Equities: Why Innovation and Durability Have Become Even More Important | Lord Abbett
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Market View

Shares of cyclical names have enjoyed a reopening-inspired rally. We think longer-term trends argue for exposure to innovative and durable companies.

Read time: 3 minutes

For the past few years, we have been speaking to clients about the changing competitive dynamics of the global economy and why the growth-value paradigm has lost some relevance within equity investing. Key to this discussion was the notion that price-to-book—the overwhelming determinant for which stocks get classified as “value” (the cheapest), and which get labeled as “growth” (the rest)—has deep flaws now that the vast majority of the most productive company assets are not even included in book value anymore.

Instead, we’ve proposed that a more accurate framework for the global economy today has three components—innovation, vulnerability, and durability. This trifurcated view of the economy and equities illustrates the way in which the technology revolution has forced companies to confront the displacement risks from more agile business models and the new, innovative technologies themselves.

As we see the current market rotation and heightened volatility—coming amid a blowout first-quarter 2021 earnings season—this framework has become even more relevant for investors. As a result of strengthening inflationary pressures, we have seen a dramatic reversal in fortunes for high-innovation stocks and more economically-sensitive cyclical stocks. The narrative that has prevailed is that with a supply shock in the economy driving stronger inflation, interest rates will rise meaningfully from their extremely low levels, thereby reducing the value of company earnings expected further out in the future. By contrast, stocks of companies that are perceived to benefit from rising rates and the economic re-opening the most are seeing strong price momentum.

For investors wondering “what’s next?” we would argue that the innovation-vulnerability-durability framework remains critical to assessing the sustainability of the earnings boom we’ve seen these past three quarters. Based on first-quarter results released through May 7, corporate earnings have had a tremendous recovery and have outperformed even the most optimistic forecasts (Figure 1).

 

Figure 1. First-Quarter U.S. Corporate Earnings Continued an Expectation-Topping Run
Dollar-level earnings for the S&P 500 index for the indicated quarters (Q1 2021 through May 7)

Source: FactSet. Data compiled May 10, 2021. Dollar-level earnings represent the aggregate amount of earnings, in U.S. dollars, from all S&P 500 companies. For illustrative purposes only.

 

According to FactSet, earnings of companies in the S&P 500® Index in the most recent quarter outpaced expectations by 22.1%, for a total of $71.5 billion more in profits than expected at the end of March. Some $26 billion of those excess profits alone came from the Financials sector, overwhelmingly from the largest banks. But then, the next three sectors—Technology, Communications Services, and Consumer Discretionary—combined for $33.4 billion of profits above what was forecast. Those three sectors are heavily populated with high-innovation companies.

Yet, when we look at the performance of exchange-traded funds representing some high-innovation industries in recent months, the record profits generated by these groups appear to have fallen flat with investors:

 

Figure 2. These High-Growth Sectors Recently Lagged Despite Record Profits …
Prices of representative sector ETFs for the period February 16-May 14, 2021

Source: Bloomberg. Data compiled May 14, 2021. ETF=Exchange-trade fund.
The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results.
Past performance is not a reliable indicator or guarantee of future results.

 

Contrast their showing with the investor embrace of two classic cyclical groups, Financials and Industrials, which have soared as a result of the expected “reopening trade” and higher interest rates.

 

Figure 3. … while These Cyclical Sectors Benefited from Investors’ Thirst for “Reopening” Stocks
Prices of representative sector ETFs for the period February 16-May 14, 2021

Source: Bloomberg. Data compiled May 14, 2021. ETF=Exchange-trade fund.
The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results.
Past performance is not a reliable indicator or guarantee of future results.

 

Looking Ahead

So, what might be the biggest risk in the market today? Let’s look at this question through the equity framework we mentioned earlier. We think there is likely some continued near-term weakness in equities of innovative companies, as the inflation narrative plays out, though longer term, the big secular growth themes of genomics, e-commerce, artificial intelligence, and cloud computing all will likely dominate the next decade. That could mean a very attractive entry point in these big secular growth themes may be setting up soon, and we believe these areas should be owned as a strategic allocation.  Moreover, there are many very durable businesses that got hit directly by the unique nature of the COVID-19 pandemic that are likely to see continued, justified strength from the reopening of the economy.

In our view, the real risk in the market today, after this rotation, is in the names that have rallied massively off the bottom. They are highly vulnerable businesses that have seen strong share-price growth and multiple expansion, even though their prospects are arguably no better today than in 2019. These vulnerable businesses include, for example, brick-and-mortar retailers, makers of the physical data servers that are being replaced by cloud technology, cable entertainment providers not adapting quickly enough to streaming. We think these are some of the areas that are most at risk of a permanent reversal, as the recent rotation loses the twin tailwinds of vaccination and economic stimulus, and investors begin to demand that companies show growth beyond just the huge, one-time jump off depressed levels from 2020.

As such, we continue to advocate for a balance between innovation and durability as core asset classes.

 

A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are undervalued, and they may not appreciate as anticipated. Smaller companies tend to be more volatile and less liquid than larger companies. Small cap companies may also have more limited product lines, markets, or financial resources and typically experience a higher risk of failure than large cap companies. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall.

No investing strategy can overcome all market volatility or guarantee future results. 

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This Market View may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize, or that actual returns or results will not be materially different from those described here.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

Glossary and Index Definitions

 

Exchange-Traded Fund (ETF) is a security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold.

Growth/Value Investing: Growth stocks may be characterized as equities of companies that have demonstrated better-than-average gains in earnings in recent years, and that are expected to continue delivering high levels of profit growth. Growth equities typically carry higher price-to-earnings multiples than the broader market, high earnings-growth records, and greater volatility than broader market. Value stocks may be characterized as equities of companies that have fallen out of favor with investors but still have good fundamentals, or new companies that have yet to be recognized by investors. Value stocks typically feature lower price-to-earnings multiples than the broader market—and often their industry peers—and somewhat lower volatility than the overall equity market.

The price-to-book ratio compares a company's market value to its book value. The market value of a company is its share price multiplied by the number of outstanding shares. The book value is the net assets of a company.

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

 

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education. No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein. If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in this Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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