Innovation Growth: A Strategy for Today—and Tomorrow
INVESTMENT CONVERSATION PODCAST 03/27/2020
Innovation Growth: A Strategy for Today—and Tomorrow
Stephen Hillebrecht: Hello, everyone. Thanks for joining us today. This is Steve Hillebrecht, director of product strategy. At Lord Abbett we have seen some historic moves in the markets over the past couple of weeks, but since our founding over 90 years ago we at Lord Abbott have learned how important is to be in touch with our clients during these volatile periods. So in addition to this podcast today, if you want to hear more of our insights on our latest thoughts on the market, listeners can also visit our Market Volatility Resource Center at lordabbett.com. Today, our focus is going to be on the equity markets as just a couple of days ago, major U.S. equity indices were down some 35 to 40% from their peaks, only to see a 20% move higher over a couple of day period--just an example of how difficult is to time these markets.
But we've also seen a large dispersion of returns within the markets, with the value indices down some 25% year to date, but the growth index down about half that amount.
In is volatile period innovation growth companies in particular have an outpacing the broad market, as well as cyclical stocks. So Lord Abbett has a unique approach to innovation and our growth equity strategies. These are highly active strategies focused on the fastest growing companies, market leaders, as well as the rapidly growing next generation of growth leaders.
Here to discuss the markets and our strategies are Matt DeCicco, managing director and portfolio manager on Lord Abbett’s Innovation Growth Equity Team and Brian Foerster, growth equity investment strategist.
Brian, maybe you can start out, a lot of people think about equities in the traditional value or growth framework, but can you talk about how Lord Abbett is thinking about innovation growth stocks, not only right now but over the long run.
Brian Foerster: Sure. Thanks, Steve. So, Lord Abbett has a pretty unique way of thinking about innovation. It’s something we've been doing with a good deal of success, going back to 2003 in small cap micro cap and large cap funds. We're really trying to capture the winners of the tech revolution that has been accelerating since the early 1960s and today is really now in full bloom. And so if you think about what's happened in the markets really over the past decade, in particular, high innovation industries like biotech, medical devices, cloud computing, artificial intelligence, and e-commerce have come into their prime. And these are big meg- trends that we believe are going to keep accelerating.
Our approach has always been to focus on key metrics like revenue growth, expanding market share and looking to own the great companies with asymmetrical upside, but also having a very active approach to mitigate the dynamic nature of the stocks in these industries. The competition is very fierce in these industries and you really have to be paying attention to changes in competitive advantages among the companies trying to capture market share.
The outperformance that innovation stocks have delivered at least so far through this incredible market volatility is, in our view, an affirmation that these rapidly growing industries are now becoming the core part of our economy and our multi decade secular bull market. Over the past 20 years they have really evolved into the most resilient industries.
Hillebrecht: Well, Matt, with that as a backdrop, turning to this market environment, can you give us a sense of what you're seeing now in the equity markets, particularly in this volatile period. The market is dealing with a lot of uncertainty around the coronavirus.
Matthew DeCicco: Sure, Steve. I think it is important to take note of the striking movements we've seen in the financial markets. Since the crisis began, from its peak, just a month ago, the S&P [500 Index] had declined 35% to approximately 2200. now we've rallied a little bit since then. Small caps, peak-to-trough, as measured by the Russell 2000 [Index] were down by 40%. The Volatility Index, or the VIX, rose to above 85 which is its highest level since the Great Financial Crisis. The U.S. two-year and 10-year Treasury [notes] have stabilized now around 30 basis points and 80 basis points, respectively. But that's down from 1.5% and 1.8% before the crisis began.
This all occurred over one month, which makes the pace of the moves very unusual. The only analogous periods we could identify were 1987 and 1962, so we’re living in a unique time in history.
With that background, there are three aspects of the crisis that we are monitoring from here. The first is the spread and virulence of Covid-19 across the globe, and now across the U.S. The second is the liquidity and operations of global financial markets. The third is the economic impact of social distancing how dramatic the fall-off of economic activity will be and what the shape of the recovery will be once the period of social distancing ends.
We believe monetary policy has addressed the second issue, the operations of the global financial markets. And we also believe that fiscal policy is in the process of addressing the economic impacts, but there is still some uncertainty about the timing of when this relief can get into the hands of the consumers and small businesses that need it.
The first aspect I mentioned, the virus itself, will be addressed with time. That this is the most difficult projection to make with confidence.
I think what's been most interesting to me is to observe some of the individual stock reactions during this period. First is the dramatic performance differential between virtual empowerment stocks-these are the businesses that have benefited from social distancing, that in some cases are up, or at least flat compared to the market moves I described earlier.
Then you have to look at the returns of those businesses that are dependent upon being around other people like cruises, airlines, and concerts, which have done much worse than the market averages.
The other dramatic performance differential is the spread between companies with secular growth themes, like in e-commerce, for example, or in biotechnology, in cloud infrastructure build-out or in semiconductors. Again, contrast these returns with the economically sensitive areas of the economy that are going to suffer from a steep and sudden decline in demand. So this is areas like banks and energy, or brick-and-mortar retail. These areas of will drop much more than the market averages during the decline.
At the [index] lows we believe the market was discounting a severe recession. This is based upon the VIX levels at 85. We look at sentiment indicators like the put-call ratio, which was at an extreme, the Institutional Investor bulls-to-bears ratio was flashing extreme bearishness, and we saw a blow out in high yield credit spreads from 315 basis points to 1100 basis points.
Since then, markets have rallied really over the last few days, we believe, due to the effectiveness of monetary policy in stabilizing financial markets and the near passage of the fiscal stimulus package. What we're seeing is a “whatever it takes” mentality, both at the Fed and in Washington.
So during this rally, we've seen some of the most beaten-down cyclical companies increase the most. That is not sustainable, in our view, because the risks that these companies faced coming into the crisis are very likely to persist in the future.
We think the innovation growth stocks provide greater opportunities today in many respects because their share prices were impacted and yet the behavioral changes in consumers and in businesses induced by this crisis may prove to be durable.
Hillebrecht: Matt, can you dig a little deeper on there and perhaps expand on a couple of examples of those innovative areas of the economy that that you're most bullish about given your outlook.
DeCicco: Sure. So let's start with technology and focus on two key areas, cloud infrastructure and software-as-a-service. Social distancing has led to a surge in working from home. This has empowered a remote workforce using their essential apps on mobile devices. The seamless transition to keep vital businesses working from remote locations with the required bandwidth and security was not possible until cloud infrastructure was built out. We believe the experience of the last month will further galvanize this shift. The business model of software as a service also has entered very well during this crisis. The software provider has very good visibility on their revenues and earnings due to the radical nature of the model, while at the same time, the client has flexibility. The stickiness of the service offering offerings has been very impressive so far.
The second area of innovation we are bullish on is biotechnology. Biotech companies have held up very well during this downturn and not just those companies working towards vaccines or treatments for Covid-19. Companies that are innovative with best-in-class and first-in-class medicines addressing a major unmet need, leveraging the genomics revolution, underscored by clearly elucidated biology.
Companies like this are, in our opinion, all-weather investments. Furthermore, we think innovation in the small and mid-sized companies within biotech is superior to the larger companies, so we expect the pace of consolidation that we've seen in the sector to continue.
Finally, we are also bullish on e-commerce. Within the consumer sector e commerce continues to be the dominant theme. And the early data points from the last few days are that the e-commerce channels across a variety of companies are accelerating. And things like telemedicine are seeing a surge in virtual doctor visits. Also, the e-commerce applications of the services businesses.
Utilizing apps like Zoom has allowed for businesses that would not otherwise be able to provide services to carry on. For example, music lessons and fitness classes are being delivered via these channels across the United States. Finally lagging areas of e commerce adoption like grocery which is only 5% penetrated compared to 20% for other retail is now seeing a boost that will sustain on the other side.
Hillebrecht: Thanks, Matt. Brian, I know you're having frequent conversations with sophisticated institutions throughout this period. How are investors thinking about using these innovation growth strategies in their portfolios?
Foerster: In talking about innovation and equities with pension plans, financial advisors, RIAs, and consultants, I've seen a lot of interest in this space in the past few years, but I would say in the past month there's really been heightened focus on these industries as this may become a historic entry point for investors with companies that are deeply discounted. Many would believe that these great innovators are now on sale.
And so investors really think about it in one of three ways. First, they're increasingly seeing innovation, not as a satellite asset class anymore where you may put a little capital towards high-tech disruptors, but rather as more of a core holding in equities. These industries are maturing quickly--they have matured quickly--both because they are growing organically and because of the displacement risk that they pose to older, clunkier and more expensive technologies.
So that's one way. The second: innovation equities also viewed as a natural hedge to be paired with a traditional or deep value fund. Innovation in fact is a big explanatory variable as to why the value premium exists or existed for a long time. And so it makes sense to pair innovation with stocks that are potentially threatened by it and need to adapt.
And then third, [innovation investing] is really viewed as a way to be opportunistic today as we eventually emerge from the market distress caused by the pandemic.
So we're not making a market call on you know whether it's today or a few months from now. But we believe it's important to note that typically the market recovers well in advance of the economy recovering from economic downturns and recessions and certainly rebalancing is on the minds of many investors today.
Hillebrecht: Matt, maybe to wrap things up here. I know a lot of investors are focused on what's going to happen in the next six, 12, or 24 hours, but a little longer term view. How are you thinking about things looking out six, 12, or 24 months from here? What is your longer-term view on the market from here?
DeCicco: In short, we're bullish on innovation equities over the next six to 12 months and beyond, because of the extreme readings I mentioned before on sentiment, the number of stocks oversold, and the level of the VIX, we believe we are probing a low in markets. It's very hard to time a low with precision, so we won't. But we have begun to position our portfolios for a strong rebound into the end of the year, and beyond. We're doing this by investing in innovative companies that have resilient fundamental momentum, which is reflected with strong relative share price momentum.
Importantly, we're very bullish on innovation for the next decade. It's an exciting time to be a growth investor. We think we're living in the early stages of the tech revolution. The tech revolution is different from the industrial revolution because the tech revolution is transforming cognitive power. Brian mentioned some of these examples earlier: artificial intelligence, autonomous vehicles, robotics, connected devices, the Internet of Things, 3D-printing, and biotechnology. All of these industries are in their embryonic stages. We expect that these industries will shape our world and our markets over the coming decades. We think the force of the tech revolution is responsible for the outsized gains in the innovation industries over the last decade.
You can see this in the returns for stocks in biotech, Internet retail, e-commerce, fintech, cloud computing, and semiconductors; we expect this to continue in the years ahead.
The tech revolution is directly impacting the technology sector, the consumer sector, communications, and healthcare. These sectors represent over 70% of the portfolio is we manage at present. Contrast that with these sectors only accounting for 30% of the value indices
Finally, we believe that innovation is going to have a lot of durability over market cycles, [favoring] companies that are aggressively taking market share in their industries. And those that have secular growth characteristics, rather than high economic sensitivity, are going to have the ability to sustain high revenue and earnings growth and should command better investment returns, because of that, during periods of weak economic growth. This has been demonstrated over the last month in the markets.
So, in closing, we're positioning our portfolios for a market that will be higher by the end of the year and we are very bullish about innovation investing in the decade ahead.
Hillebrecht: Matt, Brian, thanks for your time and thanks everyone for listening. If you have any questions please reach out to your Lord Abbott relationship manager and. And as a reminder, for more insights on the market environment, please visit our Market Volatility Resource Center at lordabbett.com. Thanks everyone. Stay healthy, stay safe.
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