STYLE ROTATION?

 THE GROWTH SELL-OFF and the influence of STYLE INVESTING

After the results season, I wrote a piece on SM titled “Result Season Lessons for Me”. The upshot was what I saw as the early signs of a sector rotation and the potential underperformance of quality growth stocks, which comprise a significant portion of my portfolio.

Below is a table comparing the performance of my benchmark to the pride of the fleet (IMO) of Australian quality growth stocks. As we can see, almost without exception, there is solid underperformance. My benchmark is equal-weighted, not market-cap-weighted, as I have previously covered the reasons for this approach.

So what's going on here to get this widespread negativity? The concept of Style Investing is useful in this regard, imo. I first came across style investing when doing the CFA course from 1998-2000. There is a book by Bernstein called Style Investing if you want to go down the rabbit hole.

In summary, it abstracts away from individual stocks and concentrates on various styles as the main driver of share prices, especially in the medium term. The main various styles are value/growth, large/small cap, low beta/high beta, and high quality/low quality.

When one style is winning, the other is losing. The main driver of that under or out performance is the abundance of earnings growth. In this context, earnings growth is a relative concept. If we have a market with limited earnings growth, investors are willing to bid up that scarce resource and secular growers' PEs go much higher. As earnings become more abundant, for example, in a stronger economy, where everyone is making money, investors are less likely to pay up for these secular growers. That confounds many investors who see no change in the underlying growth of the quality grower. The change is relative, not absolute, and that’s enough in the medium term. The impact is felt on PE ratios.

Of course, there will be investors who will go through the above list and say there is a reason for the underperformance for every stock mentioned. Style Investing would disagree with that approach. It is clear that sometimes poor news is handled much better than at other times by high PE stocks, and the relative earnings growth is the reason Style Investing points to.

That leads to can you predict changes in relative earnings growth to make money out of this. Unfortunately, IMO, I think this is another previously successful investing style that has suffered in the post-GFC era. To be clear, I think the predictive power has diminished, and it is most useful in explaining the past.

In the “old days”, when the yield curve was determined by the market, not the Fed, it gave off information. (I hope someone is finding this as interesting as I do, lol). The information was garnered by the slope and absolute level of interest rates, but mainly changes to the slope, which I will discuss here. Mainly, this is measured by the US 10-year less the 3m bill or 2Y bond, so looking at changes in the yield curve. The significance is that a flat or flattening yield curve signals hard times ahead for earnings growth. You may be aware of the “recession predictors” that economists spoke to in 2022. A flat yield curve is great for secular growers as it indicates a lack of earnings growth, maybe a recession. Obviously, a highly positive yield curve is bad for secular growers as it indicates abundant earnings growth and pressure on the high PEs that secular growers usually hold.

Looking at changes in the yield curve over the last 6 months, we see no indication that high PE stocks should have sold off. If anything, the yield curve has been supportive of growth with the long bond, 90-day bill, and 2Y bond spreads holding in the case of the 10Y/2Y and tightening for the 10Y/bill by 25bp. Intriguing, as I said, the predictive power has almost disappeared since the GFC (as with many other indicators-beware, I know I've said this many times before).

So where does that leave us? We can also see that Australia has been hit more than the US, at this stage. The Australian market is unusual in that it has a large number of low-returning companies and a few quality companies that trade with scarcity premiums. If relative earnings momentum changes, it can make high P/E stocks vulnerable to style or sector rotation. Changes to relative earnings growth will then move SP and inevitably trigger the momentum trade, which can lead anywhere, especially to excess.  That is, we have a large low-return sector that, if it can close the earnings gap, even for a while, will drain funds from the secular growers, and I think that is what we are seeing here. I can see many Insto moving at the first signs of pain.

It is occurring in the US as well, but is nascent at this stage. The vulnerable sector in the US is the magnificent 7, which have dominated earnings growth in the past 10 years or so, and deserve their premium, imo. But when I hear Bessent say he wants Main St, not Wall St, to win, I hear we want earnings growth to be spread (more abundant) to the lower quality businesses. If successful, and it is a big if, especially in the longer term, imo, it will pressure growth multiples as earnings growth becomes more abundant.

As further proof, I need look no further than my own portfolio, my best performing stocks since FY end have been the ones that have given the most grief over the last few years, IEL, DDR and MIN, all up strongly. I can also see that I am underperforming my b/m for the first time since 2022 due to the rotation. Not significant, at this stage, but signs of change, and could persist.

Implications? What to do?

So far, we have seen a moderate pullback in quality growers as per the above. It is not a route so far. Could it become a route? Possibly, depending on the size and longevity of attractive growth outside of the secular grower stocks.

Personally, I am taking a longer-term view and slowly starting to acquire those that have pulled back. Having due regard that many think this rotation has a long way to go. So I will stagger these purchases. I have started to cover the ones I sold at higher prices that looked like expensive levels. And will continue to allocate more. The strategy here is that we live in a world where growth will become difficult to generate in the LT, and secular growers will be in demand.  If Trump and his band of merry men happen to reignite the boom-bust cycle, which cyclicals and low-returning companies love, then I will reassess.

So I have added TNE for the first time since they were under $10, bought back some RMD, LOV, ALL, REA and added a little bit of WTC. HUB hasn’t fallen enough yet. We shall see. As I said several months ago, I am psychologically prepared for the toughest relative performance I have seen in a few years, and it may go on for a while.