Useful Unique Properties
Mid-Cap stocks have some unique properties that solve two important issues for investors at this stage in the economic cycle and in the current market.
Mid Cap Stocks occupy a unique place in the market capitalisation continuum around the $2bn to $10bn space. At this stage in the economic cycle professional investors are turning to Mid Cap stocks to solve two main issues.
The U.S. Mid Cap universe is 'represented' by stocks 201-1000 within the Russell 1000 index i.e. they just fall outside of the largest 200 US stocks which are the most covered by broker research. This last point is what makes them specifically interesting:
With less broker coverage, the opportunity for active managers to uncover hidden gems that can add alpha to their portfolio is more prevalent.
And at the same time, the volatility of the mid-cap universe only tends to be 10-20% higher than the entire Russel 1000. In other words, there is potential return per unit risk enhancement to be found by specialised active mid-cap managers.
Style risk is not always a factor to which investors wish to have an exposure bias - either on the growth or the value side. But it can exist as a result of benchmark choice, or market capitalisation exposure.
In many cases, much of the small cap universe is dominated by 'young' companies growing fast. And at the other extreme, large caps exhibit slower growth but are are often mature, stable and highly diversified businesses.
Mid Caps arguably fill the gap in the portfolio reserved for above average earnings growth companies (unlike large caps) without the 'newbie' business risks associate with smaller companies.
In short, investors are now looking for both quality and earnings growth, from companies that are less well known by the market. And ideally, who are in a position to capture and monetize long term trends.
Deglobalisation Has Many Interrelated Dynamics
Deglobalisation will affect stock valuations. There are many interrelated dynamics at play that represent a powerful reaction on geo-political realities.
Deglobalisation is here and is not going away soon. It represents a powerful reaction on geo-political realities, climate-related imperatives, and global macroeconomic regime change. But it is not just shaking up corporate broad rooms and forcing the C-suite to rethink strategy. It is also forcing investors to adjust their models for lower stock value expectations.
Investors' focus today is finding investment managers that are able to identify the corporate winners and losers from deglobalisation. But that requires managers with a deep understanding of how the corporate world will look in 2030 and beyond.
Deglobalisation has many interrelated dynamics that will affect stock valuations:
- Western governments are introducing incentives, regulation and new demand that encourages firms to embrace domestic production (e.g. The Inflation Reduction act, the Chips Act, and increased defence spending in the US).
- With the end of the four decade trend towards free money, CFO's are now faced with a higher and rising cost of capital. This will heighten capital allocation decision vigilance and ROI hurdles.
- As reshoring takes hold, margins may come under pressure, driven by higher domestic wage and input costs.
- At one extreme, domestic manufacturing may see a renaissance. And at the other extreme, new tech start-ups may need to deliver profitability before securing funding.
- East-West trade agreements may come under pressure as governments compensate for a deglobalised demand curve for their products, which in turn could alter both import tariffs and domestic subsidies.
It will take time before the new deglobalised equilibrium has been found. For now, investors are mapping out the possibilities, how to manage the risks, and how to maximise returns under a deglobalised configuration.
Part II of the series shows that deglobalization implies a regime change, with trend increases in capex and the labor share, as well as a higher cost of capital, lower potential growth and greater government involvement in the economy. This constitutes a secular headwind for margins and free cash flow (FCF), especially for tech and manufacturing • We are not returning to the low inflation, zero real interest rate 2010s. Further, with the end of the “Great Moderation,” we expect higher macro volatility (of GDP, inflation, interest rates and FX). • With companies facing a higher weighted average cost of capital (WACC), we expect lower average multiples. This will prove especially challenging for longer duration assets, such as venture capital and speculative tech companies that are years away from generating FCF on a sustainable basis.
Risk-Off Equity Investing
As Growth investing loses faith in a rising rate and inflationary environment, where is the smart money going?
U.S. Growth Stocks have fallen back to earth this year, and even more so than the broader index. The combination of accelerating inflation and interest rate hikes has switched investors risk-on trade firmly off.
Investing in companies run by new, unproven, or inexperienced leadership teams, building businesses built on disruption and the promise of abnormally high future earnings streams has lost followers. The question today is who are they now following?
Long Duration Equity Growth Pricing
Growth Stocks have clearly been impacted by Bond Yields. Especially the long duration growth equity managers. Is the impact now in the price?
Whether Bond Yields have peaked was a common search query that had nothing to do with bond allocations. The insights that were viewed were from asset managers running long duration equity portfolios i.e. growth strategies.
Given the underperformance of this segment of the market in the first half of the year, and the poor 18 month outlook for growth, institutional investors seem to be assessing whether the market is now at fair value.
Expect an Increased Focus on Capital Allocation, Quality and Sustainable Free Cash Flow
Until recently, we had been in a disinflationary environment since the 1980s, when Volcker helmed the Fed. This secular trend reflected three forces: (1) Correcting the policy mistakes made in the ’60s and ’70s that stoked stagflation, (2) the increasingly globalized nature of trade, investment, and finance from the mid-1980s, and (3) the deflationary impact of tech, which has been especially impactful during the last two decades. While the latter factor remains in place, we believe it is being overwhelmed by the 3Ds — Deglobalization, Demographics and Decarbonization — meaning we have entered a secular reflationary environment.
The remainder of this note briefly explains each of the three Ds and then concludes with a discussion of what all this means for investors.
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