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This year has been turbulent for financial markets, with a slew of fears weighing on investor sentiment. While these macro concerns – related to inflation, rising interest rates, and a slowing global economy – could impact the growth trajectory of many sectors, we believe our structurally advantaged investment approach helps us identify growing large-cap companies in growing industries that can persist in a variety of economic environments.
Quality Growth in the Current Market
Growth investing has been under pressure this year, underperforming the broader market largely due to the U.S. Federal Reserve (Fed) increasing interest rates in an effort to curb inflation. Higher-quality, long-duration growth companies, which would generally be expected to outperform in down markets, were negatively affected as higher interest rates have a disproportion impact on the price investors are willing to pay for cash flows farther into the future.
Looking forward, it is expected that corporate earnings will increasingly reflect the challenges that we’ve seen in the economy. As this occurs, we believe that investors will differentiate and favor stocks based on quality factors as companies with higher quality and growth characteristics are more likely to weather the storm. Given our focus on quality growth investing and identifying durable business franchises, we believe our large-cap growth portfolio, which was initially hurt by spikes in rates, is well positioned for the next phase of the economic cycle.
It is important to note that while we take macro events into consideration through bottom-up, fundamental analysis in order to help us identify stock-specific risk, we do not tactically manage our portfolio to macro events. We would rather concentrate on our structurally advantaged approach to long-term stock selection and position our portfolio to protect against unexpected macro events by adopting and maintaining sector and market cap diversification.
Managing Risk Through Diversification
Sector and market cap diversification is an important element in managing unintended risk and reducing volatility in our portfolio. We believe having material underweights or overweights across sectors or market cap segments has the potential to negatively impact benchmark-relative returns as performance across these segments of the benchmark tends to widely fluctuate over time.
For example, looking at the consumer sectors this year, consumer discretionary has significantly underperformed relative to consumer staples as rising interest rates and inflation have dampened discretionary spending among consumers. Due to the impact of macro events and other sector-specific factors on performance, taking sector bets within a portfolio can create wide deviations in performance, and as a result, introduces additional risk.
In order to minimize this risk, we aim to maintain sector and market cap neutrality over time such that our alpha is largely driven by stock selection in the long term.
However, this neutral approach does not extend to our industry exposures, an area in which we believe we add significant value as active managers. As we do our diligence throughout our intensive research process, we not only examine a company’s position within an industry but also the industry as a whole. We seek to identify industries whose profits are growing at least as fast, or ideally faster, than the overall economy.
Applying the Approach
When constructing the portfolio, we seek to identify industries that we believe have strong, long-term secular growth drivers in place and invest in growing companies within those industries. As an example, we view digital advertising to be a secular growth industry. Advertisers are increasingly shifting to more targeted and trafficked digital options to disseminate ads, allowing digital advertising to continue to take share from more traditional avenues, such as printed media and linear television. We believe digital ticketing for live events is also an attractive area, as an increasing desire for consumer experiences and the convenience of digital ticketing should drive demand higher over the long term.
However, while we expect every industry in which we invest to exhibit an upward growth trajectory, we are cognizant that some structurally advantaged industries tend to be more cyclical than others. This may be a result of the overall economic cycle, or due to a cycle native to that particular industry. As one might expect, a critical factor when investing in more cyclical industries is timing. For instance, we were adding to our semiconductor exposure in 2018, near the trough of the cycle at the time. While we continue to maintain a position and believe the semiconductor industry is an attractive growth opportunity with long-term secular tailwinds, we believe the current cycle is rolling over due to supply and demand dynamics within the industry, leading us to reduce our exposure accordingly.
Once we identify these growing industries, we look to identify companies that are taking a share of those industry profit pools, have the right management teams in place, and operate efficient and sustainable business models that boost their competitive advantage over time. We believe this focus enables us to identify the best opportunities within each sector and across market cap segments and improves the consistency of relative returns over time.
Regardless of where we are in the broader economic cycle, we continue to focus on investing in quality growth companies in quality growth industries that we believe can outperform the market and create long-term alpha.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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