Our clients’ most commonly asked questions since ‘Vaccine Monday’, Part 1: Market rotation and ESG considerations

Since ‘Vaccine Monday’ in November and the subsequent value rally, clients have been asking if we think this is another false dawn for value, and whether investor focus on ESG changes anything for cheaper stocks

21/01/2021

Ben Arnold

Ben Arnold

Associate Investment Director, Equity Value

Market rotation

Have any positions in your portfolios moved so violently in recent months as to warrant selling them?

Given the magnitude of the market rotation that began in early November, a number of stocks across the funds we run have indeed moved violently over the last couple of months. In many of our portfolios, nearly every stock has made a positive return during this rotation – for example, many of our banking and energy names have seen rises in excess of 30%. As such, where appropriate, we have been trimming positions. Managing risk appropriately is central to our thinking on portfolio construction and this has been reflected in recent trading across all our funds.

If this turns out to be another false dawn for value, what needs to happen to make it supportable?

Obviously we do not have a crystal ball to tell us exactly what needs to happen to see a sustained value rotation but we are confident many companies in our portfolios stand to benefit from a normalisation in economic activity. 2020 saw a sharp re-rating of companies deemed to be relatively sheltered from the immediate impact of Covid-19 – alongside a sharp de-rating of those most clearly in the firing line. If effective vaccines are successfully rolled out and economic activity gradually normalises, it will be very difficult to rationalise the extreme valuation dispersion we continue to see in equity markets today.

If and when there is a material shift to value, how easy will it be for so-called ‘balanced managers’ to trim holdings in, say, Diageo or Unilever and buy value stocks, such as M&S or Royal Mail?

In terms of liquidity, volumes are currently low in the market and the value investors who make up a substantial part of the share registers of businesses, such as those mentioned, would not be sellers at current prices. Certainly, it would take a much higher price for us to sell the stocks we have bought into over the past year. This does not mean it cannot be done at the margin but, given the skew in the market in favour of growth, a transition will take time and will cause prices to move significantly.

The real challenge for the balanced manager – among others – however, lies in the mind. There is a psychological barrier to selling stocks that have performed extraordinarily well in favour of those that have been studiously avoided for years. A large body of behavioural psychology literature shows that barrier can be extremely difficult to overcome – indeed, it is one reason the value premium even exists.

History also shows timing this is extremely difficult. As Warren Buffett has observed: “Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, sensible people drift into behaviour akin to that of Cinderella at the ball. They know that overstaying the festivities – that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future – will eventually bring pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: they are dancing in a room in which the clocks have no hands.” It is impossible to know if the November rotation marks the clock striking midnight for investors overly exposed to growth. What we do know, however, is that despite the rally, relative valuations remain stretched and unsustainable on a long-term investment horizon.

How have flows into your recovery funds been since November?

We cannot disclose specific fund flows but, anecdotally, we have observed a pick-up in client interest into our recovery funds, as well an increase in inflows as clients look to increase exposure to the cheaper areas of the market. We are also aware that, given how challenging the last decade has been for value, there are now very few true-to-label, scalable value franchises in the market.

Since November, have you seen any actual rotation from so-called ‘balanced’ managers who have arguably been sitting in too much growth or has it largely been algorithm trading flipping?

We prefer to stick to what we know and understand and so do not spend too much time looking at the underlying trading activity of the market. That said, data we have recently seen from the sell-side, who follow flows far more closely, suggests there is no real evidence that hedge funds have bought into the value rotation in a meaningful way – yet. The data, which covers Europe and North America as of 4 December, indicates hedge fund exposure to typical value sectors, such as banks and energy, is in the lowest decile since 2010, while exposure to growth – most obviously technology – is still in the top decile, suggesting hedge funds still have some way to go to unwind the exposures they have built up over the last decade.

ESG considerations

Do you think many of your holdings risk being ‘demonised’ as more funds go the ESG way?

While there are undoubtedly certain headwinds – some related to environmental, social and governance (ESG) considerations, some not – that the businesses we own face, the primary reason we own these stocks is because we believe the valuation ascribed to them more than accounts for the associated risks. We would argue that many of these companies – our energy holdings being an obvious example – have already been ‘demonised’ by some parts of the market but we have factored the impact of this into our appraisal of these businesses.

Do you take the recent surge in focus on ESG-related issues into consideration when selecting stocks?

Assessing the risks ESG factors pose to companies and their valuation has long been a central component of our investment process. After all, that process has evolved over the years to reflect the changing investing environment and ESG risk has played a part in this. There has, for example, been significant debate on the appropriate way to value the energy sector given the headwinds many oil and gas businesses face. Approaches such as a focus on cashflows, placing a lower multiple on earnings, the role of internal rates of return and integrating a ‘sum of the parts’ analysis have all been debated – and this debate has helped our portfolio managers reach their own conclusions.

Are you worried about a bubble forming around ESG-related stocks?

We have little to say on this issue other than to observe that throughout the stockmarket’s long history there have always been bubbles, which have been fuelled by a persuasive prevailing narrative that has a kernel of truth to it. While we have no doubt there are parts of the market being valued on some eye-watering multiples today – both related and unrelated to ESG – we spend very little time or energy looking at these companies given their valuations sit so far away from our natural hunting ground for picking stocks.

Author

Ben Arnold

Ben Arnold

Associate Investment Director, Equity Value

Ben joined Schroders in 2016 after spending 3 years as an analyst at the Royal Bank of Scotland. He moved in to the Value team in January 2018 as an investment specialist after working for two years in Schroders' Distribution division. He is a CFA Charterholder and holds an MSc in Corporate Strategy from The University of Nottingham.

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