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Institutional Investor Advisor Individual Investor

Commentary

Value Equity Strategy

Second Quarter 2018

“The way we experience story will evolve, but as storytelling animals, we will no more give it up than start walking on all fours.”

—Jonathan Gottschall

Key Takeaways
  • The digitization of markets by passive and quant-based strategies has amplified reflexivity by concentrating capital around dominant narratives like never before ­— but these stories tend to reverse.
  • Price momentum strategies have new power to drive markets, but at the cost of less market diversity, as valuation and even fundamentals are ignored.
  • As more benign policy realities give way to decent fundamentals at a massive discount, we think the opportunity in drug stocks will be realized.
Market Overview and Outlook

In our increasingly digitized world you would think that the power of stories in shaping human interactions would be on the decline, especially in the financial markets, where capital flows are being driven by a massive shift to passive, broad asset allocation and data-driven algorithms. These drivers would appear to be story agnostic. But the power of stories seduces us into an overly simplified view of our complex world — even this tale about the decline of story. The seductiveness of simplicity is why stories will never lose their power. On the contrary, the digitization of our world greatly amplifies their power.

Through social media, simple stories, regardless of their veracity, are increasingly shaping and polarizing our political discourse. Never has it been easier to propagate a story across a wide or targeted audience, and the tracking data suggests that we are especially drawn to the most extreme stories. Especially the ones that also happen to be false. Digital is hacking our storytelling minds.

 

"We see drug spending becoming less, not more, of an issue."

 

When it comes to capital markets, the major challenge is not the false narrative, but rather the reflexive impact that stories have in driving capital flows, which affects prices, and ultimately the underlying fundamentals. This is George Soros’ reflexivity framework, in which a story and the resulting action of investors create a circular feedback loop between cause and effect. Basically, stories work great until they work too great, and they reverse under their cumulative impact on the underlying reality.

The digitization of markets by passive and quant-based strategies has amplified reflexivity by concentrating capital around dominant narratives like never before. These dominant narratives have replaced individual stock stories, as capital can now effortlessly focus on broader stories at the index or quantitative factor level. However, the underlying feedback loop is the same: as capital concentrates it drives prices higher, which feeds the narrative, which feeds the price, and you wash, rinse and repeat. This concentration is giving price momentum strategies new power to drive markets, but at the cost of less market diversity, as valuation and even fundamentals are ignored. Liquidity risk then rises from excessive crowding. In effect, digitization removes old frictions, allowing systems to work better than ever before, but the ability to run hotter than ever carries the seeds of fragility: all stories ultimately collapse as change is shaped by time and the cumulative effects of the narrative itself.

Even Powerful Stories End

The recent record on overdoing market narratives at a broad scale serves as a warning. Two come to mind. First is the BRIC story that peaked in 2008. As the story went, emerging market demand was making resource depletion a reality, which fed an air-tight belief that we were at peak supply for almost all commodities. Yet a decade of commodity prices compounding at double-digit rates and commodity-related stocks leading the market led to a massive capital investment cycle, which brought on supply, and then demand ultimately collapsed around the Great Financial Crisis. As a result, we ended up with massive excess supply in most commodities, and some excess remains even today. The narrative of peak supply has now given way to peak demand stories, especially for oil, and capital investment has accordingly fallen to levels that will very likely lead to undersupply for some major commodities in the next few years. This is how capital cycles work, and digital simply amplifies the interplay of stories and prices in driving this ancient market dynamic.

 

"Extreme crowding risk makes the current market cycle very vulnerable to peak narrative risks."

 

The second is the secular deflation “ice age” narrative that peaked in the summer of 2016 — also well supported, in this case by slow global growth and mounting policy risk. At its climax, global interest rates reached all-time lows, and the number of outstanding bonds with a negative nominal yield peaked at over $12 trillion. The change that challenged this narrative arc was Trump’s “surprise” election later in 2016, followed by what looked unattainable just the year before: faster global synchronized growth in 2017.

The stock market winners from the ice age narrative were higher-yielding bond-proxy dividend stocks and low-volatility defensive stocks. As capital flooded defensive sectors with these characteristics or factors, investors blindly and aggressively looked for current income from the stock market, and relied on the yield-free bond market for capital gains. Defensive assets were squeezed to unsustainable levels by flow-driven price momentum and a powerful story. Since the peak, positive price momentum has given way to negative momentum, and defensive stocks have endured major valuation compression. The reversal got bad enough that during one period in 2016, low-volatility stocks actually experienced higher realized volatility than the overall market. Oops!

To be clear, the echoes of the ice age narrative still linger; there is still over $8 trillion in negative-yielding bonds and term premiums are still negative. This lingering quality of dominant narratives is not unusual, as people who have been fully seduced by a powerful story are very reluctant to give it up. After the BRIC-driven commodity peak, a collapse in oil prices during the Great Financial Crisis was followed by a doubling of the oil price back above $100. The price actually remained above $100 for almost four years, despite clear and mounting evidence of excess supply from the U.S. shale boom and peak capital spending projects coming online. Ultimately, excess supply did fully kill the narrative and a deep recession in global commodities ensued from late 2014 to early 2016.

It is hard to tell if the ice age narrative will face a more violent end like the BRIC story, or just a continued slow decline as interest rates creep higher from the unsustainable levels in mid-2016. From a risk perspective, a transition to a positive term premium will likely severely stress financial markets, as many asset prices are still floating at unsustainable levels from the record low rates that are slowly unfreezing. One potential silver lining for valuation managers like us is that the term premium and value cycle are likely tied, given the historically tight correlation shown in Exhibit 1.

 

Exhibit 1. Relative Performance of Value Stocks vs Term Premium on 10-Year Treasurys

As of June 30, 2018. Source: New York Federal Reserve, Ken French/Tuck Business School.

FAANG Stocks in Familiar Feedback Loop

As the ice age narrative falls farther away from its peak, it has given way to the powerful FAANG narrative. The FAANG story is seductively framed by the dynamics of disruption to drive winner-take-all secular growth for a few companies, with secular destruction for most others. Like all great stories, there are clear winners and losers, and the story is incredibly well-supported by the current fundamental data. FAANG and its global cousins are growing faster than most other companies, generating high returns on capital as these winning companies enjoy increasing economies of scale at a revenue level unique in the history of capitalism. The current fundamental strength of FAANG makes this tech cycle very different from the tech bubble in 2000, with current FAANG valuation levels looking downright sober in comparison.

The FAANG story is also fully supported by strong stock price momentum, with FAANG and technology stocks dominating market performance. This creates the necessary feedback loop, where price reinforces the story and the story reinforces the price. This dynamic is extremely powerful this cycle, as assets from conceivably different strategies converge into one major river of capital — including passive cap-weighted indexes filling with high-valuation tech and growth companies (Exhibit 2), which make passive much more cyclical than most investors realize, and quantitative strategies following price momentum, which is driven by positive earnings estimate revisions — supporting the FAANG narrative.

 

Exhibit 2: Changing Sector Composition of the Market

As of June 30. Source: FactSet. Defensive sectors include consumer staples, telecom, utilities and health care.

 

This concentration of capital is strongly reinforcing current investor behavior as passive and momentum/growth have unquestionably been the winning strategies on a rising tide of FAANG. This will continue to feed on itself while the FAANG story stays in place, but the extreme crowding risk makes the current market cycle very vulnerable to peak narrative risks. Timing the peak is obviously very tricky, and we have been early in getting off the FAANG momentum train, but when everybody is all in on a dominant market narrative it does not take much marginal change to end the party. Ironically, peak narrative risk is more extreme when the underlying story has been fully validated by the current data and collective investor experience, as has been the case with FAANG. The best stories are simple but powerful, and they carry with them the growing risk of overconfidence, complacency and arrogance. This leads to the key question of what marginal change could possibly threaten the FAANG narrative, and reverse the strong momentum in tech stocks?

Peak Risks Growing More Likely

The simple answer is anything that starts to temper growth expectations, and specifically spurs some level of negative estimate revisions over the next few quarters, could risk a reversal. As confidence builds, the list of possible peak risks grows, and it ranges from the mundane to the more dramatic.

The risk could be as simple as recent U.S. dollar strength, which directly pressures international tech revenues, a major part of the revenue mix for U.S. tech. This dollar strength is also pressuring global growth modestly, which may translate back into less global demand. U.S. tech is now the largest revenue cluster in global markets, and with size comes cyclicality, which is in direct conflict with the idea of secular disruption framing this narrative.

However, our bigger concern is that a real trade war develops and becomes a structural risk. Tariffs tax global supply chains, and through them the profit margins of U.S. multinational companies, tech and capital goods primarily, threatening to remove a key structural support for U.S. tech dominance. The market so far has been fairly dismissive of trade risks, but policy risk may start to take share among market narratives.

Some Good Areas Starved of Capital

With mundane cyclical risks and much scarier structural risks to think through, we have increasingly positioned the portfolio where the prevailing market narrative has starved fundamentally well-positioned areas of capital.

One of our biggest active bets is in U.S. drug stocks: this defensive group has fallen on hard times despite very strong fundamentals for select stocks. Investors may not be taking policy risk from a trade war seriously, but they have fully embraced drug pricing risk. The prevailing narrative is that drug stocks are not investible because drug pricing is at risk of collapsing. This narrative has unfortunately been supported by bad behavior from fallen market drug-stock darlings like Valeant, which absolutely abused pricing power. President Trump has also promised imminent drug price declines, spreading the idea with his tweets.

But we see drug spending becoming less, not more, of an issue. Net pricing for branded prescription drugs have risen only 2.4%, 3.2% and 1.9% in the past three years, despite list price increases of 7% to 12% that power the headlines. This limited net pricing has actually kept drug spending as a percentage of U.S. GDP stable since 2010 (Exhibit 3).

 

Exhibit 3: Health Care and Drug Spending

As of December 31, 2016. Source: Center for Medicare and Medicaid Services, St. Louis Fed (FRED).

 

Despite the reality of stable drug pricing, the drug price narrative has led to a massive derating of drug stocks. Currently depressed valuation levels have been rivaled only by Hillarycare and Obamacare fears, which generated equally powerful drug pricing risk narratives (Exhibit 4). However, from such valuation levels the drug stocks always delivered strong forward returns. We think this will be the case once again, as reducing drug pricing is a very challenging policy goal to actually implement. The complexity and difficulty are evident in the lack of actionable ideas in the recently announced Trump drug pricing proposals. As more benign policy realities give way to decent fundamentals at a massive discount, we think the opportunity in drug stocks will be realized.

 

Exhibit 4: Drug Price Narratives


As of June 18, 2018. Source: Goldman Sachs Research. Composite includes Pfizer, Johnson & Johnson, Merck, Bristol-Myers Squibb, Eli Lilly, AbbVie, Gilead Sciences, Biogen, Amgen and Celgene.

 

Energy is another large active bet for us. Just as the BRIC narrative of peak supply led to very poor management behavior in the form of excessive capital investment and ultimately excess supply, the peak demand narrative is leading to great capital allocation behavior. For the first time in our multidecade investment experience, energy management teams are focused on returns and generating free cash flow. This discipline is powered by long-term fears of peak oil demand, which is gating long-term capital investment that will ultimately limit supply. Peak demand is very likely a long-term reality, as is peak supply for that matter, but current investment discipline will likely undersupply the market in the coming years. The upside risk from an energy cycle is not reflected in many of the stocks, as investors focus on the trauma of the 2015 oil price collapse, anchored along with the management teams on the peak demand narrative. As capital intensity falls, risks tend to fall in unison and stocks tend to enjoy higher valuation multiples. The opposite is also true, which is why confidence in the future can be a dangerous thing. Not surprisingly, capital intensity has fallen in energy as BRIC dreams fell away, and have risen dramatically in tech (Exhibit 5).

 

Exhibit 5: Tech Nearing Energy’s Level of Capital Intensity

As of March 31, 2018. Source: Credit Suisse.

 

The impact of stories on markets has only been enhanced by the shift to digital. Digital is actually now powering one of the great market narratives of all time in FAANG, as we are witnessing massive change at all levels of society from digital disruption. The great stories always get overdone, though, and become subject to their own disruption from inevitable changes. This is especially true in markets, where the story creates powerful feedback loops that shift the underlying reality. Our goal as long-term investors is to avoid the fallout from peak narrative risks, while taking advantage of the valuation opportunities that arise as stories come in and out of focus. In our case, the process is the story, and we are sticking to it.

Portfolio Highlights

The ClearBridge Value Equity Strategy had a positive return during the second quarter of 2018, underperforming the Strategy’s benchmark.

On an absolute basis, the Strategy had gains in five of the 10 sectors in which it was invested during the second quarter (out of 11 sectors total). The primary contributors to the Strategy‘s performance were the energy and information technology (IT) sectors.

In relative terms, the Strategy underperformed its benchmark primarily due to stock selection decisions during the quarter. Stock selection in the health care, IT and real estate sectors detracted the most from relative returns during the period. An overweight to the financials sector also weighed on returns. Conversely, stock selection in the energy and utilities sectors, along with an overweight to the energy sector and an underweight to the consumer staples sector, contributed most to relative results.

On an individual stock basis, the greatest contributors to absolute returns during the quarter were positions in Devon Energy, Kinder Morgan, Alphabet, Microsoft and AES. Realogy, Mylan, Brighthouse Financial, Adient and Celgene were the largest detractors from absolute performance.

During the quarter we initiated positions in Merck, Owens Corning and KION. We closed positions in CBS, Signet Jewelers, O’Reilly Automotive and Stericycle.

Sam Peters, CFA

Portfolio Manager
26 Years experience
14 Years at ClearBridge

Jean Yu, CFA, PhD

Portfolio Manager
17 Years experience
17 Years at ClearBridge

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  • All opinions and data included in this commentary are as of June 30, 2018, and are subject to change. The opinions and views expressed herein are of the portfolio management team named above and may differ from other managers, or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge nor its information providers are responsible for any damages or losses arising from any use of this information.

  • Performance source: Internal. Benchmark source: Standard & Poor’s.
  • Past performance is no guarantee of future results.