Equities: Focusing on Durability in a Time of Rapid Change
VOICEOVER: Welcome to Lord Abbett’s Market Update. I’m Tony Fisher.
Jeff Rabinowitz: In-- in growth investing, we believe durability is actually a more critical element for success, rather j-- than just hunting for quality in companies.
Heidi Lawrence: Some of our most concentrated investments are in emerging areas, including liquid biopsy, single cell sequencing, spatial genomics and synthetic biology.
Jamie Sullivan: COVID-19's unique—some companies saw an inflection point that accelerated a trend that was underway like the adoption of e-commerce. Some businesses have been impacted temporarily, and demand will return over time. Others may be permanently altered.
Voiceover: If 2020 has shown us anything, it’s that the U.S. equity landscape is changing rapidly as new technologies come to the fore, with winners—and losers—defined by their ability to survive, and thrive, in this environment. Lord Abbett experts have developed investment approaches to respond to these new dynamics, including the concept of durable growth—the subject of today’s podcast.
One of our equity experts kicks things off:
Brian Foerster: My name is Brian Foerster, I am an equity investment strategist at Lord Abbett. We have long been saying that innovation has had a big impact on the equity markets and has created almost three categories of stocks. Innovation itself, which has caused a lot of disruption over the past 20 years; companies that are very vulnerable to the disruptive effects of innovation; and then this large category that we would call durability, or sustainability. [These are] companies that have built very strong brands, strong competitive moats-- and have adapted well to the threat of technology and innovation. I'm joined today by Jeff Rabinowitz, who leads our durable growth franchise, and is a portfolio manager, as well as research analyst Heidi Lawrence, who covers health care, and Jamie Sullivan, who covers industrials, energy and materials.
The first question's for you, Jeff. Can you describe what you mean by this concept of durability?
Jeff Rabinowitz: Thanks, Brian, and thanks everyone for listening. Durability, in its simplest form, is a measure of how likely a company's competitive advantages will persist into the future. Our investment team believes durable businesses have a higher likelihood of being better investments. But do keep in mind that just because a business is highly durable, it doesn't ensure outsized future returns. And why is that the case, you may ask? So what I'd like to do is begin by establishing the three key elements the Lord Abbett Durable Growth team believes need to combine to make a successful investment.
We believe you need one a durable business, shocking. Two, favorable long-term growth. And three, a reasonable valuation.
We assess durability by evaluating a collection of unique attributes, that when you combine them all, it can help us determine if a business will maintain and/or grow its leadership position in the years to come. Durable businesses won't possess all of the following unique attributes that I'm going to reference. But they're going to rhyme with most of them. Examples of attributes we assess for every growth company include things such as whether or not the company has an established brand name.
[Another attribute] is if the company has high barriers to entry. We ask ourselves, how strong are those entry barriers?
Other aspects we look at are, does the business have scale advantages that will make it hard for others to replicate its cost structure? Does the business have elements of pricing power?
Are there patents or IP protection? Are there elements of recurring revenues to create more stability? How agile and experienced is the management team?
The answers to these questions inform our assessment of how durable each growth business in the investment universe is. The more durable the business, the higher our confidence in stability to achieve its future growth potential.
Foerster: Thanks, Jeff. You know, we often hear comparisons, almost using these terms synonymously of durability and quality. But they are slightly different. Can you talk about how you compare the two terms, and what they mean to you?
Rabinowitz: That's an interesting question, Brian. In growth investing, we believe durability is actually a more critical element for success, rather than just hunting for quality companies. And I'd start by saying we see quality as very credible, it's a time-proven factor, it's driven alpha in portfolios in our industry for many years. And we do prefer attributes of quality, such as high returns on invested capital. That being said-- you can think of quality, actually, as what has gotten the company to where it is today.
Durability, on the other hand, is going to give you a look into whether the business will sustain those quality characteristics out into the future. Or perhaps, it can even be seen as a future predictor of whether a company may be viewed as high quality down the road that isn't today.
And in addition to these forward-looking aspects, I would highlight two other key reasons why durability is critical in growth investing. First, consider that with growth companies, you're typically assuming many years of compounding growth. The company's earnings, its cashflows, it’s three, five and 10 years out before they produce those, and that's much, much more important to the valuation than the current level of earnings that company's yielding. The more durable the business, the more likely that company will achieve or exceed the earnings that are assumed by the market--and potentially, create meaningful upside to its share price over time. A less durable business may have a higher likelihood of stumbling, and perhaps seeing its quality lessen over time, causing its shares to lag other growth stocks.
The second reason durability is key to growth investing is that many growth companies are investing today to drive long term opportunities.
In growth investing, we see durability as key, both to ensure the growth opportunity comes to fruition, or to help us assess emerging growth opportunities that aren't yet considered high quality.
Foerster: Can you give us a little insight into how you build durability into your portfolios?
Rabinowitz: You know, I'd like to highlight one of the unique things our team does. First off, there isn't a third-party data set that's out there for how durable a business is. So what we do is, we create our own data set.
And we leverage the experience of our investment team, several of them that you'll hear from today. We base what we call the durable franchise score on our proprietary framework that leverages the durability attributes I just spoke to. So what we do is essentially, we take the universe of growth companies, and we score each of them on how durable they are.
And then we regularly reassess that score. Those businesses that have low durability can actually be considered vulnerable and are not good candidates for us to own. The more durable the business, the more attractive it may be as an investment. But do remember, we combine durability, growth and valuation to identify the most attractive ideas when constructing our portfolios.
Foerster: Great. So, Heidi, let's turn to you, and can you talk about the research and selection process, and maybe give some examples of how you do this within health care.
Heidi Lawrence: You know, I think consistent with our durable growth methodology within health care, we've invested in companies that have disruptive technologies, that will alter existing methodologies of diagnostic work in drug discovery.
What are small, nascent industries today should replace the current standard of care, and we see ample room for growth over a 10-year time period. Some of our most concentrated investments are in emerging areas, including liquid biopsy, single cell sequencing, spatial genomics, and synthetic biology. This has been a large part of our focus over the past two years. As Jeff alluded to, within these attractive growth industries, we look for companies that have an early mover sustainable advantage, have acquired relevant IP in the space, and who operate with scale, offering cost advantages. Finally, we evaluate their franchise value, the agility and strength of their management team.
Within biotech, we leveraged our work in the life science tools industry and targeted investing in companies with molecular targets and mechanisms of actions that address a wide range of therapeutic applications. Two areas where we see rapid innovation are in the oncology and immunology space. We have been active in the antibody drug conjugate space, basically a highly targeted approach to killing cancer cells across a wide range of cancer types. We have also been actively investing in companies with drugs in the FcRn antagonist class. These drugs help to increase the breakdown of autoantibodies circulating in our blood, which attack healthy tissue.
Reducing these autoantibodies reduces immune related disease symptoms, and offer an alternative to broad immunosuppressive agents, which have tough side effects, and are onerous to dose. This mechanism of action has wide ranging applicability to a whole host of immune-related disorders.
By investing in companies with mechanisms that could be applicable to an entire class of disorders, we avoid companies in single indications, which could present excessive risk, especially in such a rapidly innovative space. To mitigate the risk of binary events in biotech, we also typically target investing in companies post proof of concept, or phase one, and/or phase two, and/or invest in companies that already have their mechanisms approved and at least one indication, which de-risks the asset, to some extent. We also size the position appropriately for their level of risk, and build positions over time, as we gain confidence in the mechanism of action.
Foerster: Thanks, Heidi. You know, so we've had an unprecedented event, at least in our lifetimes-- this year, with the global pandemic, which has presented enormous challenges, but also some investment opportunities. So Jamie and Heidi-- can you both talk about how your team and the process adapted to this unprecedented environment?
Jamie Sullivan: Sure, Brian. COVID-19's unique, because we haven't had a global pandemic like this in about a hundred years. That said, how we think about the durability of businesses didn't change, but our view on growth was altered by a social distancing world, which impacted companies in a way we've never seen before. Some companies saw an inflection point that accelerated a trend that was underway, like the adoption of e-commerce. Some businesses have been impacted temporarily, and demand will return over time.
Others may be permanently altered, such as some in person business meetings that can now be done remotely. So what we did was evaluate how social distancing impacted all of our holdings, whether the competitive landscape had changed, and determined how we were exposed overall.
Similar to how we score companies on how durable they are, we scored all our stocks across every sector for the impact of social distancing. So in some areas, we were more exposed to companies negatively impacted, others we uncovered beneficiaries that also fit our view of durability. Within the industrial space that I cover we identified transportation logistics supporting e-commerce as an area that would benefit, and also viewed portions of aerospace as temporarily impacted, not necessarily impaired, and will return over time.
The other main observation I had in covering my space through this is that many industrial companies are manufacturers. They have to be extremely good operators to compete when in normal times. And this ties back to what Jeff was talking about when he was describing durability. A management team's ability to be agile, manage through the crisis from a cost perspective, while at the same time preparing the business to come out of COVID stronger than they entered it. We paid a lot of attention to that throughout the year. And that's what I saw in my space. Heidi, do you want to talk about health care a little bit?
Lawrence: Sure. Thanks, Jamie. You know, in health care, COVID presented us with a plethora of investment opportunities, with the need for vaccine and treatment. In navigating COVID, and being consistent with our durable investment philosophy, we chose to increase our existing exposure in names in the bioprocessing space--the companies that basically supply the highly complex tools and equipment to manufacture the biologic materials to make the new vaccines and treatments. And we increased our exposure to names in which I call discovery enabling tools--companies that basically offer cutting edge tools to better visualize proteins and cells, to help enable better drug targeting.
Given the early nature of the mRNA technology, we didn't want to place bets on new, still somewhat unproven approaches that could easily be disrupted away, or benefit on a transient basis. This wasn't consistent with our investment philosophy.
Foerster: Great, thanks. So, another question--I know that this team, along with Lord Abbett, as a firm, has put a lot of thought into ESG. Jamie, can you talk about how you and your team integrate ESG into the process?
Sullivan: We believe ESG integrates very well when looking through a durable growth lens. First off, a higher ESG risk may mean that the durability of the franchise is lower, and therefore, wouldn't make it into our portfolios. However, we might also view a company that's higher ESG risk today as an underappreciated opportunity because we see the company's initiatives to improve and get better in ESG areas, and the market will reward that over time.
On the other hand, when you think about some of the trends that we view as underway and lasting, for example, reduction of single-use plastic, renewable energy, fuel cell technology—there are many more—but they have a positive impact from an ESG perspective. But they also provide solid growth because there's long-term demand for what these companies provide. And that very much ties into our durable growth philosophy.
Foerster: Great. So one last question, coming back to you, Jeff. So we now have a light at the end of the tunnel with what looks like very highly effective vaccines coming to market. And hopefully, the end of this pandemic at some point in 2021. Can you talk about your outlook for the year ahead, as well as beyond?
Rabinowitz: We think 2021 is going to be marked by the historic vaccination efforts around the world. While the pandemic will still present meaningful health risks, we're looking through the impacts of social distancing, to what businesses and the economy will look like post the vaccine. We're often asking ourselves, what will earnings be in 2023, or even out to 2024, for these COVID-impacted parts of the economy? We're putting tremendous efforts into assessing how those companies impacted by COVID will recover, and how long this may take.
Not everything will come back to the way it was. New habits have formed, perhaps, in areas such as travel, in terms of what business trips have-- you know, have proven to be worth taking. How many employees are going to appraise the hybrid working environment? On the flip side, just because a business has seen benefits from COVID, it doesn't mean its usage or adoption is going to similarly just mean revert, post COVID.
New habits have formed in those areas. There's new appreciations for products or services that may have been sparked by COVID, but now the genie's out of the bottle, so to speak. Companies that have maintained or grown investments in R&D may come out of the pandemic better positioned for growth. These are the areas we're evaluating in 2021, and we'd advocate looking through near term earnings trends that may be choppy, to what a more normalized level will be post vaccinations.
In terms of portfolio positioning, one of our team's hallmarks is to generate our excess returns from stock selection and high stock specific risk. We tend to position less around macro forecasts, and not have high exposures to factors such as beta, momentum, or volatility. As long as we execute on stock selection, which is our goal, this can allow us to more consistently provide excess returns across different market environments.
Foerster: So with that, I'd like to thank the three of you for your time today in providing these insights. And for everyone listening in-- for your interest in Lord Abbett and our durable growth equity portfolios. If you'd like to learn more about these investment strategies, please reach out to your Lord Abbett representative, or visit us at LordAbbett.com. Thank you.________________________________________
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Beta is a measure of a stock's volatility in relation to the overall market. If a stock moves less than the market, the stock's beta is less than 1.0. High-beta stocks are supposed to be riskier but provide higher return potential; low-beta stocks pose less risk but are also thought to offer lower return potential.
Environmental, social, and governance (ESG) criteria are a set of standards for a company’s operations that socially-conscious investors use to screen potential investments.
Price momentum is the concept that price trends for a security or defined group of securities have the tendency to persist, in either direction—an important aspect of technical analysis. Operating momentum involves companies that are recording revenue and earnings growth that is at a significantly faster rate than the general economy, and, therefore, have the potential to persist in this direction.
Alpha, often considered the active return on an investment, gauges the performance of an investment against a market index or benchmark that is considered to represent the market's movement as a whole. The excess return of an investment relative to the return of a benchmark index is the investment's alpha.
Growth companies are typically characterized by fast growth (high growth rates for earnings, sales, book value, and cash flow) and high valuations (high price ratios and low dividend yields).
IP refers to a company’s intellectual property.
Mean reversion is a financial theory positing that asset prices, historical returns and other financial metrics eventually revert to their long-term mean or average level.
Return on invested capital is a ratio that aims to measure the percentage return that a company earns on invested capital. The ratio shows how efficiently a company is using the investors’ funds to generate income.
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