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Considering Risk from a Factor Perspective July 2021

Considering Risk from a Factor Perspective July 2021

For Financial Intermediary, Institutional and Consultant use only. Not for redistribution under any circumstances. Perspective Considering risk from a factor perspective July 2021

When it comes to investing, “risk” is often defined as volatility. In fact, the biggest risk is making the wrong asset allocation decisions, or being on the wrong side of long-term trends. We’ve heard a lot about bubbles in the recent past but in my mind there has not been enough discussion about potentially the biggest Marina Severinovsky bubble: the of equity markets more broadly. Investment Director, QEP Team

Digging deeper into equity markets, value and quality are the The higher quality of earnings explains much of the valuation most dominant factors in the long run and should form a large premium attached to the US market. Clearly the question is how component of a strategic equity allocation. Consideration of these much is already in the price, particularly since the stellar Q1 two factors together paints a more nuanced picture for earnings season this year probably marks the peak of the earnings than overall market analysis might suggest. growth cycle, if only due to base effects.

Are equities due a correction? Also, from a tactical perspective, the opportunity for re-opening The US equity market has dominated over the past decade since trades to continue to perform well is greater outside of the US. the global financial crisis and that’s been justified by stronger This is because the emerging markets and Europe tend to be more earnings growth and superior profitability. The graph below cyclical and are further behind the US and UK in the vaccination shows the progression of earnings by region since the start of the roll-out. financial crisis. Earnings recovered relatively quickly from 2010, at Turning to valuations, Figure 2 overleaf suggests that nothing is least in the US, thanks to strong support from policy makers, most cheap right now. The table shows various measures of market notably the Federal Reserve (Fed). Meanwhile, earnings in Europe valuation relative to their history. The first column is the cyclically and emerging markets have been far more pedestrian. adjusted price-to-earnings (CAPE) ratio – this uses 10-year earnings in the denominator to smooth out the impact of the cycle and is the Figure 1: Progression of earnings forecasts over time (FY1) best way to compare equities and their potential performance. 5 A CAPE of 36 for the US market is as high as any time in more than a century other than the dotcom bubble of the late 1990s, and even surpasses 1929. But it’s not just the US. All equity markets are expensive, with perhaps only the UK and Japan offering some degree of relative value. 5 In practice, this means that equities are vulnerable to a correction, particularly if all of the good news is already in the price. The nature of any correction in markets – whether it simply reflects valuation re-asserting itself, or whether it is inspired by another adverse shock such as the emergence of COVID variants – is very 5 important to relative performance within equities.

However, the main point is that it’s very likely that volatility will be higher in the years to come than was the case in the period leading up to the pandemic. 5 S 5 MSCI urope MSCI merging Markets

Source: Refinitiv, as at April 30, 2021. Earnings are the weighted average EPS for the FY1 Fiscal Period, indexed at December 2007, rolling on a monthly basis. Historical trends are not indicative of future trends. Figure 2: Valuations vs. 15-year median (April 30, 2021) Equity market CAPE Forward P/E Trailing P/E P/B yield 36 23 35 4.8 1.4 US (23) (15) (19) (2.8) (2.0) 14 13 23 1.8 3.2 UK (13) (12) (14) (1.8) (3.8) 22 18 28 2.2 2.1 Europe ex. UK (16) (13) (17) (1.7) (3.2) 22 17 24 1.5 1.9 Japan (23) (14) (16) (1.3) (2.0) 17 15 22 2.1 1.8 EM (15) (11) (14) (1.7) (2.6) 22 16 24 2.1 2.8 Canada (20) (14) (18) (1.9) (2.9)

Key: - - - - xpensive heap

Source: Datastream Refinitiv, MSCI and Schroders. Data to April 30, 2021. Figures are shown on a rounded basis. Assessment of cheap/expensive is relative to 15-year median in brackets.

It also means that the US market is the most vulnerable. Looking Does inflation matter to markets? Equities don’t like deflation at simple valuations of the US compared to the rest of the world, (see the experience of Japan) or very high inflation, but there’s and the subsequent 10-year performance, would suggest that the little evidence to suggest that inflation lower than 4% is US is likely to underperform by more than 5% on an annualized particularly concerning. basis over the next decade. The largest in the US are also some of the most expensive and have yet to correct after generally However, markets move quickly. The primary concern a few months benefitting from COVID. ago was that the Fed would tighten monetary policy too quickly, resulting in another “taper tantrum” as in 2013. Now though, the Could inflation cause a correction? concern is that they are behind the curve and will be to slow to One potential catalyst for both rotation within the equity market respond to rising inflation. At the very least, this will almost certainly and a broader market correction is the potential for inflation to be a source of volatility over the course of the next year. return and the impact that has on yields. We’ve grown used Is the stage set for value’s outperformance? to declining bond yields over the past four decades but we do now appear to be at a turning point. It has clearly been a growth market for the best part of the past decade. Various justifications for this include the low level of bond We are in a situation where both cost-push and demand-pull factors yields, which boosts the attractiveness of future earnings, and the are likely to lead to upward pressure on inflation. So far, we are only de-rating of traditional value areas such as financials and resources observing this in pockets of the economy where supply shortages following the global financial crisis. Clearly, the pandemic was are greatest (e.g. shipping) or those areas most exposed to higher another shot in the arm for growth stocks as many of the growth commodity prices. This is hardly surprising given that we are in stocks were stay-at-home beneficiaries. effect emerging from a natural disaster, but the main concern will be if this feeds through into higher wage inflation. However, starting valuations are again our best guide to the future. Based on this, the current cheapness of value relative to growth So far, the breakeven inflation rate has edged up to just above suggests that – simplistically – value stocks could outperform by 2% as investors are looking through the potentially temporary around 5% per annum over the decade to come. Cyclically, it would spike in core inflation. This is something to keep a close eye on also seem a good time to get into value as cheap stocks do tend to in the months ahead, particularly from the perspective of how outperform around turning points in the growth cycle. The graph policymakers will respond. below plots the average performance of value versus growth in the US when the cycle turns. Figure 3: Value vs. Growth around turning points US value vs. growth return () rebased

5 Value outperforms

5

th pct -5 Average Current - Growth outperforms -m -m -m m m m m -5 5 M onths aroun d S growth inflect5ion point 5 Past performance is not a guide to future performance and may not be repeated. Source: Datastream Refinitiv and Schroders. Data from April 30, 1992 to April 30, 2021. Notes: average based on 9 market episodes of performance of MSCI USA Value less Growth. Inflection point calculated as y/y change in annual EPS growth lagged by 3 months to account for lag in which quarterly profits are reported. Current EPS growth inflection is measured as at August 31, 2020. Historical trends are not indicative of future trends. 2 Value has outperformed strongly since last November (when the What does this mean for future returns? first successful COVID vaccines were announced) but this is largely Figure 4 below refers to the past. What can we predict about a response to it being so oversold during the pandemic. However, future returns? Value always trades at a discount to growth of the to medium term argument for allocating more towards around 50% but, as Figure 5a overleaf shows, the discount in Q3 value stocks is still very compelling. of last year was closer to 70% – even more extreme than in the 1999 tech bubble. Since then, due to the rebound in value stocks, Value comes in many flavors the discount has narrowed, but there’s a lot further to travel for There are, however, different flavors of value, and quality is valuations to return to their long-run average. another factor to bring into the mix here. Value captures terms such as earnings and cashflows while quality can be characterized Conversely, a similar analysis for growth stocks (Figure 5b by stable profitability, financial strength (i.e. not leveraged), good overleaf) suggests that valuations are also extreme. Unlike the governance and solid growth prospects. High quality late 1990s, earnings growth has been more supportive and does are those that have greater control over their destiny. They tend to help justify some of their strong performance in recent years. By be stable growers rather than the fastest growers. definition, growth stocks exhibit higher growth than value stocks, but even after taking this into account and assuming that forward When we divide the equity universe up in this way (Figure 4), we price-to-earnings multiples, return to their long-run average can see from the left hand graph that the best returns over the this would suggest that value is likely to outperform the broader long run are in stocks which are both high quality and reasonably market by almost 5% over the next three years while growth priced. It has not historically been rewarding to overpay for quality stocks could lag by almost double that. (top right) while low quality value (often referred to as deep value, which can be found today in areas such as cyclicals, banks and In summary, all of the good news has already been priced into resources) is also not a long term winning strategy. the current premium valuations for growth stocks. Even if they continue to churn out strong earnings, it’s very unlikely to be The past few years, and 2020 in particular, have been highly enough to fuel a repeat of the past few years. We’ve already unusual in that it has been the expensive stocks that have started to observe this in the recent Q1 earnings season where outperformed, regardless of their quality. The strong performance the FANMAG (Facebook, , , , Apple, of stocks like Tesla and conceptual technology stocks that ) stocks generally posted very strong numbers that beat are not yet profitable would provide some examples of lower expectations, yet went on to underperform. It’s been better to quality expensive stocks that have benefitted from the market’s travel than arrive. preference for a good narrative over fundamentals. Turning to the same analysis for quality-value, the Figure 6 This is changing and value has bounced back since November, overleaf shows that even higher quality cheap stocks have de- with lower quality cheap stocks performing particularly strongly rated in recent years. This would include many healthcare and (see right hand table). So far, the quality value stocks have not consumer staple stocks that typically trade close to a market enjoyed the same focus, mainly because many of these stocks multiple or even at a premium due to their stable profitability. are more defensive and the market has preferred those with the greatest economic sensitivity. It’s really been a two-sided market – growth versus everything else – and the cohort of growth stocks has been very narrow, It has also been encouraging that market breadth has returned. leading to very low market breadth. However, now that we’ve had The narrowness of market participation in recent years has clearly the initial rebound in the most oversold cheap stocks, I would exaggerated the headwinds against value-based investment suggest that a more attractive part of the market today is the strategies and the return to a more “normal” backdrop is a more defensive value stocks. Taking pharmaceuticals again as an positive for all active investors other than those with a strong example, they are trading at their cheapest multiple relative to focus on growth. the market in at least three decades. Political risk relating to drug price regulation would appear to be more than in the price. Figure 4: Value and Quality performance (Global stocks) ong-term returns (102020) 2020 November 2020March 2021

Cheap Mkt. like xpensive Cheap Mkt. like xpensive Cheap Mkt. like xpensive

High High High 4. 2.4 -1. 6. 0. -3. quality quality -16.4 -12.5 4.0 quality

Mod Mod Mod 2. -1. -5.2 10. 2.5 0. quality quality -1.2 -6.6 13.1 quality

Low Low Low 16.0 5.6 4.6 quality 0.0 -3.2 -.6 quality -1.5 -13.2 6. quality

The return may increase or decrease as a result of currency fluctuations. Past performance is not a guide to future performance and may not be repeated.Source: Schroders QEP. Data from Jan 1990 to March 2021. Each month all stocks in QEP’s global mega to mid-cap universe, excluding financials and resources, are ranked using QEP’s global value rank and global quality rank. Terciles of the value rank are used to classify stocks as cheap, market like or expensive, while terciles of the quality rank are used to classify stocks as high, moderate or low quality. Market capitalisation-weighted portfolios are rebalanced monthly and US$ returns are calculated with transaction costs taken into account. A maximum stock weight of 3% is applied within each portfolio. Annualized excess returns are then calculated against a -weighted universe.

3 The growth prospects for quality-value stocks are more compelling Figure 6: Strong potential for Quality-Value to outperform than for the average value stock, while their valuations are more attractive than the average quality stock. Based on our analysis, the expected relative return for quality at a reasonable price stocks is almost 8% annualized over the next three years.

Tactically, given that there is still so much uncertainty about the - broader market as well as the pace of economic recovery after the current rebound, it would also make sense to be more hedged on - your value exposure by dialing up the quality. These stocks have a greater propensity to perform across a broader range of market and economic scenarios. -

Figure 5: Strong potential for Value to continue to outperform - 5 5a Value vs. MSI World iscount Value and Quality - - Source: QEP, IBES, data from December 1987 to March 2021. Value basket is formed from a cap weighted cheapest third of global stocks based on a MSCI World universe - (based on forward earnings, book to price and Sales to EV). Valuations are measured as cap-weighted median on each basket. The Quality basket is formed from a cap - weighted highest third of stocks based on an MSCI World universe (QEP Global Quality Rank). Top Third of QEP Value and Quality rank taken on a monthly basis. -5 - - What about other factors? Momentum is probably the factor that is most often used - alongside value but the main problem with momentum is that 5 it is transitory. Taking the last few months as an example, the composition of a momentum basket has shifted from the FANMAG stocks to energy and financials. It’s hard to build a long-term Value-Market Value Spread investment strategy based on shifting goalposts and it is best to think of momentum as a shorter term risk factor; perhaps don’t 5b Growth vs. MSI World Premium get caught on the wrong side of it but don’t chase it over the long run without fundamental support. 5 Momentum is also prone to dramatic drawdowns at turning points or periods of volatile/rotational markets. Despite the fact that markets have generally been a one way momentum bet since 5 2017, we would be wary of extrapolating this into the future.

As for size, it’s best to think about it as an illiquidity premium or a proxy for economic sensitivity. Often there are better way to 5 capture that than just buying small stocks. It is essentially a proxy for many other factors. Another area of increasing interest for good reasons is -5 sustainability. While there is some evidence that stocks with 5 superior governance outperform over time, environmental and social considerations are probably best considered as risk factors that need to be managed. In particular, being on the wrong rowth-Market Value Spread side of government regulation or activism has the potential to drag on investment performance. Clearly, pressures Source: QEP, IBES, data from December 1987 to March 2021. Value basket is formed from a cap weighted cheapest third of global stocks based on a MSCI World universe on corporates are increasing and are unlikely to abate, particularly (based on forward earnings, book to price and Sales to EV). The Growth basket is in the area of climate change. formed from a cap weighted fastest growing third of stocks based on an MSCI World universe (2 year forward growth). Valuations are measured as cap-weighted median on each basket.

4 Conclusion The market has been very macro driven in recent years In particular, asking the question of what is already in the and the next few years are likely to be more nuanced. We price will be far more important than it has been in the past believe that we are at a turning point in both the economic decade. It will also be a tougher period for investment returns and market cycle. Paying heed to long-term valuations and given starting valuations. avoiding getting sucked in near the top is the main risk we need to focus on. Schroder Investment Management North America Inc. 7 Bryant Park, , NY 10018-3706

schroders.com/us schroders.com/ca @SchrodersUS

Important information: The views and opinions contained herein are those of the author and do not necessarily represent Schroder Investment Management North America Inc.’s (SIMNA Inc.) house view. Issued July 2021. These views and opinions are subject to change. Companies/issuers/sectors mentioned are for illustrative purposes only and should not be viewed as a recommendation to buy/sell. This report is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for accounting, legal or tax advice, or investment recommendations. Information herein has been obtained from sources we believe to be reliable but SIMNA Inc. does not warrant its completeness or accuracy. No responsibility can be accepted for errors of facts obtained from third parties. Reliance should not be placed on the views and information in the document when making individual investment and / or strategic decisions. The opinions stated in this document include some forecasted views. We believe that we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee that any forecasts or opinions will be realized. No responsibility can be accepted for errors of fact obtained from third parties. While every effort has been made to produce a fair representation of performance, no representations or warranties are made as to the accuracy of the information or ratings presented, and no responsibility or liability can be accepted for damage caused by use of or reliance on the information contained within this report. Past performance is no guarantee of future results. All investments, domestic or foreign, involve risk, including the risk of loss of principal. SIMNA Inc. is registered as an investment adviser with the US Securities and Exchange Commission and as a Portfolio Manager with the securities regulatory authorities in Alberta, British Columbia, Manitoba, Nova Scotia, Ontario, Quebec and Saskatchewan. It provides asset management products and services to clients in the United States and Canada. Schroder Fund Advisors LLC (SFA) markets certain investment vehicles for which SIMNA Inc. is an investment adviser. SFA is a wholly-owned of SIMNA Inc. and is registered as a limited purpose broker dealer with the Financial Industry Regulatory Authority and as an Exempt Market Dealer with the securities regulatory authorities in Alberta, British Columbia, Manitoba, New Brunswick, Nova Scotia, Ontario, Quebec, Saskatchewan, Newfoundland and Labrador. This document does not purport to provide investment advice and the information contained in this material is for informational purposes and not to engage in trading activities. It does not purport to describe the or affairs of any issuer and is not being provided for delivery to or review by any prospective purchaser so as to assist the prospective purchaser to make a decision in respect of securities being sold in a distribution. SIMNA Inc. and SFA are indirect, wholly-owned of Schroders plc, a UK public with shares listed on the London Further information about Schroders can be found at www.schroders.com/us or www.schroders.com/ca. Schroder Investment Management North America Inc. 7 Bryant Park, New York, NY 10018-3706, (212) 641-3800. WP-RISKFACTOR

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