Contributors
Related Articles
Equity markets have witnessed significant gains and shifts, including rising market concentration. Learn how this evolving landscape fosters an environment conducive to Select Growth’s high conviction and long-term approach.
Key Points
- Equity markets have overcome numerous headline-grabbing events to produce tremendous gains over the past three decades.
- Over this period, less obvious yet influential changes occurred, including a rise in market concentration, a dramatic decline in holding periods, the rise of the intangible economy, and a 30-year bull market in bonds.
- In our view, the emergence of these factors is creating an environment supportive of fundamental, long-term oriented, high-conviction approaches to security selection, such as those employed by Select Growth.
Capital markets and the domestic economy have undergone several slow-moving yet impactful changes in the 32-year history of Select Growth. Over this period, equity markets overcame numerous headline-grabbing events to produce tremendous gains, while more impactful yet less obvious changes related to the macroeconomy and market structure occurred simultaneously.
We believe a number of these changes are reaching an inflection point that will create a more supportive environment for active management and Select Growth’s fundamental, long-term oriented, and high-conviction approach. With an increasing portion of the investment industry constructed to benefit from the backdrop of recent years—mainly through quantitative and passive strategies—it’s our belief that selectivity and long-term thinking will be the keys to success moving forward.
The Successful Few
Since its inception in February 1992, Select Growth has navigated several market-moving events to grow capital and add relative value. In the face of the tech bubble of 2000, the global financial crisis of 2007 to 2009, the COVID-19 pandemic, three bear markets, and four rate-tightening cycles, the strategy produced a cumulative, net of fee return of 3,787 percent through May 2024, relative to the 2,460 percent advance for the Russell 1000 Growth Index. Over this period, Select Growth outperformed the Russell 1000 Growth Index by an average of 2.8 percent (net of fees and expenses) in 75 percent of rolling five-year periods.
The strategy is now one of 69 large-cap growth investment products that have remained in existence since February 1992. Of those, in the period from February 1992 through May 2024, Select Growth is one of only seven products that has generated a positive excess return relative to the Russell 1000 Growth Index of more than 1 percent (net of fees and expenses), as reported by eVestment.
Power of Long-Term Compounding
Recession dates are sourced from the Federal Reserve Bank of St. Louis and based on the GDP-Based Recession Indicator Index. Rate hikes defined as month from first rate hike through the peak Federal Funds rate in each rate hiking cycle. Inception date is 2/29/1992. Returns are cumulative and calculated monthly. The investment results shown are net of advisory fees and expenses and reflect the reinvestment of dividends and any other earnings. The investment results are those of the Select Growth Tax Exempt Institutional Equity Composite. Net returns presented are calculated using actual fees and performance fees if applicable. Past performance is not indicative of future results. GIPS Reports found here
Underlying Shifts in Equity Markets
While Select Growth navigated numerous headline-grabbing events, a number of more glacial yet impactful transformations were occurring simultaneously. Many of these changes have created a challenging environment for active managers, resulting in a growing shift toward passive exposure to equity markets. In fact, the amount invested in passive equities recently surpassed active mutual fund assets to reach 51 percent of the $29 trillion in global mutual fund and ETF assets.1
We believe the success of Select Growth and active management will depend on the ability to adapt and capitalize on these changes. In our view, four key shifts in market structure and the macroeconomy have reached a tipping point that creates an opportunity for our active, high conviction, long-term approach. In the section below, we detail the long-term changes we’ve seen in equity markets and their implications moving forward.
Trend: Declining Holding Periods
Opportunity: Time Arbitrage
The market dominance of short-term trading amplifies the potential to add value by taking a long-term view, in our belief. Earnings growth remains the primary determinant of share prices over a five-year time horizon. Our disciplined focus on this allows us to cut through the noise of quarter-to-quarter headlines to focus on what’s material—the ability of a business to sustain earnings growth.
In this environment, we have found that basket trading driven by shifts in macroeconomic expectations or headlines is creating disconnects between stock valuations and the long-term earnings power of businesses.
We often use these near-term, sentiment-driven sell-offs to add to businesses in which our expectations for earnings power over our five-year horizon are unchanged. We view time arbitrage, our ability to look past transitory headwinds or headlines and maintain our long-term perspective, as our primary lever to drive alpha.
Trend: The Rise of the Intangible Economy and Superstar Companies
Since the 1970s, the domestic economy has shifted dramatically from an economy based on tangible assets (property, plants, equipment, etc.) to one based on intangibles. Asset-light businesses built on intellectual property have often developed powerful network effects, resulting in impressive profitability as they scale their internally generated assets. The massive level of capital required to replicate these businesses often creates significant barriers to entry and limits competition. As a result, scalable intangible assets, in combination with large total addressable markets, have led to the extraordinary economic outcomes achieved by megacap U.S. technology companies. These select “superstar” businesses have maintained high returns on invested capital for a longer duration than seen historically.
Reflecting this shift, the consumer staples, industrials, energy, financials, and materials sectors have fallen from 55 percent of the S&P 500 in 1992 to 34 percent as of May 2024. Meanwhile, the weight of the information technology sector has risen from 6 percent to 31 percent. Over the same period, the technology sector has seen a steady rise in net profit margins, driving overall margin expansion for U.S. equities as measured by the S&P 500.
Source: Ocean Tomo Intangible Asset Market Value Study(LHS), Factset (RHS). Inception date is 2/29/1992.
Opportunity: Assessment of Forward-looking Quality
The increasing portion of businesses built primarily with intangible assets emphasizes the need for a forward-looking assessment of quality and earnings growth, in our view. This conflicts with the increasing use of systematic approaches that often tilt exposures to one factor and/or style that has historically produced outsized risk-adjusted returns. In fact, since 2000, the eVestment U.S. Smart Beta universe has grown from 15 to 95 products3.
We believe the downfall of these systematic approaches will come from their inability to assess the potential earnings growth from businesses investing heavily to capture market share and widen their competitive advantage. Current accounting standards, which expense rather than capitalize investments in intangible assets, depress the accounting profits of businesses—typically high-growth businesses—investing heavily in intangible assets. As a result, many of these businesses are delayed in reaching profitability or have distorted valuations, keeping them from value and/or quality factor-based approaches and, in some cases, market cap-weighted indexes.
We seek to account for and exploit these distortions through an approach that focuses on a more nuanced, forward-looking assessment of quality. Our process seeks to identify businesses with attractive unit economics and financial strength, which we believe will see profitability inflect as the business reaches sufficient scale. We expect the competitive advantages of these businesses as the leaders or emerging leaders in industries with significant secular growth will allow them to sustain above-average earnings growth. With a growing amount of money invested in strategies constructed based on backward-looking data, we believe there is an increasing inefficiency for our forward-looking, qualitative approach to capture.
We believe this approach will allow us to identify the next industry disruptors early and to invest with conviction. Recent, successful industry disruptors deferred profitability by choice to acquire customers and build infrastructure, resulting in an improved competitive position. Investors who recognized the growth in the underlying earnings potential of these businesses as they reinvested capital were ultimately rewarded by significant share price appreciation.
Trend: Market Concentration and the Shrinking Public Market Universe
Opportunity: Risk Management, Improving Breadth, and Selectivity
Passive investments in U.S. equities now present significant exposures to single-stock risk. We recognize the quality of many of the largest market capitalization businesses yet believe the fundamental trajectory and risk-to-return potential tradeoff for these businesses may differ significantly. This provides the opportunity to manage portfolio risk through a selective exposure to the top five weights in the Russell 1000 Growth index, which now represent a 41 percent weight.
Moreover, the significant concentration of indexes limits the potential impact from businesses earlier in their growth trajectory. This concentration limits the index’s exposure to other areas where we find attractive secular growth, including cloud infrastructure and data analytics, medical devices, cybersecurity, semiconductor capital equipment, and consumer internet. While the earnings growth, profitability, and reasonable valuations of many megacap businesses sets a high bar, we see opportunities in non megacap businesses to develop differentiated insights and diversify portfolio exposures.
Trend: 30-year Bull Market in Bonds
U.S. Treasury yields have been in a period of persistent decline since the 1980s as a deflationary combination of globalization and technology supported benign inflation. This dynamic was amplified by the COVID-19 pandemic, as the U.S. government provided stimulus to prop up the domestic economy, leading to a significant expansion in the money supply and an easing of monetary policy that resulted in negative real yields. This era of easy money subsidized lower-quality business models that were able to externally finance growth, often despite poor unit economics, resulting in heightened levels of industry competition. This created a challenging environment for active managers seeking to differentiate businesses based on qualitative assessments of quality and earnings power.
Opportunity: “Normal Rates” and Industry Rationalization
Treasury yields have now reached levels considered historically “normal,” and many expect this higher rate regime to persist, due to the inflationary pressures of labor shortages, deglobalization, and the green energy transition. While conventional wisdom says that higher rates are a headwind for growth equities, we see evidence that this environment will result in greater dispersion in business fundamentals and industry rationalization. We view these conditions as more supportive of fundamental-based approaches to security selection.
More specifically, we believe the higher cost of capital will disproportionately affect the relative competitive position of businesses. Already, we’ve observed the ecommerce and food delivery industries rationalize as smaller-scale ultra-fast delivery competitors have recently gone out of business. Meanwhile, in the streaming video industry, outside of the largest provider by market share, other competitors lost roughly $20 billion in aggregate in 2023. As a result, each competitor is reducing content budgets and raising prices, creating a relatively more benign competitive environment for the leading streaming video provider.
Conclusion: Equity Markets’ Evolution Enhances Our Approach
Equity markets are continually evolving. While most investors focus on near-term risks and macroeconomic headlines, less visible transitions are always present. Over time, these less visible changes in the market structure and macroeconomic environment are likely to influence how managers construct portfolios and how investors allocate. Recently, these changes have rightly led to a proliferation of passive and systematic investment strategies.
It’s our view that the changes described above are creating an increasingly attractive environment for our fundamental high-conviction approach to security selection. The combination of a rising cost of capital and market concentration emphasizes the need for selectivity. Meanwhile, the changing nature of the economy and the rise of short-term trading have, in our view, amplified the benefits of a long-term perspective and a nuanced assessment of business fundamentals. While there will always be a place for low-cost exposures to market betas, we believe these developments are creating a backdrop that is increasingly supportive of our ability to generate alpha.
1 Patturaja Murugaboopathy, “Global Passive Equity Funds’ Assets Eclipsed Active in 2023 for First Time,” Reuters, February 2, 2024, https://www.reuters.com/markets/us/global-markets-funds-passive-2024-02-01/
2 Ben Carlson, A Wealth of Common Sense, “Buy & Hold is Dead, Long Live Buy & Hold,” February 17, 2023, https://awealthofcommonsense.com/2023/02/buy-hold-is-dead-long-live-buy-hold/#:~:text=The%20average%20holding%20period%20for,years%20back%20in%20the%201970s.
3Source: eVestment as of December 2023
4 “Why Has the Number of Public Companies Declined,” BlueTrust, September 13, 2023, https://www.bluetrust.com/blogs/why-has-the-number-of-public-companies-declined/#:~:text=In%201996%20the%20number%20of,and%20new%20industries%20and%20technologies.
Disclosures:
The investment results are those of the Select Growth Tax Exempt Institutional Equity Composite as of 5/31/2024. The investment results shown are net of advisory fees and expenses and reflect the reinvestment of dividends and any other earnings. Net returns presented are calculated using actual fees and performance fees if applicable. The views expressed are the opinion of Sands Capital and are not intended as a forecast, a guarantee of future results, investment recommendations, or an offer to buy or sell any securities. The views expressed were current as of the date indicated and are subject to change. This material may contain forward-looking statements, which are subject to uncertainty and contingencies outside of Sands Capital’s control. Readers should not place undue reliance upon these forward-looking statements. There is no guarantee that Sands Capital will meet its stated goals. Past performance is not indicative of future results. All investments are subject to market risk, including the possible loss of principal. The strategy’s growth investing style may become out of favor, which may result in periods of underperformance. The strategy is concentrated in a limited number of holdings. As a result, poor performance by a single large holding of the strategy would adversely affect its performance more than if the strategy were invested in a larger number of companies. Differences in account size, timing of transactions and market conditions prevailing at the time of investment may lead to different results, and clients may lose money.
Broad-based securities indices are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in a broad-based securities index. Sands Capital may invest in securities not covered by the Index. The Russell 1000® Growth Index measures the performance of the large- cap growth segment of the US equity universe. It includes those Russell 1000 companies with relatively higher price-to-book ratios, higher I/B/E/S forecast medium term (2 year) growth and higher sales per share historical growth (5 years).
The S&P 500 is a stock market index tracking the stock performance of 500 of the largest companies listed on stock exchanges in the United States.
The S&P Composite 1500® Information Technology comprises those companies included in the S&P Composite 1500 that are classified as members of the GICS® Information Technology sector. The S&P 1500, or S&P Composite 1500 Index, is a stock market index of US stocks made by Standard & Poor’s. It includes all stocks in the S&P 500, S&P 400, and S&P 600. This index covers approximately 90% of the market capitalization of U.S. stocks and is a broad measure of the U.S. equity market.
GIPS Reports found here.
Notice for non-US investors.