SWS Quarterly Research – April 2022 Update

The following is an excerpt from our recently published SWS Growth Equity 1Q2022 strategy update. For a copy of the complete document, please contact us. In the full piece, we provide our take on sifting through an increasingly volatile equity market backdrop, while assessing the strategic merits of our internally managed strategy for public growth-style equity.

Every couple of years, environments unfold that present significant challenges to certain portfolio construction practices. For active long-only public equity, namely ones populating portfolios with reasonable concentration, the current particular backdrop has stacked up a number of factors that make navigating entirely unscathed a mathematical challenge. As painful as the unrealized portfolio mark is to take at the end of the prior quarter, our constant effort to diagnose our forward path reveals a silver lining. We also see conditions for capital rotations into our targeted segment of public equity, one that has been long viewed by sideline observers as being top-heavy. We’ve been proactively repositioning our posture within the portfolio to take advantage of this, but we see areas of public equity that are also becoming increasingly compelling for reasons we dissect in this accountability update.

Measuring Stock-Picking Headwinds

The current environment has proven to be one of the more challenging for active equity managers, both long-only and long-short. Uncovering the precise drivers causing this to occur requires a deeper dive behind the broad market indices, given the headline results mask myriad dislocations lying beneath the surface. One particular headwind to our strategy has been the disparity in price outcomes in mega-cap growth issuers vs their small-/mid-sized growth counterparts. In the first quarter of 2022, this specific performance delta widened to its largest spread since March 1999. The Russell 1000 Growth Index (a proxy that includes the largest 499 growth-style US issuers) posted a +15.0% total return for the 12-mo period ending 3/31/2022. Conversely, the Russell 2000 Growth Index (with 1,244 constituents that skew further down the market cap size spectrum) posted a -14.3% total return for the same period. This 29-point delta has had an outsized impact on our portfolio due to our weighted average market cap of $291 billion in comparison to the $976 billion average of our index.

Concentration Not Unique to Growth: an S&P 500 Diagnosis

As we’ve highlighted in prior pieces, these pricing outcomes also are being delivered by an increasingly concentrated group of issuers given the market-cap-weighted nature of these indices. This phenomenon also extends beyond just growth issuers: the S&P 500 has been disproportionately impacted by a smaller set of multi-$trillion issuers. The S&P’s largest constituent, Apple Inc., now comprises 7.1% of the index. This single-issuer influence has surpassed prior maximum constituent sizes of Exxon in 2008 at 5.0%, Microsoft in 1999 at 4.9%, and IBM in 1985 at 6.4%.

Valuation multiple expansion also played a large part of AAPL’s disproportionate market influence, specifically 133% of the move since Dec 2018 when AAPL went from trading 11.6x forward-P/E vs 27.0x now. Meanwhile, its fundamental tailwinds have been derived from work-from-home computing demand compounded by a stimulus-fueled global consumer. These conditions arguably make for difficult comps heading into the coming quarters. Specifically, Apple’s upcoming March quarter print faces last years’ high-water revenue growth rate of +54%, at which time many of these benefits were in place.

A Reminiscent Exercise: Facebook a Decade Later

That’s not to say all mega-caps are created equal or that market-cap-weighted indices are flawed. As cloud computing ushers in the ability to treat compute capacity as a utility, it’s imperative to have appropriate portfolio exposure to the critical arms dealers here. In the case of Meta Platforms—the newly minted parent name to the issuer owning Facebook, Instagram, Whatsapp, and Oculus—its intent to be a meaningful player here can be seen by its AI Research SuperCluster. Discerning what this means to FB’s equity price today reminds us of a similar exercise of wading through uncertainty during Facebook’s IPO a decade ago. It is also indicative of a critical forecasting error by the market, one we specifically see persisting for a long time. We’ve also engineered our process to aspire to exploit this by transferring it into alpha.

Our 2012 meeting with Facebook management during the Chicago leg of their IPO roadshow was defined by heightened shareholder concern on whether the company would successfully pivot to mobile. Up until this point, over 90% of FB’s revenues were derived from selling banner ads on desktop PCs, where screen real estate was 20x the size of the iPhone 4S (current generation at the time). Conventional wisdom saw a theoretical cap on the number of display ads that could be crammed into a tiny mobile news feed, at a time when the company monetized US & Canadian monthly average users (MAUs) at $12/year.

The Market Continues to Misforecast Long-Term Inflections

The company’s underwriting banks’ out-year forecasts exemplified this long-term uncertainty. For example, Morgan Stanely’s stab at projecting eight years out to 2020 saw a $29.9 billion revenue scenario for Facebook, translating into a 25% CAGR off 2012’s base. Fast forward eight years later, and that projection proved to be a massive low-ball to the $86.0 billion revenue reality that the company eventually delivered, a 42% actual CAGR since its IPO. Today the company also now generates $214/year from its US & Canadian MAUs, with non-US geographies at a fraction of this figure…

To receive a copy of our entire SWS Growth Equity quarterly update, please contact us.