Long, dark nights and a chilling equities sell-off
The sharp de-rating of equities has certainly felt more trick than treat in these past few weeks. But is it justified?
Tales of terror and scary stories are commonplace at this time of year, and so it has equally proved the case for investors as the long winter nights draw in, amid a chilling sell-off across equity markets.
An omnipresent shadow over risk assets has tainted stocks with the colour red, as fears regarding the longevity of the bull market cycle have been exacerbated by wider market uncertainties. Concerns about trade wars, midnight Brexit negotiations, and rising inflation and interest rates are on everyone's mind. A subdued start to third-quarter corporate earnings has only added more wood to the pyre, while last week two of the market leading FAANG stocks gave investors a nasty bite.
The distance prices have fallen is liable to induce a shock. In truth, there have been few places to escape the sell-off in risk assets. Any companies reporting earnings that are lower than expected are being punished, with gruesome consequences for shareholders. Not even valuations have provided much of a cushion. Short-term market conditions are truly putting our faith to the test as stocks have been sold indiscriminately, with each day feeling like a case of ‘one step forward, two steps back’. In short, the market correction has been sharp, swift and left few unscathed.
Yet could we now be at levels where valuations are beginning to price in too sharp a downturn in growth? While there remains a chance of more spooky surprises in the weeks ahead, it's important to emphasise that underlying conditions for equity markets still look solid in our view. This is particularly true for growth names, where we believe scarcity and quality have the potential to drive long-term performance. This is where stock selection matters for active managers. We are keen to avoid value traps, sectors that lack catalysts for earnings momentum and upgrades, and where industry change poses disruption risk... and of course, crossing the path of a black cat.
We are prepared for market volatility to stick around, accepting that there could be more downside. However, despite the extreme market moves we have been reassured by a number of companies – across sectors as diverse as online retail and pest control – where recent trading updates have either met or beaten expectations.
Elsewhere, there are parts of the market where concerns seem overdone to us, with investors overacting to headlines. Examples of this can be found in stocks that are a play on US industrial or equipment rental in construction markets, technology innovators that are driving digitalisation automation of industry, alongside companies exposed to the secular growth drivers of demographics and greater healthcare access. These are businesses that are still seeing robust leading indicators and attractive levels of returns. Moreover, bolt-on deals and investment is augmenting underlying growth further.
Yes, we might see a small slowdown for ‘growth’ names, but we still believe these stocks can outperform industry peers. The companies we look for are those with strong top-line growth, stable, above-average earnings and forecast momentum. Typically, these are businesses with barriers to scale and pricing power whose revenues are growing faster than inflation and will prioritise reinvestment to drive future returns. On this basis, normalised markets could see these companies' share prices re-rated to premium multiples of earnings, in our view.
On this topic, the recent sell-off has also presented us with opportunity to review stocks that have de-rated to levels that are disconnected from the fundamentals, potentially providing an attractive entry point for long-term growth. While it may seem like swimming against the current, this is important to note. Considering all the talk of style rotation, there remains a mixed view on whether growth became too expensive, or value simply too cheap. For many, the spread in valuations became too extended, though we would argue the valuations of ‘growth’ stocks are not unreasonable, given their scarcity.
Either way, as the smiling jack-o'-lantern burns bright, even within growth it can now be argued that value opportunities have started to appear. A truly spooky turn of events.