The following is an excerpt from our recently published Dynamic Growth Opportunities (DGO) portfolio update. For a copy of the full document, please contact us.
As a fundamentally-based active equity manager, the core to value delivery for our clients is our continual ability to discern which companies’ equity values will be disproportionately rewarded. In the same fashion that we relentlessly scour the investable universe to uncover companies better at adapting to an increasingly dynamic market, we also consistently reflect inwardly to ensure that our investment process remains sufficiently adaptable at uncovering the winners of today, as well as those that will unfold over the next decade and beyond. This continual internal reflection of relevance is increasingly imperative when tectonic shifts impact the ground beneath us, and we see a change in the composition of market participants as a major force causing these shifts. We also don’t see this dynamic changing anytime soon.
The pool trading volume is becoming increasingly populated by algorithmic participants and passive indexers attempting to mitigate drift from their pegged bogies, which is an important dynamic to consider given that every liquid portfolio marks its entire value based upon the last-traded value of its securities. This occurs regardless of the motivations of the buyer or seller. As such, we fully expect short-term price reactions today to look very different than those of the past, which in turn makes it both foolish and costly to rely heavily upon historical charting as a guide for projecting the future. That’s precisely why we continually challenge ourselves to think through the noise, while simultaneously holding ourselves accountable to our long-term track record as the ultimate arbiter. As our quarterly progress stacks up evidence towards this initiative, we have been pleased with how these efforts have translated into alpha generation for DGO.
Regarding the increasing passive participation, little stands in the way of stemming the tide of capital flows towards indexed strategies at the macro level. This trend began in earnest around 2011, and it’s hard to uncover evidence to suggest the trend will abate: we’ve seen $267 billion in net inflows to passive US equity strategies versus $190 billion in net outflows from active strategies for the 12-month period ending June 30, 2019. However, unlike other markets where pure speculation or scarcity solely drive any hope for appreciation (i.e. all cryptocurrencies), the good news is that nothing has changed or will change the universal truth of what common equity share prices ultimately reflect: the future cash flow of the underlying company. Price indeed can and will deviate from value, sometimes for extended periods, especially when trading volumes between algorithmic-based and passive strategies command upwards of 80% of the market. However, capital will always take on Newtonian-like properties in its relentless pursuit for the highest-yielding, risk-adjusted opportunity, and its impact eventually drowns out all of the noise that can cause short-term dislocations. To witness this phenomenon, one needs to look no further than the impact of M&A.
To receive a copy of our entire SWS Growth Equity quarterly update, please contact us.