Time to get active in equities

Based on the fundamentals and valuations of certain companies, we believe there are compelling reasons to consider re-entering markets for those able to stomach continuing short-term volatility. Indeed, it may be tempting to put more money to work buying quality stocks which are priced at historically cheap levels. However, one key issue is whether to invest actively or passively. In the benign markets of 2003-06 active managers struggled to beat top quartile performance from the indices and then, more recently in the extreme sell-off at the end of 2008, active managers failed to offer much downside protection – thus investors may well feel understandably hesitant. In order to succeed, good investment decisions need to be forward thinking. We believe that the following five reasons mean that active management is poised to succeed. As volatility abates, fundamentals should re-assert themselves – During 2003-2006, global optimism about growth prospects fuelled all stock markets and led to a low volatility environment where the prospects for all stocks looked positive. The sharp correction in 2008 displayed the opposite sentiment – fear – but a similar reaction, as value was wiped off stock prices indiscriminately and, regardless of underlying company fundamentals in the future we expect a correction in this situation. We expect there to be greater dispersion at a stock level – a fertile environment for stock picking. Limited prospects for broad multiple expansion - In 1982 at the start of a long bull market the price to earnings ratio of the market was approximately 7 per cent and short-term interest rates were nearly 20 per cent. Over the intervening years, as interest rates tumbled, equity valuation multiples expanded and markets soared in the tailwind this created. Now as we enter a much more austere period with P/E averaging 16x the opportunity for expansion is much reduced and the ability of a company will be measured more on the success of their core strategy and business fundamentals to drive equity returns. We believe that with this dynamic, security selection will be crucial. The end of the ‘rising tide that lifts all boats’ – The S&P 500 grew at a consistently high teens rate over 2003-2006 which is about two times its historical average. Today, when faced with shrinking markets, companies have to battle their competitors for share. Those companies with cash flow to finance growth and differentiated products which can maintain margins and those driven by secular rather than economic growth should still be able to generate growth – but can only be identified through careful research. Recovery will look different – Currently in 2009, where the consumer is saving and deleveraging rather than spending and actions taken by central government are still not translating into easy access to credit, the conditions are tough for any but the most well funded companies. We think that high quality share gainers will lead the market and active managers with a quality bias should be well positioned. The growth of passive has created market inefficiencies – An investor who decides to allocate to an index is making an asset class decision rather than a company-specific investment decision. By allocating to stocks at current index weights, that investor, by definition, is not price sensitive at the stock level. At its extreme, this price insensitivity often leads to index imbalances, such as the weighting of technology stocks in the growth benchmarks in 2000, or the rise of financials in value benchmarks in 2006. These inefficiencies could be exploited by the bottom-up, valuation-sensitive active manager. In this highly uncertain environment, we believe there are important characteristics that will give certain managers an advantage. Managers with deep research resources, a forward-looking investment process, and who are truly active, should find today’s climate favourable.