SWS Quarterly Research – July 2022 Update

This past Friday we published our quarterly update to SWS Growth Equity, our in-house actively managed equity strategy designed to exploit market inefficiencies over multi-year periods. For investors with higher risk tolerances and longer time horizons, Growth Equity takes a more concentrated approach with its 36 portfolio positions, in contrast to our asset allocation strategies that utilize diversified passively managed ETFs. Therefore, it contains a higher concentration of stocks that we believe have superior internally funded growth initiatives.  

For reasons that our quarterly update explores in greater detail, the 2022 market backdrop has proven challenging for Growth Equity and similarly styled strategies. However, in the diagnosis of the current dislocation’s cause, and in updating our positions’ underwriting with the latest data, we see silver linings forming. For a copy of the full analysis, please contact us.

Active management can be viewed as distilling the market down to a set of companies that one believes have superior return prospects. In periods of increasing investor fear, conditions can occur where entire baskets of stocks see indiscriminate pricing corrections. In some cases this can occur in light of improving return prospects of specific issuers. Our quarterly analysis highlights evidence of this unfolding:

Half of the issuers in the Russell 2000 Growth index—accounting for over 600 stocks—are down 64% YTD on average, with the bottom quartile down 77%. Narrowing participation isn’t isolated to small-cap though; the bottom half of all large-cap growth issuers are off 45% YTD on average compared to the -28% overall Russell 1000 Growth Index return. With such a large quantity of issuers experiencing massive price erosion in such a short time period, it’s a clear signal that the baby’s being discarded with the bath water. It also signals that many surviving business models (ones also using the opportunity to strengthen their competitive advantage) are being commingled with business model failures in the fire sale. 

For the past few quarters, the market has been rewarding larger companies disproportionately than smaller ones. Now that we have issuers with >$1 trillion market caps, it’s also creating a dynamic where these “megacaps” are having outsized impacts on market-cap weighted proxies, like the S&P 500 or the Russell 1000. Observing the spread between smaller and larger issuers shows a performance gap whose width hasn’t been seen in over two decades:

Our update last quarter outlined how a ballooning market cap disparity has translated into the market being propped up by a disproportionately small field of megacap issuers. The second quarter of 2022 did little to alleviate this disparity: Russell’s proxies show a 15 percentage point gap for the 12-month period ending June 2022, with the 2000 Growth (i.e. small-cap growth) posting -33.4% and the 1000 Growth (i.e. large-cap growth) posting -18.8%. This trailing-12-month gap narrowed from its 29-point spread last quarter, at which time it surpassed the prior record small-vs-large spread disparity occurring in Mar 1999.

We go into further detail on how today’s dislocation is more a confluence of factors than a singular culprit, but we see the solution requiring far less heavy lifting than the one required in 2008/2009:

The capital rotation required today is very different and far less about shoring up balance sheets in the entire financial services sector. It’s more about revealing promising embedded cash flow prospects to a new set of investor eyeballs—or to blurry-eyed ones of those that survive…From a timing perspective, it’s also likely to occur after the over-levered/overextended participants have been flushed out. That exercise began over 18 months ago in meme stock short squeezes and has continued along the way to retail investor capitulation and marquee crossover hedge fund hot water.

We’re also in an entirely different realm of credit risk when it comes to the health of the consumer. With inflation hitting levels last seen in the 1980s in US, we also see a path forming for improved conditions as we head into the back half of 2022:

We’re also on very different footing with the health of the consumer today than in prior downturns, as evidenced by debt service ratios (9.5% now vs the 13.2% peak in 4Q2007) and excess savings levels (to the tune of $2.4 trillion). Yes, inflation is a persistent challenge with which to contend, but even here we see early signs of improvement. Core CPI improved in June despite the headline uptick, and many major culprits behind the baskets that comprise CPI are showing signs of alleviation. 

Since we’re never afforded visibility on the factors that will cause bottom formation, we learn from prior disruptions to inform our current game plan:

It’s far too early to declare that we’re nearing a dust-settling moment—another visibility impairing sandstorm could be around the corner—but in our constant diagnosis of the fundamental inputs, we see evidence to support that the market’s inherently anticipatory nature may already reflect a sizeable amount of bad news. As in every major dislocation in modern equity market history, the white flag gets waived long after market price recovery.

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