Year to date Commentary: Quantitative U.S. Large Cap Growth Equity
STRATEGY APPEARS WELL POSITIONED,
DESPITE RECENT UNDERPERFORMANCE
- Equity markets in 2019 have rewarded strategies favoring large growth stocks with high valuations, particularly in technology, and punished more diversified investment approaches.
- The Glenmede Quantitative U.S. Large Cap Growth Equity Composite returned 21.7% gross of fees for the year as of August 31, versus 23.3% for the Russell 1000 Growth Index — underperforming by -1.7%.
- The strategy’s underperformance is attributed to its multi-factor approach favoring stocks with lower valuations, underexposure to the five largest technology stocks and companies with positive earnings surprise signals.
- Research from Nomura/Instinet shows that lowervaluation stocks have underperformed during periods similar in 2019 with a large decline in the U.S. Treasury yield curve — and outperformed in subsequent years as the yield curve normalized.
- We believe the Glenmede Quantitative U.S. Large Cap Growth Equity strategy, favoring stocks with attractive valuations and strong fundamentals, is well-positioned, in markets where the largest growth stocks with high valuations are less attractive and more volatile.
STRATEGY UNDERPERFORMED IN 2019 VERSUS THE RUSSELL 1000 GROWTH INDEX
Year to date, the S&P 500 and the Russell 1000 Indexes have returned 18.3% and 18.5% respectively. High momentum and defensive stocks have led the market higher as investors continued to seek out growth with concerns on the ongoing trade war with China, slowing global growth and the inversion of the Treasury yield curve. Growth stocks have significantly outperformed this year with the Russell 1000 Growth Index (total return of 23.3%) ahead of the Russell 1000 Value Index (total return of 13.8%) by almost 10%. Dispersion across equity styles has been wide with mid cap growth (+28.9%) and large cap growth (+22.8%) outperforming all other style categories (Exhibit 1).
2019 EQUITY MARKETS PUNISHED STRATEGIES FAVORING LOWER VALUATION, CAPITALIZATION AND RISK
The Glenmede Quantitative U.S. Large Cap Growth Equity Composite had a total return of +21.7% (21.1% net) through the end of August. On a relative basis, the Quantitative U.S. Large Cap Growth Equity Composite underperformed the Russell 1000 Growth Index by -1.7% (-2.2% net). A significant portion of the relative performance shortfall can be attributed to multi-factor stock selection biases towards stocks with attractive valuations, relative underexposures to the five largest technology/internet companies (MSFT, AAPL, AMZN, GOOGs and FB) and downside risk screens (e.g. earnings surprise signals) as depicted on Exhibit 2.
A CHALLENGING MARKET FAVORED THE LARGEST STOCKS WITH HIGH PRICE/EARNINGS RATIOS
It has been a challenging environment for our strategy and many other active large cap growth equity managers who focus on owning companies with a combination of favorable fundamentals, earnings growth and reasonable valuations. Companies with Price-to-Earnings ratios above 25 returned an average of 26% (Exhibit 3), significantly outperforming the Russell 1000 Growth Index. The average stock in the Russell 1000 Growth Index (equal-weighted) with P/Es under 15 have underperformed with an average return of only 13%.
Relative valuation spreads between the Russell 1000 Growth and Value Indexes have reached 10 year highs in August, including price/book, P/E (forward) and price/sales. (Exhibit 4)
As factors like price momentum and market capitalization have outperformed in 2019, the largest Russell 1000 Index constituents appear less attractive and more volatile than smaller cap ranges. The top 50 stocks by market cap show elevated levels of price/earnings, price/book, price/sales, and PEG (Exhibit 5).
EQUITY STYLE PERFORMANCE HAS BEEN CORRELATED WITH SHIFTS IN THE TREASURY YIELD CURVE
Joseph Mezrich, director of quantitative research at Nomura/Instinet has analyzed the strong relationship between equity style performance and significant changes in the Treasury Yield Curve. Since 2009, the Treasury yield curve (10-year versus average of 2-year and 3-month) has declined from over 3% spread to an inverted yield curve (as of 8/31/2019). Over this period, stocks with the most attractive book/price (top quintile) have underperformed the most unattractive (bottom quintile) by about 27%. In past periods with large declines in the yield curve (1997-2000 and 1977-1981), there were similar trends of value stock underperformance followed by strong outperformance in subsequent years as the Treasury yield curve normalized (Exhibit 6). We have started seeing the reversal of this in September as evidenced by an increase in the 10-Year Treasury yield with value stocks outperforming growth stocks during the first two weeks of the month.
THE STRATEGY REFLECTED A P/E DISCOUNT TO THE RUSSELL 1000 GROWTH INDEX
The Quantitative U.S. Large Cap Growth Equity strategy with its price/earnings ratio of 17.7 versus the Russell 1000 Growth Index of 23.5, is now at a 24.6% discount relative to the Russell 1000 Growth Index. This is the largest relative valuation discount in over 10 years (Exhibit 7).
OUTLOOK: GLENMEDE’S MULTI-FACTOR APPROACH IS WELL POSITIONED IN THE CURRENT ECONOMY
The latest U.S. real GDP estimate for the 3rd Quarter is 2.0% versus 2.1% for the second quarter and 3.1% in the 1st Quarter. Economists are estimating annual GDP growth of 2.4% for 2019 and 1.8% in 2020. While growth is moderating, the U.S. consumer is still holding up with personal consumption expenditures estimated to grow 2.5% this year and 2.2% in 2020. Although the ongoing trade war with China and the recent inverted yield curve continue to be potential concerns, many expect the Fed to lower the discount rate at the upcoming meeting. Currently our leading industry group indicators favor overweightings in Materials, Capital Goods and Financials, and underweighting Consumer Discretionary and communications. Going forward, given normal market volatility and positive economic growth, we believe this strategy is well positioned with its multifactor approach favoring stocks with lower valuations, stronger fundamentals, positive earnings/revenue estimate trends and attractive technicals. (Exhibit 8)
Despite recent underperformance, we believe the Glenmede Quantitative U.S. Large Cap Growth Composite is well positioned for a potential rebound, given its multi-factor approach favoring stocks with lower valuations and stronger fundamentals.
The strategy’s P/E of 17.7 reflected a nearly 25% discount to the Russell 1000 Growth Index’s P/E of 23.5, as of August 31, 2019 — a potential advantage if the market rotates toward lower-valuation stocks.
Given expected positive economic growth and strong consumer spending, our leading indicators favor overweighting Materials, Capital Goods and Financials, and underweighting higher-priced sectors, such as Consumer Discretionary and Communications.
The views expressed represent the opinions of
The views expressed represent the opinions of the portfolio managers as of August 31, 2019. There can be no assurance that the same factors would result in the same decisions being made in the future. In addition, the views are not intended as a recommendation of any security, sector or product. Past performance is not indicative of future performance. Returns reported represent past performance and are not indicative of future results. Actual performance may be lower or higher than the performance set forth above. For institutional adviser use only, not intended to be shared with retail clients