Your view on US large caps should be based on whether you think they are an investment decision or a gamble, argues Joseph Mariathasan

The elephant in the room for any institutional investment portfolio is the US large cap market, which represents a major proportion of the total global equity market capitalisation.

The US markets have been out of favour in Europe for a long time. However, this appears to be changing, according to Logie Fitzwilliams, who runs the London office of specialist US equity manager Brown Advisory. "People are now talking about
increasing US allocations," he said, speaking before the collapse of Lehman Brothers. "Many investors believe that as the US went into this slowdown before the UK and rest of Europe, it should emerge first and [they] want to be positioned accordingly. Improving confidence in the dollar relative to sterling and the euro is also helping sentiment. Investors believe currency could be a tailwind to performance for the first time in many years. Finally, the sell-off in equities has created some exciting opportunities and there appears to be a lot of value in many of the best US companies."

Moreover, on a trailing 10-year basis, the S&P 500 has performed as badly now as it has ever done, according to Shigeki Makino, CIO of global core equities at Putnam. "So perhaps investors should be thinking of getting exposure soon. Maybe not in the next six months, but thereafter," he suggests.

The credit crunch clearly has had the most severe impact on the US financial sector, but in large part it has only affected those companies that rely on debt. While spreads have gone up, benefiting the banking sector, a lot of its lending has been curtailed. However, notes Chris Orndorff, managing principal at Payden & Rygel who is responsible for its equity strategies, many of the larger non-financial companies have been accumulating cash over the last couple of years and as a result they are better placed than mid and small cap companies as they have less need for debt.

Moreover, there has not been a fall-off in earnings in the non-financial sectors, and balance sheets are looking healthy, with no negative reports of a lack of liquidity, says Makino. "Over a long horizon, the opportunity for investors is to pick a point when it is time to get into names that have been beaten down badly," he adds.

Diversity of approaches

It is often argued that the US large cap equity marketplace must be the most heavily researched set of stocks on the globe. Moreover, as Mark Donovan, co-CEO of Robeco Boston Partners, points out: "Ten to 15 years ago, managers could claim that their edge was better access to management that gave them better information. With all the changes in the regulatory environment as well as the development of faster information flows, that is certainly not the case now."

But the indiscriminate sell-off seen in the financial sector over the past year does raise the issue of how efficient the marketplace really is. As Donovan argues, firms such as his seek outperformance through analytical edge. Not surprisingly, given its size, the US large cap marketplace probably has the largest diversity of investment approaches of any asset class applied to it. It is awash with firms set up by finance academics who have gone on to apply their theoretical insights to making real money for their investors as well as themselves.

European investors can take a simplistic approach to the US market. Although the US equity market represents almost half the global capitalisation, they often leave one manager to cover the full range of opportunities.

Brown Advisory, for example, recently launched three Dublin pooled funds for the European marketplace - a mid/large cap value, a mid/large cap growth and a small cap strategy - but is finding that it needs to have a combination of all three to satisfy what European investors are really looking for, according to Fitzwilliams. It is finding that many prospective clients do not wish to have multiple managers and take style and size bets within the US marketplace but prefer to own one strategy that gives them broad exposure to the US equity universe.

Growth or value?

The problem investors face is that markets go in cycles but it is difficult to predict when value or growth will outperform, says Jonathan Coleman, (pictured left) co-CIO of Janus Capital Group. Value outperformed early this decade, then this shifted to growth at the beginning of 2007. But more recently the strategies have performed similarly.

However, those investors seeking active managers should be aware that the value index is fairly consistently the top quartile performer in the universe, according to Orndorff. As a result, a European fund looking for a value manager would do well to just invest in a value index, he advises.

In contrast, among growth managers the index is a low performer, leading to the conclusion that active management in large cap growth space is more worthwhile from an investor viewpoint. Not surprisingly given his views, Orndorff's own firm just manages a growth product.

However, Robeco Boston Partners, which was acquired by Robeco in 2002, is a value manager, according to Donovan. It specialises in US equities while the US component of global funds is managed from Rotterdam. "Not every process will work 100% of the  time [and] we accept that at times we will be out of favour," he admits. "But when a turn in style happens, it is in the early phase of the turn that you get the most outperformance. While growth took the leadership early last year there has been a tremendous dispersion of valuations during the last few months. This is a great landscape for value investing."

Other firms attempt to manage a number of different styles within the same organisation. Having started as a growth-oriented firm, Janus runs a variety of strategies based on a common research team. It also owns two other firms: Intech, which applies a purely mathematical investment strategy with all stock decisions resulting from a mathematical algorithm based on the volatility of stocks; and Perkins, Wolf, McDonnell and Co, a Chicago investment firm known for a more conservative, value-oriented investment style.

Many firms, such as Putnam, run a range of US equity products covering growth, value and core together with what they see as more specialist products such as ‘distressed stocks' with large sales but not market capitalisations, according to Makino.

To run both value and growth strategies within the same organisation is not straightforward. Many would argue that fund managers have an ingrained growth or value viewpoint that is difficult, if not impossible, to switch. A common solution to this dilemma is to utilise a single but separate research team to supply ideas to separate value- and growth-focused fund managers.

Paul Chew, director of research at Brown Advisory, argues that the benefits of having analysts covering both growth and value companies within their sector far outweighs the complexity. "We believe that portfolios based on analysts who focus across both growth and value stocks within their sector will be more diversified," he says. "Our value portfolio, for example, has a lot of technology while our growth portfolio has a lot of energy and industrials that have done very well. In dynamic sectors like healthcare and technology, analysts can get blind-sided by value traps and end up recommending companies that are in decline and potentially going out of business.

"Like other organisations with common research teams, the fund managers have a very strong focus on a single style and are responsible for ensuring that the philosophy of the fund is maintained. The analysts, by contrast, can cover both."

Chew explains that in determining whether the stock is suitable for a value or a growth portfolio, analysts ask what makes the stock attractive. "Is it the ability of the company to grow earnings rapidly by gaining market share from its competitors or serving a large and growing market? If so, it is a growth stock," he says. "Or is the stock price trading at a discount to what we believe to be its intrinsic value? If so, it is a value stock."

What don't we know?

Former US defence secretary Donald Rumsfeld once famously noted, "we don't know what we don't know". There are those who feel that his statement best characterises investors' confidence in the US large cap sector's current valuations in the wake of the events of the past year. As a result, the key issue for any investor contemplating the US large cap market is their position vis-à-vis the financial services
sector.

Earlier this year Ben Inker, the CIO for quantitative strategies at GMO, said: "We believe that the uncertainties around the ultimate value of much of the US financial system are so large that it may very well be advisable to substantially underweight or avoid financial stocks - not because we know the stocks to be overvalued, but because the magnitude of the unknowns is such that we mere mortal analysts cannot hope to know what the true values of the companies are."

Richard Pzena, (pictured right) the CIO and founder of Pzena Investment Management, which adopts a classic value investment approach, has the opposite view: "The sub-prime mortgage and liquidity crisis has sent investors into panic mode about financial stocks, driving their prices far below their underlying value. Major firms with strong franchises have fallen precipitously, despite their historical records."

With a passionate belief that the markets have got it wrong, Pzena has launched a strategy focused on a concentrated portfolio of approximately eight to 20 global financial stocks. "Citibank is not just a static pool of assets, it is a fee-generating business," he says. "Citibank's revenues excluding marked-to-market assets have been steadily going up while assets have been declining - a process of deleveraging."

Moreover, banks are now facing less competition, Pzena argues. "The euphemism for banks losing market share was ‘disintermediation'. They have been losing market share for 30 years to hedge funds and others who were willing to lower prices and leverage up their investments to get higher returns. The competition is now out of the game. The US commercial banks have the highest level of capital for 20 years and the highest capital ratios."

Pzena Investment Management advises its most aggressive investors that a financial-only strategy has the highest return potential, saying: "It is risky but most investors are mistaken to be light on financials. The issue is whether they rectify that through us or by hiring someone who has a more diversified strategy."

Pzena feels that the market has over-reacted, primarily because of the effects of marking to market balance sheet investments. "The crisis is all over, the marked to market valuations accelerated the losses tremendously," he says. "In the past, banks wrote off stuff when they actually lost money over a number of years. Now they write it off immediately when other people think they have lost money. In the last cycle, losses were spread over three to five years. This year the banks have taken the write-offs in advance."

He adds: "The last time there was a crisis of confidence in financial institutions was in 1990, caused by commercial real estate excesses rather than residential. In this cycle, the data suggests that non-performing loans and so on are less severe but the market reaction is more severe. For the financial services in aggregate in 2007, the book value actually expanded. The idea that there was mass destruction of value is false; there was a mass destruction of market value. This was a healthy reaction to excesses of loose lending. This happens time and time again."

Pzena argues that the derivative indices for sub-prime mortgages imply a total loss rate for a portfolio of mortgages of 42%. "If you assume that the loss on any single transaction goes to 60%, that would imply 70% of homeowners will default. The aggregate so far in 2007 was 2.3%. There is $1.3trn [€880bn] of losses in the US mortgage market on a mark to market basis. I am 98% sure it will be less than that. You need to assume 50% of people with negative equity will default. A Fed study found only 6.4% defaulted in Massachusetts when it had a 9.2% unemployment rate."

Most firms appear to have views somewhere in between those of Inker and Pzena. Makino is underweight financials "Even though several banks look cheap, it is not clear how much capital they need to raise," he says. "We will stay on the sidelines until we get a better idea of what the credit losses will be. The mortgage rates for borrowers have not declined so that high inventories and high rates means downward pressure on values."

Orndorff is also cautious. "We are getting to the point where the banking sector is looking interesting but it is still too early," he says. "From July to September/October last year the banks spent most of the time in denial. Then from October to January they started realising the mess they were in and began firing the people in charge. They have spent the last six months assessing the damage and in a risk-control mode, shrinking balance sheets. So it is not good to invest in just yet. But some institutions are starting to have conversations about how to make money going forward. When the majority of banks are starting to have these discussions, that is the time to invest."

Other firms are seeing opportunities thrown up by the sell-off. Janus finds the financial sector intriguing, says Coleman: "We are finding interesting and compelling ideas. We undertake in-depth analysis to understand who are the real winners and losers with the expectation of a holding period of three to five years. Given the current strain on the financial system, certain companies will emerge as extreme winners and others are going to end up as extreme losers." 

Where next?

Given the recent establishment of a London office, Brown Advisory certainly believes that the timing is good for European investment into US equities. But the real impetus that will drive increased demand for US large cap equities may be a clearer picture of the financial services sector. And the jury is still out as to whether the marketplace will eventually swing round to Pzena's viewpoint.