Read Time: 10 mins
Larry Puglia, Portfolio Manager,
US Large-Cap Core Growth Equity
Equity markets have rebounded well from the pandemic‑related lows of March 2020, displaying an encouraging level of resilience. While this is positive, we remain circumspect about the potential time frame for economic recovery. Our sense is that the current crisis could have a longer‑than‑expected tail, delaying the recovery beyond what the market consensus is currently anticipating. Meanwhile, the environment is likely to remain uncertain for some time.
Regardless, our investment approach and portfolio focus remain unchanged. We continue to look for high‑quality companies that can potentially produce durable growth in earnings and free cash flow over time.
Given the extreme economic dislocation, near‑term earnings forecasts for many companies have become clouded. To better understand the longer‑term picture and potential outcomes, we allocate the companies within our investment universe into three main categories.
The companies that we look to invest in have various, consistent qualities that single them out as potentially advantaged long‑term businesses. Such attributes include high barriers to entry, low availability of substitute products, industry leadership, and pricing power with both suppliers and customers. Also essential is capable management that can allocate capital effectively and efficiently. These quality identifiers are particularly relevant for companies currently allocated to Category 2, for example. Despite earnings being negatively impacted in the short term, and share prices falling sharply in some cases, these qualities give us confidence that the companies can not only recover, but go on to excel, longer term.
At this point, it is worth highlighting some of these “all season” growth companies—examples from both Category 2 and Category 3—and what we believe are the durable qualities that identify them as potential long‑term growth compounders.
Technology/consumer services giants Alphabet (Google) and Facebook are good examples of companies currently in Category 2. Both have been hurt by the current crisis and suffered steep share price declines during March; however, we believe that both businesses could ultimately be beneficiaries of the current environment.
The largest portion of both Google’s and Facebook’s revenues comes from digital advertising, an area of spending that has seen significant cuts in the current environment as companies canturn it off very quickly during times of stress. Compare this to TV advertising, for example, which tends to be more contractual in nature and paid forward, so not as easy to unwind.
What is most encouraging however, and underpins our positive long‑term view of each business, is that as quickly as digital advertising can be switched off, it can be switched back on again. Digital advertising is the most measurable, and return‑on‑investment visible, spending that companies have at their disposal. As such, we believe that it will be the first place they return to as soon as any budget becomes available.
Also potentially benefiting Google and Facebook on a longer‑term basis is the growing “cord cutting” trend currently evident among companies and consumers. This trend (which is perhaps most prominent elsewhere, among content streaming platforms) is also increasingly evident in the advertising realm. Prior to the onset of the crisis, many companies had already set aside substantial sums for TV advertising. However, with limited new content presently being made and, crucially, with no live sports being shown on TV, companies are looking to reallocate their TV advertising budgets to digital, and, in many cases, this money has been making its way to Google and Facebook. And once the cord is cut, be it by companies or consumers, data has typically shown that a large percentage never go back.
Some concerns have been voiced about the elevated valuations of higher‑growth companies, particularly in areas like technology. An unusual feature of the current crisis is that growth‑oriented names have continued to notably outperform their value and defensive counterparts.
As such, certain technology sector names, for example, may appear expensive currently, relative to the broader market. It is our job as investors to research these businesses in detail, all the time looking for any unique qualities or advantages, as well as potential limitations, and determining our own fair valuation based on this analysis. Take Amazon, for example. Amazon is the dominant player in the retail sector, with the potential to extend its reach into other key retail segments. The company’s other main businesses, Amazon Web Services and its advertising arm, have offered additional, diversified revenue streams, and the company has generated substantial levels of free cash flow. The combination of these features has given us comfort in our position in Amazon.
There is no magic formula or silver bullet for finding quality, durable growth companies. It involves a lot of hard work, digging, and detailed research and analysis. And in unprecedented times like today, it involves continuous engagement with company management teams, asking difficult questions, checking and rechecking investment theses, and ultimately deciding if the company’s longer‑term strategy can still be delivered.
While consensus opinion is anticipating a relatively quick, “V shaped” US economic recovery, we are of the opinion that a recovery may take longer than expected and be more “U shaped” in nature. We anticipate that earnings revisions will be necessary for many companies, which makes us more cautious about the near‑term outlook, particularly given the rapid recovery we have seen in the stock market so far. That said, we do believe generally that there is a solid return opportunity in US equities, especially looking out over an 18‑ to 24‑month time horizon.
As an investment team, the message that we continue to reiterate is: “Don’t let perfect be the enemy of the good.” Even some of our highest‑conviction holdings will likely see earnings revisions if the businesses have been closed or unable to trade during the crisis. However, with the quality attributes these companies possess, we believe that they will bounce back in time and continue to deliver potential earnings and free cash flow growth over the long term.
The companies mentioned above represented the top 3 largest holdings in the US Large‑Cap Core Growth Equity Representative Portfolio, as of March 31, 2020.
The specific securities identified and described do not represent all of the securities purchased, sold, or recommended for the portfolio, and no assumptions should be made that the securities identified and discussed were or will be profitable.
Key Risks — The following risks are materially relevant to the strategy highlighted in this material: Transactions in securities of foreign currencies may be subject to fluctuations of exchange rates which may affect the value of an investment. The portfolio is subject to the volatility inherent in equity investing, and its value may fluctuate more than a portfolio investing in income‑oriented securities.
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