OB Report
February 2022
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The Devil’s in the Details:
Quality is Paramount

Murray Leith By Murray Leith, CFA Executive Vice President & Director, Investment Research

Looking back, 2021 was a great year for the economy and many stocks. After contracting in 2020, the global economy expanded by an estimated 5.6% last year, while the MSCI World Index produced a total return, including dividends, of 21.2%1.The main Canadian and U.S. equity benchmarks led the world’s major markets with returns of 25.3% and 27.5%, respectively.

While the overall global economy is back on its pre-pandemic expansion track, many markets are still struggling. In particular, stocks in developing countries have lagged, with the MSCI Emerging Markets Index producing a loss of 3.4% in 2021. The Organisation for Economic Co-operation and Development (OECD) believes that lower-income economies, particularly those where vaccination rates are low, are at risk of being left behind.

The OECD predicts that global growth will moderate to 4.5% in 2022 and 3.2% in 2023, and cites inflation as the greatest risk to the economic outlook. If elevated inflationary pressures prove to be persistent, central banks might have to raise interest rates sooner and by more than expected.

The prospect of slower economic growth and higher interest rates has made investors nervous. Consequently, equity market volatility has recently intensified. While the major stock market averages are holding fairly close to their highs, there have been notable shifts in which stocks are leading and considerable drawdowns in parts of the market.

Small Growth Stocks Out of FashionMany of the popular stocks in the first half of the pandemic have fallen hard, while those that initially lagged have recently performed remarkably well. Growth stocks in general, and small growth stocks in particular, were the early winners, but it’s the smaller growth stocks that have fallen the hardest. In fact, since peaking in the second week of February 2021, a little less than a year ago, and through to January 15, 2022, the Russell 2000 Growth Index of smaller stocks is down about 20%. Since that time, large growth stocks are up roughly 14%, while large and small value stocks are up 19% and 10%, respectively.

Let’s look at one exchange-traded fund (ETF) that is illustrative of this trend. Cathie Wood, CEO of ARK Invest, was the star investment manager in 2020, but her success peaked around the same time that small growth stocks were hitting their highs. Since its peak in February 2021, Wood’s ARK Innovation ETF is down about 50%, paralleling the decline in the Goldman Sachs Non-Profitable Tech Index. While the businesses in the fund have exciting long-term prospects, many have yet to earn a profit. Large holdings in the fund, such as Teladoc Health, Zoom Video Communications, Roku Inc., Spotify Technology, Block Inc. (formerly Square Inc.) and Shopify have suffered major declines.

What’s noteworthy is that since the pre-pandemic market peak on February 20, 2020, and through to mid-January 2022, the ARK ETF has underperformed the broad U.S. market and some big value names. Over the near 23-month period, the ARK ETF returned 30% versus 35% for the S&P 500 Index, 35% for Warren Buffett’s Berkshire Hathaway and 47% for The Royal Bank of Canada.

Why are small growth and non-profitable tech stocks performing so poorly relative to other stocks? We believe it is because they were overhyped and overpriced. These stocks were major beneficiaries of the massive fiscal and monetary support provided by the authorities. Now that fiscal programs are abating and central banks are tapering their bond-buying programs and preparing to raise interest rates, the hot, hyper-growth stocks are losing their appeal and support. Market liquidity is still ample, but the general expectation is that it will deteriorate as the year progresses. The market is forward looking, and stock valuations are starting to matter more to investors as they look ahead to a time when financial conditions and liquidity won’t be as favourable.

We think 2022 will be a tougher year for the economy and for stocks. As such, we believe investors should moderate their return expectations and be prepared for increased market volatility.

Many pundits are arguing that value-type stocks, like banks and energy firms, will continue to perform better than growth-oriented stocks, like Google and Microsoft. Their view is underpinned by the mathematical reality that higher interest rates weigh more heavily on the valuations of businesses that produce greater earnings further into the future. Yet, it’s also true that growth stocks tend to outshine value stocks when economic growth slows, as investors are usually inclined to pay a bigger premium for the narrower group of businesses that can deliver growth in a slower-growth world.

In general, we expect large-cap stocks – the big and familiar companies that dominate our clients’ portfolios – to do better than small-cap stocks in 2022. This is typically the case when investors start to get nervous late in an investment cycle. Because central banks are expected to raise interest rates to fight inflation and since growth stocks are considerably pricier than their value counterparts, it’s tempting to favour value stocks over growth. While that is a logical conclusion, we think it is too broad a generalization. The correct posture will likely prove to be more nuanced, in our opinion.

We think quality will override growth and value as the most important factor this year, and we believe both growth and value stocks with strong fundamentals will perform well in an environment with slower economic growth and tighter monetary policy. Larger, higher-quality growth businesses with deep economic moats and reasonable valuations should be favoured over more speculative, higher-growth businesses. Accordingly, we favour the FAANGM group of businesses (Facebook, Apple, Amazon, Netflix, Google and Microsoft) and other large growth stocks like Visa and Starbucks over the speculative, higher-growth businesses promoted by Ms. Wood and featured in the ARK ETF.

With many of the former market darlings down considerably from their highs, some investors see bargains and opportunity. While there are certain to be proverbial “babies thrown out with the bathwater,” we caution against the idea of using discounts to peak values as a barometer. Peak valuations achieved during a liquidity-driven speculative craze are seldom good yardsticks to measure value. In many cases, the prices of the former darlings are still higher than their pre-pandemic levels and rich relative to their underlying fundamentals. If the fall-out from the dot-com bubble is a guide, it could be a long time before speculative growth stocks shine again.

Higher-quality value firms – both large and small – with solid and enduring business models and strong balance sheets should be favoured over lower-quality value businesses. Canadian Banks, Utilities, Telcos, Consumer Staples and Health Care are among the value-oriented industries that we think will outperform in 2022. While we are generally less enthusiastic about economically sensitive businesses, we remain constructive on Energy firms, as oil and gas prices will likely be supported by the lack of investment in the sector in recent years.

Above all else, we believe it’s important to be diversified. While our top-down views on the economic outlook have some influence on our bottom-up, company-by-company analysis and recommendations, it’s important to appreciate that economic forecasts can be wrong. Consequently, it’s most important to focus on where businesses will be three to five years down the road and make sure portfolios hold a diverse collection of high-quality businesses that will endure and thrive in the long run.

1 All return figures in this article are in Canadian dollars and include reinvested dividends.

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