At the Janus Henderson Global Media Conference, “New Investment Paradigm: Uncovering Opportunities and Challenges,” our senior leaders and key portfolio managers from around the globe shared their insights and outlooks for their markets. In this session, Co-Head of Equities George Maris moderates a discussion on positioning portfolios for changing market conditions with Portfolio Managers Doug Rao and Brian Demain.
Louise Beale: Last but not least, and we’re going to consider the outlook for U.S. equities, the market’s tug-of-war. And for that, let me introduce George Maris, Co-head of Equities, who is going to lead the panel on this. George.
George Maris: Louise, thank you. Greatly appreciate it. It’s my pleasure to introduce two of our most senior portfolio managers. First, Doug Rao, who is the lead Portfolio Manager on our Concentrated Growth and Concentrated All Cap Growth strategies, a primary strategy there being the Janus Henderson Forty strategy.
And in addition, Brian Demain, who is also one of our senior portfolio managers. He is the leader of the Mid Cap Growth group, and the primary strategy there is the Janus Henderson Enterprise strategy. So, Brian and Doug, thanks and welcome to this panel.
So first off, if I may, I think the past year and a half is truly unparalleled. When we talk about unparalleled, oftentimes it’s hyperbole. I don’t think that’s the case here. I don’t think we’ve ever had the kind of economic and human shock that we’ve witnessed over the last 15 months or so. And we’ve certainly witnessed one of the most extraordinary hits to global GDP in growth as well as recoveries globally. And as a consequence, we’ve seen with the recent signaling from the Fed a week ago, that they expect to raise interest rates by 2023, so a lot sooner than not only they had mentioned but also the market had anticipated just a short while ago. So given this shift, Doug, let me start off with you, how do you expect the tug-of-war between stock valuations and interest rates to evolve?
Doug Rao: Thanks, George, and thanks to everybody for listening to our panel. That’s obviously a very, very difficult question. The way I try to frame it as an analogy is there’s that children’s song, “The Itsy Bitsy Spider.” And I think of our companies as the itsy bitsy spider and they’re climbing up the water spout. And interest rates or macro or headlines are the rain that washes them back down. And it’s their growth, their growth in free cash flow, their growth in earnings, their innovation that allows them to keep climbing.
And so I would certainly anticipate stormier weather ahead from an interest rate standpoint because I think real rates globally have been pinned near zero for a considerable period of time, and obviously we’re now entering a period where economies are starting to expand again and, in addition, there’s a lot of stimulus. And so we would expect our companies to continue to focus on the things that are in their control. And that is innovating, delighting their customers and investing capital in wise ways.
Maris: And Brian, how do you think this evolves?
Brian Demain: Thanks, George. I think the reaction last week was a signal of just how important interest rates will continue to be to the equity markets. The entire economy is so financialized and equities have gone so long in duration just by virtue of the growing importance of growth stocks in that economy that interest rate dynamics will have profound effects on the equity market, I think, for a while going forward.
In particular, as we think about what happened last week, the Fed basically cut off the right tail of the distribution. They basically signaled they won’t let inflation run away. But let’s not kid ourselves and call this a hard money situation. They were talking about slowly raising rates two years from now.
And if you look at five-year inflation break-evens, they’re still higher than they were during the entire period of secular stagnation. They’re back to levels we last saw in the mid-2000s. And so it’s a different paradigm than we’ve seen for the last ten years and it will continue to matter which… Doug’s Itsy Bitsy Spider analogy was great because we like to focus on the spider but unfortunately, the rain is out there and just we have to be aware of it as well.
Maris: Yes, absolutely. I think if I can, I’d love to get your thoughts, Brian, and I’ll start off with you on this one. Clearly, the pandemic has reshaped how I think everyone globally has worked, spent, exercised, travelled, just consumed, lived during the past 15 months. But as these lockdowns are starting to end, as we’re starting to see economies and society open a bit, we’re seeing people return to offices and pre-lockdown activities, what imprint do you think the COVID experience will have on the economy and consumer behavior, or actually all behavior going forward?
Demain: Yes. So what we do on the equities side here at Janus Henderson is try to think a few years out and invest with a longer time horizon. So the obvious question becomes what will stick from COVID and what won’t. Look, digital transformation and ecommerce are the obvious places to point and they’re exceptionally important and a lot of those trends are here to stay.
A couple of things worth thinking about beyond those two very important dynamics. One is the way people are distributed across the country. We’ve had a trend for 40 years of cities like New York and San Francisco being the only places you could go if you wanted career mobility and economic mobility. And that led to incredible concentrations of wealth, very high real estate prices and the like.
The remote working environment should ease some of the pressure in those cities and open up other cities to growth. And that has impacts on the housing market and the housing stock in the country. That’ll take place over decades. It’s going to be important to understand the cycles in any given time. But a sustained investment period in housing seems an interesting downstream implication.
And another one we think a lot about is small business ecommerce enablement. There’s a lot of focus on digital transformation with the larger software companies, but every small business needs to delight its customers and serve its customers in a way that they’ve historically lagged on.
The idea for a millennial of calling up a restaurant to order your food rather than just do it online is a serious piece of friction that may cause the restaurant to lose business. So this idea of enabling small businesses to embrace technology is I think another theme that we think could have a lot of legs coming out of COVID.
Maris: Thanks, Brian. Doug, would love to get your thoughts on what you think sticks and where the opportunities lie.
Rao: Yes. So I definitely agree with what Brian said. When COVID hit… We own a luxury retailer. And when COVID hit, the stock dropped like a stone. Historically, the stock had correlated quite closely with travel stocks and, in particular, where the Chinese were travelling. And a large percentage of their business came from both duty-free stores and high streets in Europe.
And so a funny thing happened though, is that their business came roaring back. Unlike travel, which stayed reasonably flat after collapsing, this company’s business came roaring back. And the point of it is that what they benefited from was a multi-channel approach to accessing their customers.
And so I think the biggest trend we’re seeing, and some of the things Brian talked about are subsets of that, is that every enterprise, whether it’s a government or education or corporation, is figuring out ways to be more multi-channel because multi-channel creates resiliency. And so the one thing I hear from many of our large cap companies is that they’re focused on more resiliency and adaptability. And so Brian talked about work. Work is going to look different.
Another area that I think we’re very interested in is healthcare. And so one of the enabling technologies during COVID was telemedicine. And so when you think about the Apple watch and telemedicine and continuous glucose monitors and things like that, there are going to be other ways for people to access the healthcare system.
If you look, the two most stubborn areas of structural inflation in the U.S. economy have been healthcare and education. And both of those have really been untouched by digital technology. And so that’s another area that we’re spending a lot of time focusing on, is what are the companies that are going to benefit. Certainly, we think the one of the biggest costs in the US healthcare system is compliance on chronic illnesses, and so this is a very clear and obvious benefit to society.
And so those are the types of things that we’re looking for or that we’re looking at in terms of how things have changed. And we do definitively think that a multi-channel approach to accessing your customer is the best model, going forward. And that’s one of the reasons we have seen a big increase in investment in software and hardware.
Maris: Thank you, Doug. If I can, just shifting the dimension here for a moment, and this is going to be I think a very helpful question to have you both opine on given that, Doug, you’re one of our leading large cap growth portfolio managers, and Brian, you’re our leading mid cap growth portfolio manager. We’ve had a decade-long level of outperformance of growth over value. And recently, we’ve seen some semblance of value reasserting itself certainly from the fall of 20 and we’re seeing certainly talk about rotation and a stylistic change happening in the market.
What are your thoughts, if you can, in terms of whether or not you think… What do you think of the attractiveness of the growth sector relative to valuation? And what do you think the catalysts are to drive growth stocks going forward? Doug, if you wouldn’t mind, do you want to lead us on that?
Rao: Sure. So I recently heard Howard Marks speaking about growth versus value. And he said the definitions are so crazy because what constitutes a growth stock in the index is their growth in revenue, their growth in earnings, their growth in free cash flow. What constitutes a value stock in the S&P value is price to book and price to earnings, so it has nothing to do actually with the fundamentals of the business.
And so we try not to think about things in terms of growth and value. We tend to start by thinking about are you on the right side or the wrong side of the digital divide. And so if you deconstruct any index in the United States over the last decade, growth has outperformed. And the reason growth has outperformed is because there are more technology-oriented companies as a percentage of the index, and those companies have grown earnings and free cash flow at a greater rate. And so clearly, in this period of recovery, you should see cyclical stocks, which I guess people could label value stocks, but I don’t. We think of growth stocks as just being companies that have a positive sloping secular line over time. But their earnings will grow the fastest and will certainly grow the fastest in 2021.
What can help growth stocks outperform again, and Brian touched on this last week, was the Fed still seems fairly sanguine about rates and so therefore, growth outperformed. But I think more importantly for us, what we’re looking for are how our companies comp the comp, so what their comp store sales look like in 2021 over the benefit that they had over 2020. And so they’re going to have to climb that wall of worry and put up good numbers.
But I think the thing that I think is more interesting is everyone who is excited about the cyclical stocks today, they’re going to be faced with the same situation as the growth companies were faced with in 2021, which is tougher comps as things are very easy for the cyclical companies today as compared to last year, where their businesses collapsed.
So I think the biggest question that I think Brian and I probably agree upon is that I think we both do believe that low-end wages will continue to rise. And it started before COVID. It started probably in 2017. And the labor is still fairly short in the United States. Some of it is stimulus related.
But that wage inflation that should happen probably will lead to some structurally higher inflation, going forward. But my firm belief is that that is good for the economy, it’s good for the stock market and it’s good for society.
Maris: Brian, your thoughts.
Demain: Yes. So, look, it’s hard to time the growth-value dynamic over the next quarter or half year. But some of the things we’re thinking about around this, one thing echoing Doug’s comments about the dynamic of growth versus value, the traditional growth-value paradigm was written during an era of the industrial economy where growth was constrained by putting PP&E in the ground where you had traditional capital cycles in industries.
In a digital world with network effect business models, growth businesses can scale faster and larger than they ever could in the past. So that would argue for… It’s hard to look at backward-looking historic spreads between growth and value and make sense of them in the current economy. That being said, a stock is still ultimately worth the sum of the discounted value of its future free cash flows.
And when I look down in market cap, the benchmark that my strategy uses is the Russell Mid Cap Growth, and in that benchmark, a full 30% of the benchmark trades at over 15 times revenue. That’s not earnings. That’s not EBITDA. When you understand what a company trading at 15 times revenue will have to do to justify that stock price, it probably needs to compound its revenue at something close to 20% organically for a decade. And that’s something that less than 1% of public companies have done over the last ten years.
So the dynamic is different in different parts of the market cap spectrum. But down in market cap, many… This dynamic of internet scale businesses is a very real dynamic, but there’s a fair amount of optimism priced into a fair number of the more rapid growers in the lower cap growth, the growth benchmark.
So I think the dynamic as a growth investor is to understand the fundamentals of the businesses but also be mindful of valuations. So a value investor should care about growth. A growth investor should care about the value they pay for the business. And I think that’s the most important dynamic for us in the mid cap area of the market today.
Maris: Thanks, Brian. Just as a follow up, if I can, as someone who is looking for companies that are going to grow and transform society potentially, right, are there any areas or industries that excite you the most?
Demain: Yes. So I’ll touch on a couple. We’re excited about what’s going on in biotechnology. Basically, with all the advances in biology, gene sequencing, but then you layer on machine learning, that really amps up the speed of drug development and discovery.
And we’re seeing some unique treatments in gene therapy. mRNA has been discussed quite a bit. Liquid biopsy, which is diagnosing solid tumor cancers just using tumor DNA, finding tumor DNA that’s floating through your blood is a really amazing innovation that could lead to earlier cancer diagnosis and really transform that paradigm. So that’s something we’re spending a lot of time on.
Another area I would point to is we’re obviously 20-plus years into the growth of ecommerce but some of the last, most challenging to move online segments of durable goods are really moving online, whether that’s furniture or housing or automobiles. And we know the playbook, having watched other industries move online. And predicting that curve is a pretty powerful trend to invest behind in the current environment.
Maris: Thanks. And Doug, your thoughts? I know you talked a little bit about what’s happening in healthcare.
Rao: Yes. I think Brian stole my answer for the most part. But the only thing I would add is I think we’re all very excited about battery technology and battery storage and how both the electric grid will become more important, and the transition of the automobile fleet globally from internal combustion to electric. And the investment cycle that’s required is going to span decades and trillions and trillions of dollars. So that will certainly be fertile ground for investing.
Maris: Great. And then final question for you both and one that probably hurts me to ask more than others, given that I manage global and international equities. But the U.S. equity market has dramatically outperformed its global counterparts for the better part of a decade. What are your thoughts with respect to the prospects for U.S. equities going forward? Doug, do you want to lead us on that?
Rao: Sure. So the U.S. still punches well above its weight from an innovation standpoint. And so we’ve been blessed with breakthrough building-block technologies and platform companies that have been able to scale globally. And so getting back to Brian’s point about the capital intensity and the network effects, the U.S. has really been enriched by a number of companies that have really come to dominate large parts of the world. And so that doesn’t mean that that is our birth right and I’m increasingly impressed with a lot of the Chinese innovation, particularly in the internet space. And we’re starting to see actually more innovation out of areas of Europe, particularly Scandinavia, that are interesting as well.
Maris: Your thoughts, Brian?
Demain: Yes, I don’t think I have much to add. I guess the only other points I would make is the pandemic certainly highlighted the industries in which the U.S. is the global leader, those being technology and healthcare, which were both… Their profiles were certainly enhanced by the pandemic.
And then also the U.S. policy response was more aggressive and probably appropriate for the dynamics last year than we saw from much of the rest of the world. And those things have helped. The going forward call is a tough one to make. But it is clear that the U.S. does still lead the world in terms of innovation. And that’s a pretty good starting point for value creation.
Maris: Certainly. Well, look, Brian, Doug, I just wanted to thank you for your time today. Really appreciate it. Hopefully the audience found it as insightful as I did. And with that, going to send it back to Louise. Louise, thank you.
Beale: George, thank you very much. And I’m sure the audience did find it very insightful indeed.