Contrarian Growth Investing in an Evolving Market
Q&A with Evan Bauman, a Managing Director and Portfolio Manager at ClearBridge Investments
Do you believe 2019 will be a positive year for equity markets?
There is significantly higher likelihood of that than three months ago. In the off-presidential election year cycle, generally the third year is a pretty good one, with the buying opportunity usually in the second year. We won’t know for sure until a couple years from now but this is setting up like another classic second-year off-presidential election year correction, which often leads to a much better market over the next couple of years. We’re going to see different-looking leaders in the market, though.
Since 2009, we’ve seen a momentum-driven environment led by the FAANG stocks (Facebook, Apple, Amazon, Netflix and Google). We saw a pullback in a lot of those names in the fourth quarter. Was this the start of a turning point?
The market had a major shift in a lot of areas. One was volatility, where the VIX came into the early part of the fourth quarter around 10 or 11 and spiked as high as 35. That’s an extreme level. So the return of volatility was a factor.
What had been best described as “complacency” was replaced by enormous levels of skepticism, panic and fear, as measured by a lot of indicators. We saw extreme levels across sentiment indicators during that fourth quarter drawdown, which was only about 20 percent peak to trough, but was the first major correction in terms of magnitude that we have had in a number of years.
There was a sell-off in a lot of the big cap names. Apple, for example, has retreated almost 40 percent off of a $1.1 trillion market cap level. What is emerging from that sell-off is different-looking leadership: sectors like energy start to emerge. You see deal activity in other areas that are starting to lead to a re-rating of valuations in some of the lagging parts of the market.
Generally, when you get this type of violent, meaningful sell-off, it is a correction in an ongoing bull market – actually a pretty healthy and not completely unexpected one. The subsequent years look very different in terms of leadership, and that’s what we’re starting to get this year.
The competitive advantages FAANG stocks had are starting to erode, and they will be spending a lot of money to keep up their growth rates. Could a shift of leadership be at hand?
One of the biggest misperceptions is that FAANG is one entity. They all basically traded together on the upside in 2017, and on average the FAANG names were up about 40 percent across the board. They all seem to trade together, and we can debate why that is the case.
A lot had to do with money flows into passive products. As a growth manager, we own companies regardless of benchmark positioning. Our active share, or how different we are from the benchmark, is extraordinarily high. But if you’re a traditional large-cap growth manager and you have not owned those names, it has been an extraordinarily difficult market to outperform.
Do you believe the market was going through another tech bubble?
This was never a bubble, not a valuation bubble. You could argue some of those names, like Netflix, are clearly on the higher end of valuation metrics like price to cash flow and price to free cash flow (where there is no free cash), but companies like Apple and Facebook have true valuation support and rock-solid balance sheets. You had so much passive ownership of these names in ETFs and by active managers who, frankly, felt pressure to buy these stocks in order to keep their jobs. You hear anecdotes about growth managers feeling they had to at least neutralize these positions in their portfolios. But we look at everything from a bottom-up perspective.
Why do you think things are changing?
We look at businesses. Sectors and subsectors or industries like biotechnology have true exclusivity in intellectual property and very little competition in some of these nascent markets. You are paying 10 times earnings for these companies, which is almost unheard of, the first time in history, whereas everybody was falling in love again with big tech.
Assuming new money is not coming into the market, to bid up undervalued, under-owned areas, you must take money from somewhere. The definition of a crowded part of the market is that when money starts to rotate, even if the market caps are large, it can be pretty volatile.
The return of volatility is an active manager’s friend, is it not?
It can be. We’ve owned businesses for decades, some since they were much earlier in their life cycles, small and mid-cap companies and now they are borderline mega cap names.
The idea of this strategy is to take advantage of volatility, but when the market goes straight up with no liquidity and no volatility, it can be difficult when you have these pockets of volatility. We will probably get back to the market in general, but by no means would we say the market cannot retest the lows we saw in December. Nor would it be unhealthy to have what normally happens: a retest, causing a healthy dose of panic and fear.
We are about 10 percent off the lows. A lot of investors feel like the coast is clear. Then when you retest, as it has almost every time you’ve had one of these cascading waterfall sell-offs, it can drive up negativity significantly from the retail investor and sentiment indicators.
How do you approach stock picking in this market environment?
We pick our spots. We are valuation-sensitive. Even though the market is still only 10-12 percent off all-time highs, our portfolio is close to historical lows on a valuation basis, both absolute and compared to the index versus the market.
We’d rather buy companies that we know that we’ve done multi-years of research on and management teams are very important to us. We don’t screen. We’d rather really get to know a business inside and out, get to know a management team and how they think about accreting value to us as shareholders over the long-term, what they’re going to do with the balance sheet during periods of stress, what they’re going to do with their free cash flow and how they’re going to return cash to shareholders.
The fact the market has obviously gotten more downside volatile, it’s created opportunities for us.
Evan Bauman is a Managing Director and Portfolio Manager at ClearBridge Investments, a subsidiary of Legg Mason. His opinions are not meant to be viewed as investment advice or a solicitation for investment.
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