Why Consistency Matters In 2017

Since 2009 quality and growth companies have outperformed significantly. However, sentiment changed following the UK’s decision to leave the EU and the election of US President Donald Trump.

Style rotations, where investors switch one type of investment style for another, are nothing new. At some point during most investment cycles, different styles – such as growth, quality, value and high dividend – will outperform at different points as investors rotate in and out depending on their outlook for the future.
In practice, there can be overlap across these styles. Take for example, consumer staples company Procter & Gamble, which features in the quality, value and high dividend indices, or Alphabet which can be classed as both quality and growth.
In 2009, we saw a sharp turnaround in equity markets as investor sentiment turned following the Global Financial Crisis (GFC). This was marked by a sizeable cyclical rally where, at the trough of the market in March of that year, value and ‘low-quality’ companies outperformed for a period as investors sought out companies on cheap valuations. During this, and other rotations witnessed in the past 15 years, the shift tends to be pronounced but relatively shortlived, typically lasting from three to six months. Once emotion resets and investors begin to differentiate between those stocks that genuinely offer value and those that have been cheap for good reason, value’s outperformance tails off as quality and growth push back.
Over the last 50 years economic growth, as measured by GDP, has been gradually slowing and in the few years leading up to 2016, earnings growth was thin on the ground. Any growth we did see was primarily driven by investment from China, which had a knock-on effect on commodity prices and those resource and energy companies exposed to that.
But in the last 12-18 months, investment-led growth from China tailed off as it began to rebalance its economy to a predominantly consumption-led model. In this environment, companies overly reliant on economic growth looked out of favour, with those exposed to structural (more permanent) or secular (longer-term) growth themes coming to the fore. For us, this meant themes of technology (particularly software) and changing demographics (e.g. healthcare and growth in emerging market wealth). At the beginning of 2016 valuations became stretched, like elastic, and when the market began to fall, those areas that had outperformed in 2015 snapped back.

What changed?
In the short-term, when there are sharp changes in sentiment, market dynamics can shift to create an environment that some investment strategies and philosophies are simply not wellsuited to. In the run-up to 2016 and in a world where global economic growth had been subdued, the market had been rewarding those companies that could still deliver growth. Indeed, quality and growth had outperformed significantly since 2009, as shown in Figure 1.

But sentiment started to shift at the start of 2016 and volatility spiked. While December 2015 marked the first US rate rise since the GFC, talk had already turned to a US recession, banks got even cheaper and investors sought comfort in defensive areas of the market. Oil hit 10-year lows in February only to rebound into quarter end, while commodities prices also rose. The result was a quarter in which investors took profits from growth names – the strong performers from 2015 that were perceived as expensive – and recycled their cash into both the cheap, value names in commodity industries and the more stable, defensive growers, particularly those offering a yield. Again, the elastic that had been stretched snapped back.
This approach continued to work into mid-year, as the defensive utilities, telecoms and staples sectors and the more cyclical materials and energy sectors led performance.
However, to paraphrase an oft-used sports term, it was a year of two halves. Sentiment clearly shifted in the wake of the UK referendum on EU membership, when the decision of the British public to vote for Brexit initially surprised markets. While this created uncertainty, which was heightened further during the run-up to the US election and the eventual victory of Donald Trump, the year ended with an apparently more positive outlook for growth.
In the US, Trump’s ‘America First’ rhetoric supported domestic companies, regulation looked set to be relaxed and corporate tax levels reduced, and December closed with a second US rate rise in 12 months. In Europe, even the uncertainty around the UK’s position in the EU and the wider ramifications for the region couldn’t dampen the recovery in companies most sensitive to economic sentiment.
Commodity companies continued their rally, but this time were joined by financials; not just in the US where the outlook for interest rates and bank capital requirements are less stringent, but also within Europe’s fragile banking industry. As the market sought out cyclicality, the defensive growth and yield companies suffered.

The future
In the short-term, we expect the rotation into companies sensitive to economic sentiment that we have seen in recent months to continue. There is a widely-held belief (which we believe is priced into markets) that President Trump will announce expansionary policies that are pro-growth. This should help the ‘value’ stocks further. However, current valuations suggest almost flawless execution of Trump’s policies, and it is quite possible that they are not fully enacted, or indeed are imperfectly executed. Moreover, his protectionist pronouncements may dampen growth, hence our belief is that growth expectations are currently elevated, as are valuations of recovery or value stocks. It is possible that there is further upside for this part of the market but it requires excellent execution. We believe that growth, while positive, could still disappoint, so the outlook for those growth or quality companies less dependant on accelerating economic growth can improve.
Indeed, the market has already started to differentiate between those companies that have the fundamentals to justify continued upside and those that don’t. With that, we have seen both growth and quality perform strongly in the first two months of the year (Figure 3).

As medium- to long-term investors, our role is to look beyond the short-term noise to find attractive longer-term winners. Quality companies can be found across a range of sectors and, while secular (longer-term) themes of technology and changing demographics continue through our portfolios, the opportunity set is evolving.
With US interest rates on the rise, US financials look more interesting and share prices certainly show the market’s interest, but which ones offer sustainable shareholder value? Globalisation has been a huge positive for equity markets over the past 30 years and protectionism could be a shock, so who stands to win should we enter a period of ‘deglobalisation’? The oil price is relatively stable in the mid-$50s range, while commodities prices more broadly are improving, and domestic US businesses are a potential beneficiary from Trumponomics, the caveat about full implementation of Trump’s policies aside. All of these factors (and more) will dictate market dynamics for some time.
Within our quality framework, we should be able to find beneficiary companies trading on attractive valuations, but with the fundamentals to justify share price growth. It’s simply a case of finding them, and therein lies the importance of a truly integrated and collaborative research team with access to the highest levels of management globally.

Positioning
We continue to like defensive growth companies, ones that have the ability to deliver consistent levels of growth in a low-growth world. Unilever is a good example; a company that is held across global, UK and European portfolios. The consumer goods firm behind household brands such as Persil, Dove and Vaseline offers high single-digit growth potential and, in recent years, has been refocusing its business on higher-growth home and personal care products.
Where appropriate, we have been adding to companies that stand to benefit from the shift in economic sentiment, particularly in the US. Without compromising a focus on quality, this has seen certain portfolios across our equity team invest in US financials such as Goldman Sachs and Bank of America, beneficiaries of rising US interest rates and better growth, as well as companies such as United Rentals which stands to benefit from Trump’s desire to increase infrastructure spend.

Conclusion: Quality still works
Our message is: we believe a quality style bias still works, but where you look for quality will be crucial. Our consistent approach to seeking out those high-quality growth names will not see us distracted by short-term style rotations. Consistency is key.
As Warren Buffet said: “It’s better to buy a wonderful company at a fair price, than a fair company at a wonderful price”. We believe our well-established and consistent process means we are well-placed to continue delivering solid risk-adjusted returns for investors, even though our investment style may go in and out of fashion and may underperform when markets go up very quickly.

William Davies – Head of Global Equities – Columbia Threadneedle Investments