If even half the proposals put forward by US president Donald Trump in areas such as tax reform come to pass as the Federal Reserve moves to re-normalise interest rates, it will present a significant opportunity for active managers of small and mid cap US stocks, managers at William Blair have said.
Robert Lanphier and Dan Crowe, portfolio managers on the company’s Mid Cap Growth and Small-Mid Cap Growth funds, point to a shift in the prevailing market environment; from an initial post-election ‘rising tide’ that floated the price of all stocks in the US market, to a period in which investors are beginning to become more discerning in terms of company fundamentals, including quality of earnings and the ability to maintain prices of products and services at a time of rising inflationary pressures.
Having co-founded the Mid Cap Growth strategy in 1997, and the Small-Mid Cap Growth strategy in 1998, Lanphier notes that the ability to eke out alpha will increase as the market begins to digest the implication of a return to historical mean inflation and interest rate levels.
“If you look at the performance of our [small and mid cap] portfolio at the time of the Presidential election, we were slightly ahead of our benchmark year-to-date. In the remaining seven weeks of 2016, investor expectations of a stronger economy based on the immediate enactment of Trump’s campaign promises, disproportionately drove the more economically-sensitive companies higher and our portfolio lagged. Yet in the first two months of 2017, as investor expectations began to moderate around the Trump initiatives, we materially outperformed our benchmark.”
Lanphier sees it as a sobering of investor attitude, versus Trump initiatives coming to fruition immediately.
Crowe adds that the differentiators between companies at the stock level are becoming more apparent.
“Since the New Year, we have seen diffentiators in terms of, for example, how tax reform will impact companies particularly. Initially tax reform was seen as helping all companies, but now the question is being asked as to which companies will keep the savings from such reform. Consider gas stations; if the oil price goes down, the gas station does not benefit, this goes to the consumer. So, for many companies, this will be the case; good for economy, but not necessarily for the companies.”
The companies that William Blair’s strategies are looking to include are those that will be able to keep the money, those that are seen to offer differentiated value propositions for investors.
Crowe notes that in the US, employment, housing and jobs seem to be in OK shape, but this also means that “We are going to see companies have some expense pressures that they’ve not had for a decade.”
The managers have been talking to companies about how they can overcome those pressures, for example, by cutting costs or increase prices for products and services. Rising rates and employment costs are challenging for non differentiated companies, they stress.
Lanphier adds: “You also need to look at these rate rises in terms of modern history. Even if we have three small interest rate increases this year by the Fed, the federal funds rate will still not be close to its 50-year average.”
What will not happen, the managers stress, is a wholesale decision to switch sectors. The sector allocation of the small and mid cap strategies flows from bottom up stockpicking; it is from this that any adjusted sector exposure would flow.
Alpha opportunities are seen as growing. Volatility as measured by the VIX index has been low. But as the referred to differentiation occurs, volatility could rise. This is something that as active managers they are keen to see happen.
A continued period of low volatility has “to an extent been a challenge for a fundamental bottom up manager,” Lanphier says.
“There is a need to see the ability to differentiate between high and low quality and high and low growth stocks in the market. That is difficult when free money seems to float all boats.”
Adds Crowe: “We are not saying passive doesn’t have a place, but active does too.”
He notes that the ongoing flows into passive funds at a time when volatility has been low, has created opportunities for active managers going forward. They can identify companies at low values, but with above average quality metrics. It is an environment in which active managers such as themselves ought to do well, subject to continuing the efforts to correctly analyse and identify those opportunities.
Having recently met investors across Europe, both Lanphier and Crowe note that, anecdotally, there seems to be a growing hunger for US assets among European fund buyers.
But European investors “get it” Lanphier says. They are seeing through the noise, such as the off-the-wall tweets by Donald Trump, and appreciate that while the US small and mid cap universe may be more US-centric, it is built on an economy that is looking solid and possibly even accelerating a bit. And this is the area in which market inefficiencies exist.