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Alexandra Morris was feeling pretty upbeat when she addressed staff to say, emphatically: “We’re back.”
Morris is the investment director at Norway’s Skagen Funds, which manages £5.6bn of assets across a clutch of different strategies and maintains a core focus on stock picking. The easy money era of low interest rates and drab inflation made life hard for her. “It was not any fun at all,” she said, as abundant liquidity pumped up worthy and unworthy risky assets alike.
But an aggressive series of interest rate rises and an outbreak of inflation raised expectations that some high-flying stocks might stumble in the new era of a higher cost of money. In turn, that might mean stockpickers and so-called value stocks will have their moment in the sun. “It’s time for active management, we’re back in business,” she recalls telling colleagues. “This is good for us.”
The only problem was: this was in early January. Soon afterwards, US stocks started sipping the artificial intelligence kool aid, sending a handful of related stocks flying and lifting the whole S&P 500 index. Why bother doing all the hard work finding diamonds in the rough when you can sit in a cheap index-tracking fund after all? Nonetheless, Morris is undeterred.
Active fund managers always say it is time for active management. The clue is in the name. They also always say it is time to look past whizz-bang, high-octane unprofitable companies and focus on cheaper but durable stocks instead. Again, that may well be true, but you never heard portfolio managers in the post-financial crisis era saying they were buying any old rubbish. Quality has always mattered.
Still, in the regime shift now under way, the stockpickers really mean it this time. In large part, this is about debt. When interest rates were low, companies did what you would expect and borrowed money on the cheap. When the pandemic hit, this went into overdrive.
But in the next year or so, the final bill will come due. A lot of companies are about to learn the hard way that they cannot roll over the money they borrowed at 2 per cent in 2020 at 2 per cent again in 2024. Try on 8 or 9 per cent for size, and good luck. Those paying back floating-rate debt are already feeling the pain of expensive debt servicing costs.
Whether this builds up into a wave of corporate defaults or failures is a matter of intense debate in investment circles. Rating agency Moody’s said this week that speculative-grade (ie, riskier) companies in the US have almost $2tn of debt falling due between 2024 and 2028, up by some 27 per cent from its earlier study covering the four years to 2027. In the next five years, a record $1.26tn in safer corporate bonds also fall due.
Also this month, Goldman Sachs totted up the stats to show that, astonishingly, almost half of all US-listed companies in 2022 were unprofitable. “Higher funding costs could force some of these companies to cut labour costs or even close,” analysts at the bank wrote.
For now, credit spreads suggest any alarm is well contained. Still, this is worrying news for holders of those stocks, including those with holdings through passive, index-tracking strategies. And it is potentially great news for stock pickers who hope they have done their homework well enough to avoid those particular names or even to pick cash-rich companies that are relishing the high-rates era.
“Right now, active management should be part of a portfolio,” says Helen Jewell, chief investment officer at BlackRock Fundamental Equities. Debt levels are one factor that could generate the dispersion between different stocks that she is looking for, but also, this environment lends itself to a close read of companies’ market share and strategy. Not all real estate or healthcare companies, for example, are alike, she notes.
Jewell likens this situation to preparing for a long run — an analogy I found quite amusing at the time, but less so while hauling myself around the Royal Parks Half Marathon with insufficient training under my belt last weekend. “If you’ve only trained for 12 degrees and it turns out much hotter, that’s when the really good runners shine,” she said. “You need to adapt.” (Reader: it was unusually warm, and I did not adapt.)
None of this is to say that the famous runaway performance this year of the Magnificent Seven stocks — Apple, Microsoft, Google parent Alphabet, Amazon, Tesla, Nvidia and Facebook parent Meta — is heading for a beating. Several of those stocks also comfortably meet any sensible definition of “quality”.
But active management-minded fund managers broadly agree that the only two ways of beating the market this year are to load up even further and rather recklessly on this tiny number of tech stocks, or to seek out other less popular companies with conspicuously durable earnings and low debt burdens, and lean on them to do the hard work. If you are lucky, some of them might even turn out to be acquisition targets.
This is not the first time we have heard this refrain from index-averse investors, and it will not be the last as large asset managers search for a way to convince clients they can beat cash rates without jacking up risk levels. But if it can’t work out now, when can it?
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