Raphael Fiorentino
Raphael Fiorentino
Nov 23 - 5 min read

Guess who's been outperforming lately? (and what to do next)

Wait, what?

With US-China trade tensions escalating, oil price tanking, Europe busy undoing itself, the Fed tightening and the ECB threatening to follow suit(ish), you’d be forgiven to expect a certain profile of publicly-listed shares to fare particularly poorly: that of companies with dodgy balance sheets (ie. EU Financials) and/or consisting of highly regulated, lumbering, tax-collecting, ex-monopolies (EU Utilities, Telecoms, Energy); basically, companies from sectors whose destiny depends more on Government and Central Banks interventions than on their intrinsic ability to engineer economic profits. Charles Gave, one of the most experienced fund managers in activity, opposes these “administered” sectors (in which he admits to never invest in), to the “free” sectors (in which he focuses his investments), and this distinction is proving particularly helpful to shed light on recent market developments.

So guess what. Nothing has outperformed nearly as much over these past 3 months than the shares of the largest EU companies from “administered sectors”. While large cap stocks did outperform smaller cap ones by +3% (both in the US and in EU), the performance benefit of belonging to an administered EU sector contributed another +4.5% over the past 3 months (-1% in the US).

Large cap companies outperformed in EU this quarter, but especially those from “administered” sectors (note: circle size represents the % weight contribution to the market index)

Outperformers in Europe - August to November 2018

If a sizeable percentage of your portfolio consists of stocks that are neither very large nor from administered sectors (this represents 600 of the top 1,000 listed EU stocks but only 10% of the index weight), then chances are that you have compounded the misery of a -6.5% drop in market returns with another -4.5% or so drop, due to your “free sectors” positioning.

Three things we take away from Butterwire’s engine output as we look to the coming months:

  1. Ever since late January, global financial markets have been pricing in ever lower global growth (and equity returns) expectations

    To the point where by mid-summer, our iGDP indicator started to suggest a tactical move out of risky assets and into safe ones (ie. from equities to cash and/or government bonds)

    Butterwire’s iGDP (global growth expectations, blue area) and iEMR (equity returns expectations, yellow line) iEMR around 0% since February as iGDP has been hovering around the recessionary threshold of 1.5% since July

    iGDPR & iEMR graph

  2. Since July, this iGDP indicator of global growth expectations has been indecisively hovering around the 1.5% mark (below which a clear recessionary regime is established) – so markets are equally concerned and conflicted... but about what?

    a. Is it about a triumphantly protectionist and hawkish US as the rest of the world devalues and de-integrates?

    In which case lower growth and higher inflation outside of the US foreshadow torrid times ahead for equities, and would explain why "administered sectors" have recently outperformed in Europe and Emerging Markets

    ...even though neither gold nor oil prices nor the USD have moved materially higher.

    b. Or is it about a US slowdown as Corporate America is not able to cope with a higher cost of capital, forcing a reversal of Fed policy?

    In which case higher global growth and disinflation would be in on the horizon, which would explain why "disinflationary EM growth" stocks (see here for more details on Butterwire’s macro profiling of stocks) have recently been outperforming in Asia ex-Japan

    ...even though US Tariffs are around the corner, US Treasury yields have been rising, and the yield curve has been flattening

  3. While good old "bottom-up" stock-picking may feel unrewarding right now, it also creates opportunities to hang on to holdings with solid investment thesis and attractive fundamentals

These fundamentals will reassert themselves as soon as markets stop oscillating between opposing "top-down" thesis about where the world economy is headed. But circling back to another of Charles Gave’s contribution to investing wisdom: "there are times to be making money and times to avoid losing it." which very much describes 2017 and 2018 (and the start of 2019) respectively.

 

PS: cue humble pie on the Butterwire menu this past quarter... 2018 is indeed shaping up as the toughest we’ve encountered this decade, with both absolute market declines to contend with AND the best performances highly concentrated in a few large stocks. Our experience is that when there are only 35% to 40% outperforming stocks globally (38% in 2018), it becomes difficult to get to our target win rate of 55% (see graph below).

Butterwire’s stock classification at year start and % of outperformers at year end 55% win rate target much harder to reach as the pool of winning stocks shrink

Candidate performance

As a result, and also due to the change in macro regime from the January market boom, to the recent bust, the "candidates" suggested at the start of the year didn’t manage to even match the market index.

Butterwire’s stock classification at year start and % return relative to a market tracker index Less than 40% of the stock universe outperforming in 2018 likely to prevent us reaching our 2% excess return target

Relative Performance

For EU and the US, it’s all been unravelling these past 3 months thanks to substantial size effects, compounded in the EU by the "administered sectors" effect, knocking 3% off EU stock selection performance and 2% for the US. Only the stocks with high recession-resilience scores avoided the debacle, but not by much.

Median year-to-date outperformance by stock classification as of January 2018

Outperformance by stock classification

Because Butterwire doesn’t discriminate by size at the stock selection stage (only at the portfolio construction stage as a source of active risk that can be mitigated), beating the EU index became a tall order when the largest 70 EU stocks returned +7% more than next 930 within the 3 past months! And as stocks from the administered sectors have on average weaker fundamentals than those from the "free" ones, they also tended to be underrepresented in butterwire’s lists of interesting candidates.