The tech titans have led the US stock market to hair-raising heights, and a painful bruising could be on the way.
The US equity market has been the star performer this year, with the technology-focused Nasdaq index performing particularly strongly, reflecting superior returns from growth stocks compared with value stocks.
In the first seven months of 2018, the Nasdaq 100 rose by 13 per cent and the S&P 500 added 5.3 per cent, compared with 2.4 per cent for the MSCI World index.
Amazon, Netflix and Microsoft were responsible for most of the US equity gains, while rising interest rates and US president Donald Trump’s tough talk on trade weighed on the rest of the market.
A sea change of technological disruption expedited by exceptionally low interest rates has created the perfect environment for growth investing in recent years, especially for elements of the fast-paced technology sector known by acronyms such as FAANG (Facebook, Apple, Amazon, Netflix and Alphabet’s Google) and more recently MAGA (Microsoft, Apple, Google and Amazon).
‘These companies have made a lot of people rich, and for good reason: they are not the flights of fantasy of the dotcom era, they actually have genuine earnings, solid cash flows and global dominance,’ says Tony Lawrence, a senior investment manager in the multi-manager team at Seven Investment Management (7IM).
With the tech titans leading indices ever higher and creating a tough yardstick for outperformance, only 15 per cent of active managers in the Investment Association’s North America equities sector have beaten the market over the past five years.
Managers such as Baillie Gifford, Morgan Stanley and T Rowe Price have, however, revelled in this environment, outperforming by an impressive margin.
Pattern of disruption
The three top-performing funds in the sector over the past five years – Morgan Stanley US Growth, T Rowe Price US Large Cap Growth Equity and Baillie Gifford American – share two main characteristics: highly concentrated portfolios and significant weightings to the technology sector.
Taymour Tamaddon, manager of the T Rowe Price fund, points to secular demand for public cloud computing services as a driver of growth. He says: ‘Certain companies are benefiting from the shift of advertising spending to digital and social media channels.
Facebook and Alphabet are the firm incumbents in this area, although Amazon is encroaching with its nascent advertising offering – if you can call an $8 billion (£6 billion) run rate business growing by 70 per cent a year nascent.’
He also favours companies capitalising on the convergence of communications and computing, including internet software companies such as Red Hat and digital payments companies such as PayPal and Visa.
Despite the bull run in US equities since 2009 pushing share prices to lofty heights, he regards valuations as ‘reasonable’ – though ‘not cheap’ – for many of his high-conviction positions, given their strong fundamentals and further growth potential.
Almost 40 per cent of constituents of the Baillie Gifford fund by weight are growing their revenues by at least 40 per cent year-on-year, and it is not just companies such as Amazon that are topping the revenue growth table.
The team behind the fund believes it is ‘likely to be closer to the beginning than the end of pleasing long-term returns for the portfolio’ because of the onset of a ‘once in a multi-generation shift in the leadership of the global economy’, which is creating a broader base of the ‘exceptional growth’ companies liked by Baillie Gifford.
‘We are seeing the pattern of disruption witnessed in retail and advertising over the past 20 years spreading into previously immune and unrelated industries,’ says co-manager Helen Xiong.
Interactive Brokers in finance, Shopify and New Relic in software, Wayfair in home furnishings, GrubHub in online food ordering, Redfin in real estate, Tesla in transportation and energy, and Vertex Pharmaceuticals and Abiomed in healthcare are all growing their revenues at above the portfolio’s median rate of 26 per cent.
Whitechurch Securities, however, is cautious. It moved to an underweight position in US equities in early 2017 over two concerns: valuations and low volatility.
Managing director Gavin Haynes says: ‘Valuations appear elevated, trading significantly above both the five-year and 10-year averages, while sectors such as technology look stretched, following an exceptional run. The continued low volatility suggests complacency, which also makes us nervous.’
He warns that any correction in the share prices of the tech giants will significantly hurt the sector’s current top-performing funds, not least because of their concentrated nature. Baillie Gifford American, for example, has just 42 holdings, with more than 50 per cent of its £1.6 billion of assets in its top 10 names and 10 per cent in its largest holding, Amazon.
Fellow wealth manager Brooks Macdonald, in contrast, believes the US equity market premium is justified and is retaining an overweight position for two different reasons: the pace of economic expansion, and impressive earnings growth among US companies.
Companies that have so far reported second-quarter earnings boast average growth of 27 per cent a year – even higher than in the first quarter.
Investment director Edward Park says: ‘The current US earnings season has seen more than 80 per cent of companies beat expectations so far – the highest percentage in more than 10 years.
This alongside valuations only slightly higher than their long-term averages makes US equities attractive, particularly when the rest of the world’s pace of growth appears to be losing momentum.’
Access all areas
Brooks Macdonald’s primary exposure to the US market is via index trackers, which it uses for low-cost access and because the US index is famously hard for active managers to beat over the medium to longer term. However, it also uses active managers that the prevailing macroeconomic environment favours, as satellite holdings.
These are growth funds at present. Charles Stanley also rates the benefits of being active in this sector, particularly at the moment. Analyst Adam Carruthers says: ‘Not looking like the benchmark when it’s overpriced is not risky but desirable.
Active managers’ defence is a combination of a high active share, tactical use of cash and in some cases being able to take short positions.’
He highlights Fidelity American Special Situations, which differs from its benchmark by 87 per cent, Findlay Park American, which has 15 per cent in cash, and Artemis US Extended Alpha, which can profit from falling share prices, as strong fund picks.
He points out that the valuation premium of US growth stocks versus US value stocks on a price-to-book basis is the most extreme since 2000.
7IM believes the increasing cost of capital coupled with disappointing earnings growth reported by some of the best-performing tech companies, including Facebook and Netflix, could signal the start of a shift from using potential future revenues to value growth stocks to adopting more tangible current valuation matrices – making a value investment strategy more attractive. 7IM’s Lawrence likes the valuation opportunities among smaller companies (see box), but recommends balance.
He says: ‘Value investing will come back at some point – maybe when interest rates have normalised – but because it’s hard to take a view on when styles will move in and out of favour, we advocate looking for the best active managers in each camp.’
For those nervous about a rotation back to value stocks, Quilter Cheviot Investment Management likes both the Sands Capital US Select Growth fund, a focused portfolio of companies that justify their valuations on underlying cash flow growth, and BNY Mellon US Equity Income, a high-quality, large-cap value portfolio that yields around 3 per cent.
Cathedral Financial Management uses Threadneedle American as its core US equities position, in the belief that it can deliver over the medium to long term because of its active approach. ‘It has delivered strong returns through managing a 70- to 90-stock portfolio with broad market exposure,’ says research analyst Shane Bennett.
Tax breaks set to boost small companies
One of Canaccord Genuity Wealth Management’s favourite portfolio themes is US small companies, which stand to benefit more than their large counterparts from US corporate tax reform.
‘Small caps will benefit from the tax cut more than large caps, because they were generally paying the full rate and, crucially, are likely to take advantage of the accelerated tax depreciation for new investments,’ says chief investment officer Michel Perera.
‘Indeed, we have seen all-time high capital expenditure intentions from US small caps and think this will drive their performance for the next few years.’
His favourite fund in the space is Artemis US Smaller Companies, run by Cormac Weldon. Weldon likes consumer cyclicals and financial services – sectors that should benefit from steady consumer spending and rising interest rates – as well as healthcare, which is Canaccord Genuity’s secular play for this economic cycle.
‘The fund has beaten both the S&P 500 and the Russell 2000 convincingly this year, and based on its positioning, we would see further strength ahead,’ adds Perera.
Meanwhile, 7IM likes the THB US Opportunities fund, which invests in ‘micro’ companies that are trading on ‘super cheap’ valuations relative to large businesses.