In this episode of Markets in Focus
Investors once were used to seeing momentum swing between growth and value stocks in a classic economic cycle. But the pandemic subverted all of that, creating shorter mini-cycles as cases rose and fell. Now with interest rates on the rise, a new chapter might be about to unfold. Matt Orton, CFA, Chief Market Strategist at Carillon Tower Advisers, talks with John Indellicate, CFA, Co-Portfolio Manager at Scout Investments, Michael Waterman, CFA, Portfolio Manager at ClariVest Asset Management, and Steve Singleton, Head of Risk at Carillon Tower Advisers, about 2022’s emerging opportunities in the seesaw world of factor investing.
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When I think back over the past 18 months, whiplash is probably the best way to describe the drivers of the market. As we've recovered from the COVID-19-induced crash, we saw growth massively outperform, followed by a surge in value, only to see growth start to outperform and dominate again. But within these high-level trends, we also saw big changes to the size factor, leverage, and quality over the past 18 months. Today we're going to review some of the key trends in factor performance and how this has impacted active manager performance. We'll also look at how managers can leverage changes in the market environment going forward within their portfolios.
This is Markets in Focus from Carillon Tower Advisers. I'm your host, Matt Orton join me and my colleagues as we discuss the latest trends and developments driving the markets, visit us at marketsinfocuspodcast.com for additional episodes and insights.
Today I'm lucky to be joined by John Indellicate, who is a Co-Portfolio Manager of the Scout Mid Cap Equity Strategy, along with Mike Waterman, who's a Portfolio Manager at ClariVest Asset Management, focusing on alternatives and micro- and small-cap strategies, as well as Steve Singleton, the Head of Risk at Carillon Tower Advisers. So to start things off and before we start to look at our outlook heading into 2022, I think it's worth spending a few moments providing context about the environment from which we're coming. And one of the most visible changes over the past 18 months has been the dynamics between growth versus value. And Steve, maybe you can start us off and provide a more nuanced view of this and talk about some of the factors that are at play underneath the surface that are helping to drive the changes.
Sure, Matt. You know, with regard to growth and value, you know, the short answer is typically always economy, inflation, Fed and interest rates and, and this particular period really isn't any different. I think when we look at the last 18 months, they're part and parcel to the continued long journey of a secular decline in interest rates that has fueled a 40-year bull market. And the last 18 months are exacerbated in particular by the very sharp downward shift in the yield curve, pushing nominal rates to the lowest we've seen in post-World War II era. It's the Fed’s response to COVID and its variants, and it's the setup for this recent window. If I look back to Q3 ‘19, which was the last time value beat growth, if everyone recalls, that was the quarter where the yield curve actually inverted, and 2s were ahead of 10s.
We subsequently got a third rate cut in 2019 that propelled growth back on top. And it stayed on top, for much of the next 12 months, largely because of what we saw in Q1 2020, which was our response to COVID, which is, you know, a disease we had never seen before. So what you saw there with interest rates near zero at the short end and not even as high as 1% at the longer end, we saw growth do extraordinarily well, particularly the longer duration growth, and value tended to lag quite precipitously up until fourth quarter, when we started having discussions around vaccines and antivirals and the like coming into play to be able to offset COVID and give us a sense that the economy could resume some measure of growth.
And that really unleashed a fury in the areas that had underperformed, which were small caps and value. They did extraordinarily well in Q4 and in Q1 of this year, before, again, we began to moderate as data coming in on COVID and its variants and second shots and booster shots of how that works and how economies are reopening. That data has left the markets uncertain at best. What normal now looks like, or the new normal, sort of changes from week to week, discussion to discussion. And it's seen growth and value begin to vacillate quite a bit since then.
Thanks Steven. Just to build on that a little bit, there's also been some pretty big changes between large and small caps this year, and one area where that narrative of growth coming back to start to outperform value where we haven't seen that has been in the small cap space. So Mike, given your focus on small caps, both growth and value, maybe you can dive into some of the factors that are at work down-market cap, and why growth has lagged in small caps lately.
Thanks Matt. I'd first like to start off talking about growth and value where it's basically been a two-factor market environment: growth and value. If you were an active manager who was highly exposed to growth, you probably did well. If you're an active manager that was highly exposed to value, you probably didn't do as well. And I think the driving force behind why growth has done so well is what the Fed has been doing. They've kept interest rates so low for so long, it's really impacted the way people value these growth stocks. So you can think about growth stocks; oftentimes their entire valuation can be attributed to their future earnings streams, and with the interest rates low you're discounting that future earnings stream at basically a negligible rate – zero penalty on these earnings. But what you're seeing now is interest rates starting to rise.
And when that happens, you're starting to penalize the future earning streams quite a bit more. And when that happens, you see, that's just moving away from growth stocks to stocks that have evidence of historical fundamentals, historical earnings. Now, in terms of large versus small, we see that in small cap, there there's a huge proportion of companies that are non-earners. So in small cap, it's upwards of 40 to 50% of companies based on the Russell 2000 weight that are non-earners. In large cap, it's less than 10%. And what you've seen in small cap, where the biggest drivers of performance over the last four years, I would say, are these non-earners, these concept stocks. And they've just done so well because interest rates were so low and now with the interest rates moving up again, these stocks are really coming back down to earth.
They're really getting crushed right now. And so I would say that because of this and because large caps have such few non-earners, they haven't been as impacted. So you seeing growth hold up pretty well in large cap, whereas in small cap, which is heavily exposed to these non-earners, these companies are really getting crushed, and that's really affecting the difference between growth stocks and value stocks in small cap. And hopefully it will start to see a market where two factors aren't dominating performance. And I think we're starting to see that, year to date, in some other factors.
Great, thanks, Mike. And I think kind of building on all of this then is kind of looking at how active managers fit into that equation with this, you know, performance between large, smaller growth and value. And, John, given that you are a core manager in the mid-cap space, which is a pretty wide market cap range, I'm sure that you've, you felt a lot of these changes that are taking place in size, value, and momentum throughout the year. How have you monitored and handled these changes in your investment portfolio?
So one of the benefits being a mid-cap format is that we can pivot the portfolio toward whatever areas have the best opportunities right now, especially if we have conviction that a given factor is going to outperform for an extended period of time. This year has been a little challenging because we really haven't had those extended periods of outperformance for any given factor. As you kind of mentioned already, the beginning part of the year, the value stocks and the small cap stocks were working, but then in the middle part of 2021, that reversed. The growth stocks all caught up in terms of performance, and ever since then, we've more or less been tracking together. And neither of those factors has really been sending you a strong signal. Over the last couple of weeks, we started seeing some divergence, so maybe we're starting to see some factor leadership again, but it's probably too early to tell.
Oftentimes our factor positioning is a reflection of how we view the macro economy. Early in the cycle, when expansion is pretty broad and you have a lot of companies that are benefiting from early cycle, that's when value stocks start working. Then, as you go later on in your cycle and earnings growth starts being a little bit more scarce, that's when your growth stocks start working. This year has been interesting because that classic stylized cycle hasn't really worked. It's been subverted by the pandemic. And we've had a lot of these mini-cycles that play out over a couple of months, basically as the COVID cases ebb and flow. Currently in our portfolio, we're not trying to take a big factor bet. We're very barbelled right now in terms of having some large ideas and small ideas, growth and value ideas, and we'll start making shifts in the portfolio once we see some evidence that one of these factors is going to start leading the market again. A factor that we have been exposed to throughout the year is the beta factor. We've seen the economy pick back up from 2020’s depressed levels. We've seen unprecedented levels of fiscal and monetary stimulus, and both of those things combined to make us feel that markets are headed higher and beta’s a traditionally a good factor to help express those views.
And so I know different from yourself, some active managers have taken some fairly large bets, some of which worked, some of which have not. And Steve, maybe given your focus on risk, are there any parts of the market where active managers broadly have been winning or losing, given the factor shifts that we've seen this year?
Active management is always challenged on what it is and how it works in terms of being able to beat benchmarks and beat peers. Factor shifts exacerbate the problem, and particularly when they are short-term rather than longer-term trended. And that's largely because active managers are theme-based: you know, they’re valuation, growth, profitability, et cetera; you know, largely their turnover-resistant. There are some that adopt turnover strategies as part of what they do. But when factors shift away from managers’ themes or philosophy, you'll see underperformance. Similarly, when it shifts towards them, you see outperformance. So in a year where factors are shifting, you get both sides of that, and it's been a conundrum.
This recent set we've noticed that the longer-duration growth managers that did very well in 2020, because the trend of that first three quarters was sort of in their sweet spot, they did poorly over the subsequent two quarters, Q4 2020 and Q1 2021. And, they've been sort of battling this year to stay around even or get back up above. Similarly, momentum managers suffered this year as momentum shifted from growth to value and is now somewhat muddled in between the two. Finally, size shifts have been quite notable. The reversion trade that began Q4 of 2020 favored not only value, but the smallest market segments as well. And so that persisted through Q1 before returning to normal and created some dislocation for managers as well. Large cap growth is fairly flat for Q1. Large value was up near 11%, and micro cap value up around 29%. When you look at today, micro-cap value is still hovering around 29%. Large value has moved up slightly, but large growth has, again, taken off dramatically. So in the context of this, it's, it is quite difficult for managers to work through these shifts. And what we've found is that those who have been able to thread the needle in between all of these particular factor moves have been able to actually do well.
Excellent. And I think maybe a natural progression now is to start looking towards 2022 and what might be in store for active managers and the market going forward. And Mike, maybe I'll throw this to you to ask how you've been thinking about balancing some of the exposure to factors we've discussed, like value or cyclicality or momentum going forward? How has this guided where you're finding some exciting and interesting opportunities in the small cap space?
Thanks Matt. Yes. So at ClariVest we have many tools to evaluate factor behavior. On a daily basis, we're looking at our factor exposures to the portfolio. When I say factor exposures, I'm talking about style factors as well as stock selection factors. We're also looking at the contribution to risk, the contribution to return in the portfolios, and each morning we’re presented with an optimized trade list that incorporates all of these views, as well as the stock selection views. And it generates risk-reward, optimized trade list. Now when we think about building a portfolio, we build from the bottom up. So we're not trying to predict factor performance next year or two years from now, and then build the portfolio accordingly. Rather, we let the fundamentals and the trends come in through the bottom, come through at the stock level. So to the extent that you have valuation or growth or momentum or quality or any other host of factors doing well, and they have some kind of fundamental reason why they're doing well, they'll start to see that come at the stock level and build up at the portfolio.
And to the extent that these factors and trends are persisting, you'll see the exposures build up to these factors as well. Now, in terms of where we're seeing some good ideas right now, we like banks and semiconductors. We like banks because analysts are raising estimates there. The industry momentum is very good there, so you’re having investors coming in adding banks to the portfolios, bidding up the prices there. And you also have short sentiment looking good there. So short sellers are staying away from this industry. And it also makes sense that we need to thinking about factors just to understand what the drivers are. So in banks, we have interest rates rising, which means that's going to help their net interest margins. We have the economy improving, the economy growing, so that's going to help loan growth.
Their balance sheets are in pristine condition. They learned a valuable lesson after the Global Financial Crisis. And the No. 1 industry where M&A activity is happening right now is in banks. And that lends support to bank valuations going forward. Another area that we like is in semiconductors. Some of the factors that are showing positive sentiment there, again, are earnings revisions, earning surprises, and, reporting surprises. So what's happening is these semiconductor companies are reporting, they're beating estimates, consensus estimates, and investors are liking it. Now, semiconductors have had a headwind, as everybody knows, most industries are suffering supply chain issues, but on the other side of that, semiconductors also have record levels of backlog. So as the supply chain starts to clear up the semiconductor companies have the whole ammunition stored up, so you continue growth going forward.
And also what we saw with the supply chain issues in semiconductors is that the governments realized this is a national security interest, and so you're going to get some more support from sovereign governments I think as well in the semiconductor space. And finally, society's moving toward more technology, you know, from watches to cars. Now there's going to be things that we can't even imagine that they're going to be needing semiconductors and that change will just continue. But when thinking about factors, I think what's really important is not just looking to see how factors are doing, but to understand the underlying trend of why that's happening at the company level, looking to see what's going on at the company level, how that's affecting the industry, and getting a better understanding of why those factors are performing the way they are. That way I think you'll get the best opportunity for your portfolio.
Excellent. Thanks, Mike. Banks and semi's: there are two very important parts of a small cap and really the overall economy. John, maybe a similar question. How are you tilting your portfolio heading into 2022? And are there any particular sectors that you favor right now?
Sure. So I mentioned in terms of factor and positioning that we're already over with the beta factor, and I think into 2022, that'll continue to be a good place to be. We think that as you continue to see the economy expand, markets should continue to drive higher. We will put an asterisk on that, pending no policy mistakes from either the fiscal or monetary side. Our particular strategy is always underweight the leverage factor. Leverage is one of those factors: It doesn't matter, doesn't matter, doesn't matter. And then all of a sudden it matters a lot, and that especially matters more as you're getting towards the end of an expansion cycle, and while we think 2022 is going to continue to be expansionary, we are getting closer and closer to the end of the cycle. That's going to start raising rates.
And as you start raising rates, eventually they're going to make that monetary policy error and eventually we'll have a recession. And so we think being lower leverage will pay off well for us. On sector positioning, our biggest overweights right now are the energy and materials spaces. Over the last few years, there has not been a lot of capacity added in terms of new supply for oil, copper, various chemicals. And there's a lot of reasons behind that, but the net result is supply is not able to ramp up as quickly as you're seeing demand ramp up. Demand for a lot of these areas has been depressed because of the pandemic. Mobility's been low, travel has been low. Now that people are getting back out there and doing a lot of things, you're starting to see demand for these commodities really ramp up. Add onto that another layer of anticipated government spending on infrastructure and green energy projects, and the supply-demand dynamics are really attractive.
Also, I will caveat that with we'll see what happens with the next variants on COVID and if the Federal Reserve makes an overly hawkish tilt here. But barring one of those being a long-term problem, we think energy, materials are pretty attractively set up. We also really like some areas in healthcare. Medical devices, specifically, is an area that was depressed during the pandemic. People couldn't go and get some of their elective procedures. And so we think that the rebound when people go and get those medical procedures, we think that medical devices are set up pretty well going forward, too.
Great. Thanks, John. We’re pushing up against time a little bit, but I do want to get some input from Steve on one factor that we haven't really discussed yet, which is quality. And we've seen quality bouncing back over the past couple of months. And so I want to ask you, Steve, do you think this can continue? And how could that guide investing either growth or value and even small caps, which, one could argue, might have some lower quality characteristics?
Yeah. Quality is a safe haven in times of uncertainty. What investors are essentially saying is that I feel comfortable investing in a solid company with a strong balance sheet, predictable earnings, and profitability that leads to reinvestment in asset growth. In the context of where we are today and sort of try and ascertain how the economy grows and fares from here in the presence of COVID and its variants and in the continuum that is the paradigm shifts in technology that empower future productivity, quality will remain a bedrock. Managers on both sides, value and growth, will use quality as a guard rail against the perils of uncertainty, staying a bit closer as uncertainty rises as now, and that’s why we are seeing quality doing well this year, and loosening the reins as the horizon becomes more clear. Obviously, the largest, most successful companies growing earnings in a sustainable fashion fall into this category, but as you say, what about small caps? You know, they're harder to find because of the earnings numbers that Mike had pointed out, but they do exist and we find in our work that portfolios of all sizes that lean toward quality in either selection or construction they've outperformed this year and they’re likely to continue to do so in these times of uncertainty.
Excellent. Thank you very much, Steve. I'll throw over to Mike. How important do you think valuation is going to be in 2022? And is there a particular capitalization where you think it will matter most?
It's a good question, Matt. To me, valuation is always important. Unfortunately, the market and I don't always see eye to eye, but I think with interest rates moving up, I think it'll move closer to my view. In small cap, we've already seen the move toward investors favoring value. However, that move has been generated mostly on the fall of these concept stocks. So it's more that these stocks have fallen than value stocks have done well, but I think we'll see a transition from the emphasis being on these concept stocks falling back down to earth toward investors appreciating the characteristics that value stocks have to offer. And because we've seen that transition starting to occur already in small cap, some of the steam has already has already come out of the bubble, I would say, from growth to value, but we haven't really seen that happen in large cap yet. So, large cap: They don't have very many non-earners and you haven't really seen the transition from growth to value, but as soon as that transition happens, it starts to happen in small caps, I think we’ll also start to see it in large cap and I think large cap will benefit more from value research than small cap, since small cap has already benefited a little bit from that.
Excellent. Thank you, Mike. And maybe time for one more question. I'll throw this to anyone who wants to answer it. Growth and value factors aren't exclusive to the stylistic benchmarks with those names, like the Russell 2000 Value, Russell 2000 Growth. Can you talk about how maybe value can be performing well within a growth benchmark or vice versa?
I'll take a shot at that, Matt. I think when we're looking at Russell in particular, their methodology for developing the benchmarks and the style sides of the benchmarks is that they take one third of any universe and they mark that as pure value, and another third as pure growth, and it's based on the price and some other factors that they use. So then the middle third is a blend and these are names that actually have exposure to both the growth and value benchmarks. And so if you're a growth manager and there's a time where value's doing well, obviously leaning towards those names that are in the blend, in the growth benchmark keeps you inside of growth, but you're actually being able to take advantage of the fact that value is moving in your growth portfolio. A lot of what will direct you there, again, will probably start bottom up as you work from a characteristic perspective as a manager to look for catalysts in that blended side that are going to drive the appreciation of stock with anticipation for the procurement of cash flows.
Great. Thank you, Steve. And thank you to Mike and John as well for all of their insights today and thank you our audience for joining us. And with that, thank you again and have a good rest of the day.
Thanks for listening to Markets in Focus from Carillon Tower Advisers. Please find additional episodes and market insights at marketsinfocuspodcast.com. You can also subscribe to our podcast on Apple podcasts, Spotify, or your favorite podcast app. Until next time I'm Matt Orton.