Tilting towards opportunities during a market crisis
The beginning of March 2020 ushered in a widespread sell-off across asset classes and geographies as investors switched to safer strategies or disinvested altogether.
The fundamental principles of investing dictate that in uncertain times only steady and rational minds can position investors to benefit from market shocks and prepare them for the inevitable recoveries.
Rational investors should focus on trends and opportunities based on prevailing investment style factors. These style factors include well-known ones such as value, growth, quality and momentum. Investors must understand how their equity portfolio has been positioned from a style factor perspective as this will provide insight as to how the portfolio will navigate the current market turbulence and how it is positioned to emerge.
Our conviction of the merits of style investing, as well as our success with it over the years, has shown that certain styles – particularly growth and quality as well as momentum – are in the winners’ circle in this time of market turbulence. Furthermore, a V-, U- or L-shaped COVID-19 recovery path scenario will produce specific style winners.
Winners through the current turbulence: a style lens
Strategically, our focus is not on which equity sectors will be the winners during a crisis, but rather which style(s), and hence companies, will be the winners. Our extensive research has shown how specific styles direct investors towards companies that will be the long-term drivers of South African equity returns.
In the first quarter of 2020, at the start of the COVID-19 pandemic, the growth and quality investment styles showed how investors flocked to the safety and resilience of good-quality companies that have been growing their earnings consistently, despite challenging times. This can be seen by growth and quality long/short returns in Figure 1. In this crash, we experienced a sharp equity sell-off and a prevailing risk-off sentiment. Despite this, and unlike in previous market crashes, the momentum style saw investors flock into trending companies. This can be seen by momentum long/short returns in Figure 1. However, we believe this momentum flight reflects the feature of the momentum style of ‘latching on to whatever works’, which is similar to how it had latched on to the growth style, which appeared to be working in 2019.
The style loser was the value style, as investors were selling off both defensive- and cyclical-value companies in this risk-off environment.
Figure 1: Sector long/short returns
What next? The market direction informs best-performing style
A recovery is bound to happen as investors return to the market, economies regain lost ground, and as the pursuit for alpha returns over defending a portfolio is resumed. This is when lucrative opportunities arise from correctly predicting a V-, U- or L-shaped recovery path scenario and positioning a portfolio’s strategy with the appropriate style tilting. Our analysis provides a useful understanding of which style is likely to benefit most from the different types of market recoveries.
- In a V-shaped recovery path (the best-case scenario) where we expect a sharp and relatively fast-paced bounce-back after a market shock, we believe the value style is appropriate. This style tends to perform best in a risk-on environment driven by a positive outlook.
- In a U-shaped scenario, which is similar to a V but takes longer to bounce back after the market shock, we believe the quality style prevails. This style tends to be resilient and performs best in times of uncertainty as investors flock to the safety of good-quality companies.
- In an L-shaped recovery path (the worst-case scenario) where there is a more protracted and stagnant negative impact on future economic activity, we believe the growth style does best. This style tends to reward companies that have been able to deliver earnings growth, despite challenging times.
Even though the pandemonium around COVID-19 has been relatively short-lived so far, interesting patterns supporting our views have already emerged. The Figure 2 scatter-plot depicts the daily returns from 24 February 2020 to April 2020. Figure 3 shows how by averaging these returns there is a clear preference during falling markets for quality and growth styles at the expense of value. However, when the market bounced back in April 2020 on renewed positive sentiment, we see a clear preference for the value style, at the expense of quality and growth styles.
Applying a macroeconomic lens to guide market direction
We have seen that different styles produce different performances during specific macroeconomic conditions. Our approach has been to identify and forecast these macro conditions using the insights of our proprietary quantitative macro (QM) indicator. Specifically, we have seen that a recovery situation supports the performance of value style, an expansionary phase supports momentum, a slowdown phase supports quality, and a contraction favours a growth style.
It is important to note that, prior to the COVID-19 crisis, our QM indicator had already forecast a contractionary environment from the beginning of 2019. In Figure 4, we have zoomed into the past four years’ forecasts of the QM indicator to explain the different environments it had forecasted and which styles were the winners in each calendar year.
In 2020, our QM indicator continues to forecast a contractionary environment, which should be no surprise in the context of the additional strain from the COVID-19 pandemic on economic activity. This contractionary environment tends to favour the growth style, as there is little economic growth, overlapped by increased uncertainty, which also favours the quality style.
Defensive strategy: tilt towards growth and quality
Our QM indicator continues to signal a persistent contractionary macroeconomic environment. As a result, our STANLIB Multi-Factor Fund (see Figure 5) is defensively positioned with our biggest allocation towards the growth and quality styles, and our smallest allocation to value. Companies that currently score highly on this combined style allocation, include Clicks, Naspers, Santam, Vodacom and Capitec, and the fund is therefore overweight in these stocks.
Figure 5: Current factor positioning: April 2020
Style tilting to weather the storm
Our investment approach to tactical positioning in this environment and to optimise returns over the longer term means it is vital to:
- examine a portfolio’s positioning;
- focus on identifying the appropriate style rather than sector to guide asset allocation;
- use robust macroeconomic tools that forecast economic environments; and
- use a rules-based and systematic approach to position the portfolio for a V-. U- or L-shaped recovery path.
Regardless of these unusual circumstances, we continue to rely on our data-driven, rules-based and style-focused investment philosophy to identify and reap rewards from the opportunities that arise. Our analysis above, as well as the success of the STANLIB Multi-Factor Fund, provide proof that style investing in the South African market not only works in defending a portfolio, but also in positioning a portfolio for recoveries.