing interest in large caps at the expense of small.
SSGA, according to McGoldrick, is seeing more demand for large cap. She says there has definitely been a shift in mind set in the US - and to some extent outside the US - from small cap to large cap. "Valuations look fairly attractive for, say, the S&P500 compared to small cap in the US, the price/earnings ratios are lower and yields on S&P500 stocks are higher than they are on small caps … so, from a valuation perspective, large caps are looking more attractive."
In a riskier world, it is also true that large caps offer more protection. "If there is a US recession caused by the fallout from the US sub-prime after-effects, then small caps will get sold quicker than large caps," says Jacobs. "It has been a concern for us for some months, as in a scenario where the costs of refinancing operations goes up, small companies do less well."
Morris points out that credit has gone from being virtually free to being non-existent during the last few months. "As a result, there is an advantage to those companies that don't require outside capital to fund growth," he says.
"During the last five to six years, large caps have not had a place in which to play, resulting in dramatic multiple compression. Now I believe that is about to change. Large US companies have a valuable role to play in the global economy, have high teens return on equity capital and generate plenty of free cash flow. Many of these companies trade at attractive valuations and provide attractive unlevered mid-teen return opportunities."
While there is no doubt that US large caps may represent the most widely researched and hence the most efficient equity market in the world, it is easy to adopt a naïve approach to passive investment and not recognise the limitations imposed by tracking an index.
The S&P500 for example, has a very high exposure to financials, a sector that many are concerned about following the sub-prime debacle. As Turner points out: "With the big money centre banks, you don't quite know what is out there, so near term, there is a lot of uncertainty in financials but many more opportunities in technology."
Morris adds: "The financial services sector will go through problems in the short term, but there will be survivors."
The growth of 130/30 products has also introduced a new alternative to the manager selection choice. "European investors are particularly interested in our 130/30 strategies," says SSGA's McGoldrick. "We have 130/30 large cap portfolios and also 130/30 mid cap portfolios - the first client that funded our large cap 130/30 was actually a European pension fund. In terms of long only versus 130/30, I would say that maybe a quarter to a half of enquiries are for 130/30." But it is perhaps the impact of style cycles that could conceivably have the most important impact on strategies for investment in US large caps. As Paul Rissman, CIO of Alliance Growth Equities, the growth arm of Alliance Bernstein, admits in a recent white paper, "the Russell 1000 Growth index has underperformed the Russell 1000 Value index over their entire history of almost 30 years." This has certainly been true during the recent post-TMT bubble years, when value focused managers have generated huge outperformance and gathered enormous amounts of new assets on the back of it.
Rissman, however, does make a strong case for taking a radically different view of growth stocks than has historically been the case. The historical pattern over the last 40 years, he says, has been a "seemingly secular trend of value outperformance over time punctuated by brief but intense spurts of growth winning big".
The most notable growth bursts occurred in the ‘nifty-fifty period' between 1969-1972, the oil bubble between January 1979 and August 1980, the Savings and Loan crisis between August 1988 and December 1991 and the internet bubble between May 1998 and February 2000.
But the argument he makes is twofold. First, index construction has fundamental flaws in it that means that growth indices do not accurately reflect what growth managers would prefer to invest in.
Second, Rissman says: "Growth stocks may be priced at previously uncharted lows, not only to their own history but, more importantly, relative to value stocks. So inexpensive, in fact, do growth stocks now appear, that it may be questionable whether they can grow any less expensive, and therefore to what extent they may further under perform value stocks."
Moreover, Rissman argues that, not only are growth stocks looking cheap but there has been a long-term secular change in the marketplace that has eroded the differential behaviour of value and growth stocks. Economic volatility has dropped as a result of globalisation and more effective central bank policies. There has also been a growing awareness of behavioural biases that have previously underpinned the distinctions between growth and value stocks.
The rise of quantitative fund management in particular - which Rissman points out has accounted for more than 40% of the assets in new mandates during 2005 and 2006 for US large cap and international equities in the US - has contributed to this because, as he points out, "models don't have behavioural biases".
Does this mean the end of style cycles? Rissman argues that the answer is no, but adds: "What could be different is an end to secular head winds that have faced growth investors for decades. Growth indices would appear no longer to be disadvantaged by stocks that are too expensive and destined to under perform an index of stocks that are fundamentally too cheap. The cycles would likely be oscillations around a constant equilibrium rather than reflecting a secular trend towards value."
But, as Rissman admits, even if we are at equilibrium now there is no way of telling when the next burst of growth outperformance will come, and when it will be a great time to be a growth investor. However, as he explains, it does matter if there is equilibrium today; growth investors have nothing to lose since they are now on a playing field that is level rather than pitched against them as in the past when value had a long-term advantage.
While such a view would raise the eyebrows of deep value managers, it is certainly true that the near term is likely to be as favourable for growth investing as any time in the past, and growth specialists see themselves as well positioned to benefit from the sort of arguments espoused by Rissman. Turner believes that even in Europe, "it is increasingly true that there is a style orientation and a recognition that styles go in and out of fashion. Core managers do tend to extremes in style and that is when they get into trouble."
For specialist growth managers, it is earnings expectations that drive stock prices and Turner's philosophy is to identify those stocks where earnings will exceed expectations. For this, it relies on the three areas. The first is understanding a company's business model, relying on the firm's own sector expertise. The second is meeting with companies - where large cap company meetings can contribute to knowledge of the industry background and mid cap company meetings can give insight into companies where less research is undertaken.
The third aspect is independent third-party research relying on a database of well-regarded providers who can give up-to-date information, for example on the results of drug field tests in the health care sector.
Bob Turner says that a key element in the firm's ability to outperform is its "close-knit, long-standing culture with an almost non-existent turnover of staff, with 20 members who are both portfolio managers and analysts".
He adds: "I am an active member of the telecoms team. My brother Mark is a member of the financial services team, and everyone is an equity owner of the firm." The approach relies on portfolios of 70 stocks or fewer with concentrated portfolios having as few as 25 stocks.
"Outperformance against an index means getting the big stocks right. If we don't like Microsoft we won't own it," continues Turner. "So Microsoft will either be at the top of our list or at the bottom. Second, it is important to get mid-sized stocks in the portfolio. The Russell 1000 Growth index has 305 of stocks that are mid cap. Over the last 16 years, mid cap stocks have outperformed the very large caps, so it is important to get them into the portfolio.
"Our sector teams identify rapidly increasing growth stocks. Those with a $3bn (€2.1bn) capitalisation that can grow to $7bn and then onto $13bn which, in many cases, we may have owned as small caps. Our large cap portfolios will never fall below 70% of the benchmark capitalisation weightings but we will typically have a third in mid cap." But what are the risks for investing in US large caps? Clearly the headlines are currently dominated by the implications of the sub-prime mortgage crisis but Turner's view is that the sub-prime problem is very quantifiable.
"Whether it is $100bn or $150bn, within the context of the US economy, it is manageable," he continues. "The main risk for large cap stocks in the rise of trade barriers." US large cap stocks are very international and have benefited greatly from globalisation.
Despite this, there is always the danger that the US Congress may create tougher barriers to free trade and comments by some of the current Democratic contenders clearly raise concerns outside the US. "All party candidates say one thing on their campaign trail to wow the electorate, and do another when they are actually in power," Turner says.
"China has shot itself in the foot with all the tainted products coming into the US, whether it is pet food, or lead paint in toys." Clearly this provides invaluable ammunition to those seeking higher barriers to foreign competition.
If value investing has run its course for the time being, should investors take the risk of investing solely in a pure growth manager such as Turner? Most would probably see this as a step too far but it leaves strong growth managers facing the issue that they are either reliant on being combined with value and possible core managers to provide a style neutral total exposure, or else reliant on fiduciary managers such as Altis who are prepared to take on strong style bets in their manager recommendations and are in a position to monitor the marketplace and make changes as they see fit.
This is in strong contrast to traditional investment consultants and the question is how long will it take for the European institutional market to be ready for such a radical approach.