The market indices had already rebounded nicely by November. Then Joe Biden got his victory and the world got its great vaccine news. All of these combined to help equities continue their rise into the stratosphere. But much of this is based on the performance of the mega caps. And if the mega caps’ valuations were stretched before the pandemic, now they’re even more so.
So now everybody wants in. Fund flows into equities reached record levels over the past two weeks. It’s getting crowded. We think this over-bullishness may backfire. The mega caps’ growth has been driven by a massive amount of money that is managed without any fundamental research. This is dangerous. They are chasing momentum stocks, playing with technical charts, concocting algorithms, or passively matching an index.
And the sector rotation? It’s already started: right now, we’re seeing rotation from growth to value, large cap to small cap, technology to cyclicals. We expect this to continue and even strengthen over the next six months. This is when our proprietary strategy will help the Evli Global Equities family of funds distance themselves from the passive and herd-following investors. It happened in 2010-2016 and we believe it will happen again.
The Evli Global Equities family of funds consists of seven funds which invest in different geographical regions. The investment strategy of the fund family is disciplined and repeatable, focusing on free cash flow generation, the ability to cover debt obligations and finding underpriced shares. It is time tested, with a proven track record.
Don’t dance where the elephants play
Remember the IT bubble? An era of hot, ‘innovative’ stocks whose valuations couldn’t be justified based on the old standby metrics. Back then, new metrics were conjured up to justify what was, in retrospect, an obvious overvaluation. At Evli, we want to help our clients avoid falling victim to the next bursting bubble. We believe all trends, just like the IT bubble, come to an end sooner or later.
The latest trend is no different. Lately, investors were chasing the mega caps at any cost. But at some point, a rational repricing of assets will make a comeback.
Some mega caps are fantastic companies, but they can also be grossly overvalued at the same time. Especially now: in order to justify their sky-high valuations, they will need to execute on their strategies to absolute perfection.
In the short run, the stock market is like a voting machine, and momentum is in the lead. The thing about momentum trading is that it easily becomes crowded trading. That’s because momentum investors are more likely to overpay in pursuit of the lottery effect, for fear of missing out on the next Tesla or Apple.
In the long run, the market is like a balancing scale, where mean reversion always prevails. What does this mean for the mega caps which have skewed the index returns while small/mid-sized stocks have mostly underperformed? Mean reversion would lead the momentum-boosted, high-beta mega caps to suffer disproportionately to a similar extent that they outperformed in the bull run.
The terms ‘innovation’ and ‘disruption’ apply to many of today’s index giants, but there will always be new innovators and disruptors. A look at the top 10 index names at the start of each decade reveals that many of them disappear from the list by the next decade. The performance of stocks after they reach the top 10 in size is often an underperformance compared to the strong growth that got them into the ranking in the first place.
And, make no mistake about it, the scale was bound to tip back in favour of smaller caps. We’re seeing the beginnings of this now: over the last month, there’s been a clear outperformance of small-caps over mid-caps, value over growth, and laggards over momentum. This is happening both in the US and in Europe.
A proven strategy over the long-term
Evli’s funds have time and results on their sides: many years of strong track records across a variety of funds, winning multiple awards in the process. The strategy and track record are consistent and understandable, even for non-professional investors. It has also been proven effective in Evli’s credit funds for over 20 years.
Other fund strategies can be based on theories that are complex or abstract, or on strategies that have only worked in the recent past and extrapolated to the future. Evli’s clients can rest assured that our Portfolio Managers have a repeatable, rules-based, uncomplicated approach. Our PMs can tell you why each stock or bond belongs in the portfolio. They’re not just following the herd.
Across Europe, there are an abundance of actively managed equity funds, but Evli’s Global Equity family of funds has a low correlation of alpha (high information ratio) with these other funds. This makes Evli’s funds a strong tool for the diversification and value enhancement of any investor’s portfolio.
The dinosaurs were big, fearsome and seemingly invincible, but even they didn’t stay on top forever. The survivors were not determined by size. We believe there could be consequences for the managers who only chase size, momentum or other strategies that ignore fundamentals. A focus on quality cash flows combined with pricing discipline will rule in the long run.
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Kim Pessala
