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Market View

Missing out on the 10 best performers in the category benchmark can really hurt.

Last week, we highlighted the broad reasons why we believed growth investing may be in the beginning of a new bull market, beginning with small caps recovering from a steep period of risk aversion, and then continuing into the mid- and large-cap space, with transformational companies growing much faster than the overall economy. This week, we look more closely at both how important it is to own the fastest-growing companies within a diversified portfolio and a few examples of where to find these companies. 

The Importance of Owning the Fastest Growers 
In looking at equity-market performance year to year, the big winners tend to far exceed the broad market, and, at times, carry the market. This was epitomized in 2015 when the “FANG” phenomenon (Facebook, Amazon, Netflix, and Google) led the market, and in the late 1990s, when “the four horsemen of tech”—Cisco, Microsoft, Intel, and Dell—delivered massive returns that eclipsed the rest of the strong bull market. When you quantify just how dominant leading performers have been year to year, the historical importance of owning such stocks becomes readily apparent. In many years, investment performance of the broad market has been negative without them, or simply far below average. (Remember, the market may not perform in the same manner under similar conditions in the future. Past performance is not a guide to future performance and should not be the sole factor of consideration when selecting a product.)

In discussing the importance of staying invested in equities in general, we often have stressed the pitfalls of timing the market by analyzing the impact of missing the 10 best days in the market each year.  In Table 1, we note what would happen if an investor missed out on the 10 best stocks, on average, in a calendar year.

 

Table 1: Missing Out on the Top 10 Stocks Can Really Hurt
10-year average return of 10 best performers in the Russell 1000 Growth Index versus rest of the index and S&P 500 Index

Source: Lord Abbett. Data as of September 30, 2016
Past performance is not a guarantee of future results.  For illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

There is volatility in the market and a sale at any point in time could result in a gain or loss. Your own investment experience will differ, including the possibility of losing money. You cannot invest directly in an index.

Investing in Innovation
We envision very significant  opportunity over the next decade in three areas of the economy: 

  • Cloud computing, which is a second wave of transformation from the Internet revolution, namely moving content and data off the device and into the vast virtual environment of the cloud.
  • The ongoing genomics revolution, where we are seeing enormous fundamental strength in a number of areas of this industry, which went into a severe correction over the past year due to political risks.  In our view, those risks may be overstated, and the industry could be ripe for a strong, sustained bull market.
  • The enormous impact of digitization on the U.S. consumer and the powerful force of Internet retail in taking market share from traditional bricks-and-mortar retailers and malls—a trend that is only likely to intensify.

The Cloud Juggernaut
We have written, on a number of occasions over the past few years, about the emergence of cloud software as a dominant theme, and we believe this segment of the broader technology sector is in the midst of a transformation.

Early on, the development of cloud technology began with smaller tech firms looking to provide storage capabilities for corporations looking to offload precious server space and computing speed. However, what began as an efficiency-seeking task rapidly emerged into an enormous industry, in which the likes of Microsoft, Amazon, and Alphabet (Google’s parent company) moved aggressively into this space, realizing the outsized potential of owning content

Whether it’s software, hardware, networking, or services, cloud computing is redefining the entire information technology industry, said Rick Vallieres, a Lord Abbett research analyst. In the process, cloud computing also has enabled strong growth in a number of sectors in a relatively slow economic environment.

“Today, we see leading-edge tech companies that were born in the cloud and have transformed their respective markets,” he added. “Others are providing the platform for innovative start-ups to expand at a rapid clip.”

As the CEO of one software service company born in the cloud put it, “Cloud computing is a better way to run your business.”

Among the many benefits are cost savings for both providers and customers, “pay as you go” pricing, resource flexibility, and ease of use and speed of deployment. 

For long-term investors, cloud exposure means inclusion of companies across the capitalization spectrum. “Large-cap names dominate the ‘infrastructure as a service’ market,” said Vallieres, “but throughout the market caps are companies that build on cloud, deliver their applications from the cloud [software as a service], and provide services to help customers transition to cloud.” 

 

Table 2. Cloud Shift Summary, by Market Segment

Source: Gartner, July 2016.
Note: BPaaS = business process as a service; IaaS = infrastructure as a service; PaaS = platform as a service; SaaS = software as a service. For illustrative purposes only.

 

Clearly, being able to identify the winners in a transformational space, wherein corporate spending is increasing substantially, will be a powerful investment opportunity for the next decade.

New Life in Biotech 
Similarly, biotechs are poised to continue the secular bull market that began in earnest in 2010 and that, we believe, will last far into the next decade.

Tom O’Halloran, Partner and Portfolio Manager for Lord Abbett’s growth equity strategies, has been bullish on this space for years, noting that it took more than 10 years and billions of dollars to map the original human genome. Now, thanks to unprecedented technological advances, industry and academic researchers around the world can access vast data to understand genetic mutations that may factor in a wide range of maladies, including the leading causes of death.

“This transformative innovation, as evidenced by the plummeting cost of sequencing the human genome is taking modern medicine to a higher level,” said O’Halloran. “The pace of this advance is breathtaking compared to Moore’s Law,* which enabled the computer revolution. Genetic sequencing has now sharply outpaced this.”

The genomics revolution’s first breakthrough is targeted therapeutics. The information enabled by the genomics revolution allows biotechnology companies to identify the specific genes whose instruction set has gone awry and caused diseases. Drugs that target the specific “bad” genes are much more precise than chemotherapy drugs, potentially offering greater efficacy and less harmful side effects. This has led to a number of successful oncology and rare diseases drugs.

Then there are immunotherapy drugs, which mark cancer cells and revitalize the immune system’s capability to attack them. These drugs often are combined with targeted therapeutics for greater effectiveness. The next-generation approaches spawned by the genomics revolution seek to head off cancer earlier in its development.

Further, between 2011 and 2015, the average biotech stock rose nearly 400%, according to Bloomberg, as investors realized the outsized potential for these transformational companies. Thanks in large part to rapid drug-price inflation and some headline risk associated with high-profile drug costs, political risk served as a catalyst last year for a massive sell-off in this industry to the tune of 50% declines.  This reset likely was long overdue, yet has set the stage for a renewed bull market, in our opinion, since none of the fundamental strength dissipated during that sell-off. Looking ahead, we believe investors have the potential to realize outsized opportunity if they can distinguish between great science and great marketing among drug companies.

E-commerce: Conquering Time and Space with Your Fingertips
Last, our view of e-commerce is not too far from consensus, in that we believe massive, low-cost Internet retail companies will continue to take market share from traditional retailers.  Clearly, e-commerce has revolutionized the way mass merchandisers operate. Consumer expectations for time and convenience have never been higher. Delivery times are more compressed than ever, while convenience and savings to consumers have accelerated. 

As a result, e-commerce is expected to rise, from 14% of total retail sales in 2015 to 20% by 2020, according to Lord Abbett estimates, which would translate to $580 billion of spending. But while that may be good for top-line revenues, many investors aren’t factoring in the associated impact on margins from chasing that opportunity by investing heavily in technology and distribution, especially when one e-commerce giant dominates the business by strategically trading margins for rapid market-share growth. 

Most at risk from this dynamic, in our view, are purveyors of smaller, easier-to-ship, branded items that are sold broadly. We’ve already witnessed how much sellers of lower-priced items such as books, music, and videos have been ravaged by e-commerce. (See Table 3.) The survivors left standing will likely continue to see further declines in margins as free shipping and handling (currently about 70% of all online orders and growing) becomes more prevalent.

 

Table 3. Retail Categories That Have Been Most Affected So Far
E-commerce penetration, by category

Source: Lord Abbett estimates.
Assumptions, opinions, and estimates are provided for illustrative purposes only. Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

 

The bottom line is that in the coming years we expect leading Internet retailers will spur further consolidation of the market, which should enormously beneficial to investors until the sector reaches full maturity.

A Return to High-Growth Stocks for the Long Run
Our view is that an investor should look for the most powerful secular markets, identify the long-term winners, and then take advantage of the market’s tendency to persistently underestimate the growth and return potential of certain special companies. Thus, having a portion of high-growth stocks within your overall asset allocation can be a powerful driver of long-term investment success by exposing investors to the most innovative parts of the U.S. economy, even when the broader market continues to muddle through.

 

*Moore’s law refers to the number of transistors per square inch on integrated circuits had doubled every year since the integrated circuit was invented. (Source: Intel.com.)

This article 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.

Risks to Consider: 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. Historically speaking, growth and value investments tend to react differently during the economic cycle. Since value stocks are often cyclical in nature, they may benefit from the increased spending that usually occurs during an economic expansion. Growth stocks may also perform well during an expansion, but they may also be out of favor during market downturns, when investors pay more attention to price ratios. 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. No investing strategy can overcome all market volatility or guarantee future results.

Note: 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. Assumptions, opinions and estimates are provided for illustrative purposes only. They should not be relied upon as recommendations to buy or sell securities. All amounts, market value information, and estimates included herein have been obtained from outside sources where indicated or represent the good faith judgment of Lord Abbett. Where such information has been obtained from outside sources, Lord Abbett cannot guarantee the accuracy or completeness of such information.

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.

The Russell 2000® Growth Index measures the performance of those Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.

The Russell 1000® Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values.

The opinions in 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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