As the Hermes US All Cap Strategy passes its third anniversary, we believe it is well positioned for a higher volatility environment, where cyclical names can rise to join the market leaders. Against this backdrop, stock pickers will have the best opportunities to reap the rewards. Here we explain why.
The investment landscape is changing. It is no longer characterised by low growth: instead, higher economic growth, a pickup in inflation, rising interest rates and volatility are likely to persist. In such an environment, passive strategies, which have previously benefitted from low volatility, are likely to disappoint and stock pickers will make a comeback.
Today, US economic growth is robust, which is consistent with the view, supported by a number of academic research papers1, that economic expansions tend to be longer following recessions caused by balance-sheet stress. However, the market is behaving as though the recovery is nearing an end, with narrow market leadership in structural growth stocks.
Given that the outlook for economic growth appears to be stronger than the market is discounting, we expect the currently narrow range of leading stocks to broaden out across cyclical sectors like Commodities, Industrials, Financials and Technology. In contrast, we have little exposure to consumer stocks due to the risk of disruption (see our previous commentary: ‘Burned by the churn: outlasting disruption in the S&P 500’).
Moreover, forecasts suggest that all of the cyclical sectors, in addition to Technology, will deliver annualised earnings per share growth in the mid-teens or above until 20202, which supports our thesis that market leadership will broaden out. At its current P/E ratio of 18x, the market is aligned with its long-term average, thanks to the positive impact of US tax reform.
Against this backdrop, we believe that Hermes US All Cap is well positioned to exploit the short-term nature of the US market and build on the 10.2% net annualised performance it has generated since launching in May 2015.
Figure 1: Cumulative performance of Hermes US All Cap Strategy, since inception
|Rolling performance||31/05/17 to 31/05/18||31/05/16 to 31/05/17||31/05/15 to 31/05/16||31/05/14 to 31/05/15||31/05/13 to 31/05/14|
Source: Hermes Investment Management as at 31 May 2018. Performance shown is the Hermes US All Cap Strategy in USD, net of all costs and a 50bps management fee, since its inception on 31 May 2015. The benchmark is the Russell 3000 Index. Past performance is not a reliable indicator of future performance.
Why Hermes US All Cap?
Hermes US All Cap is a natural extension of the firmly established Hermes US SMID Strategy: it employs the same long-term, bottom-up process and is managed by the same team. The enlarged opportunity set for the Strategy, which expands beyond the US SMID remit to include large-cap stocks, allows us to invest in what we perceive as the best US companies.
Quality – and a margin of safety
We therefore look for companies with economic moats – defensible franchises that make it difficult for new competitors to gain strength – and proven business models that generate attractive returns over time. We seek companies with experienced management teams that have a successful track record of allocating capital. Moreover, we also look for companies with strong cash flows and balance sheets. Together, these enduring competitive advantages allow us to invest across cyclical factors.
ESG: an investment imperative
ESG analysis is deeply integrated into our investment decisions. As such, we focus on investing in companies with sustainable business models. In turn, this steers us away from industries such as coal, tobacco, gambling and weapons, and companies in less controversial sectors that exhibit poor ESG behaviours.
By working closely with our in-house engagement team, Hermes EOS, we engage with companies exposed to significant ESG risks in order to generate positive change, such as greater transparency, better waste management and treatment of workers. Today, Hermes US All Cap engages on about 60% of the portfolio by weight.
The long-running US equity bull market has made some investors comfortable with taking on equity risk – and as the investment landscape changes, we believe that passive strategies will be less likely to protect investors against a higher volatility environment.
A feature of the US All Cap Strategy is its significant exposure to ‘winner-takes-all’ companies – that is, where businesses capture a majority of the market share through network effects – like Amazon and Mastercard. We have also generated strong returns by backing skilled management teams, such as those steering the life science company Danaher, its industrial spin-off Fortive, and healthcare company Baxter.
An optimistic outlook for US banks
We also believe that the market is overlooking value in US mega-banks. The bank stocks we own – such as Bank of America, Citigroup, JP Morgan and Wells Fargo – each have a durable competitive advantage and a formidable franchise. Our optimistic outlook for the sector stems from a combination of tailwinds – including a looser regulatory framework which makes US bank stress tests more transparent, higher interest rates and tax reform – which should result in some banks paying out more than 100% of earnings, according to forecasts3. Furthermore, in a rising interest-rate environment, Financials tend to outperform Technology stocks (see figure 2). So far this year, tech companies have had the upper hand but are unlikely to sustain this outperformance if rates continue to rise.
Figure 2: US financials tend to outperform tech stocks in a rising rate environment
Source: Haver Analytics and Citi Research as at 31 May 2018
We believe the Hermes US All Cap Strategy is well placed to navigate this changing investment landscape. As such, we will continue to invest in mispriced high-quality companies with sustainable business models for the long term – and hope to build on the solid returns generated since the Strategy’s inception.
The value of investments and income from them may go down as well as up, and you may not get back the original amount invested.
The above information does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments.
It should be noted that any investments overseas may be affected by currency exchange rates.
Past performance is not a reliable indicator of future results and targets are not guaranteed.
- 1 See, for example, ‘The Aftermath of Financial Crises’ by Carmen M. Reinhart and Kenneth S. Rogoff published by the National Bureau of Economic Research in January 2009
- 2 See, for example, ‘Global Financials Strategy: The Rates, Credit, Earnings Tug-of-War’ published by Citigroup on 5 April 2018. Note: forecasts are not a guarantee of future performance.
- 3 See, for example, ‘The Fed makes the start of summer more stressful for select banks’, published by Keefe, Bruyette & Woods on 21 June 2018. Note: forecasts are not a guarantee of future performance.