November 30, 2018
Robert A. Gillam, CFA Chief Executive Officer McKinley Capital Management, LLC
The firm’s mission is to be a premier global growth specialist providing superior relative investment returns over the long term and exceptional client service.
Sometimes it is easy to get lost in the noise of global markets, macro shifts, risk-on/risk-off bets, tweets, elections and hedge fund and derivative repositioning. However, it is at these times, when it is most important to fall back to basics; the investment beliefs that sustain an investment process. In the case of McKinley Capital Management, LLC (MCM), we believe in Growth; not the style Growth per se, but rather the fundamental economic concept of corporate growth. We believe that the market efficiently discounts absolute and historical corporate revenue and earnings growth and that most often buying companies with such characteristics does not lead to relative outperformance. On the other hand, identifying, and then owning, companies that are expected to grow at a growing rate (acceleration) and emphasizing the ones that consistently deliver revenue and earnings announcements better than expectations is a better strategy. Don’t get confused between Growth the style and growth as I just defined it. The media often confuses them. In fact, during these times of noise, I find reviewing the data to be helpful; almost like a guiding light in stormy weather.
First, some background. A common definition of Growth, the style, comes from the vendor, Axioma. According to them, Growth is defined as sales growth, estimated sales growth, earnings growth, estimated earnings growth. Technically speaking, this is a regression component weighted variable that leans most heavily on historical earnings and sales data. This seems consistent with definitions described by much of the financial media and what has seemed to be the driving force of the market gains throughout 2017 and much of the first 2/3rds of 2018. Many companies described by this method can be labeled as FAANG, (Facebook, Apple, Amazon, Netflix, Google) and include some of the largest companies in the U.S. When one listens to the media and the hysteria in all of the commentary surrounding the “Growth vs Value” debate, we would think that these companies have outperformed massively and consistently since the Great Financial Crisis in 2008/09 and that would technically be correct, but only with two important caveats; first that one has an end date of 9/30/18 (October and November have been terrible) and second that average includes a very short and very strong burst of return for a 1 year period that skews up the overall average. Figure 1 shows this Growth performance vs. the Russell 1000 through September 30th and Figure 2 demonstrates the significant burst of return that skewed the average between September 30, 2017 – September 30, 2018.
If this burst had not occurred and the Growth and Value returns had matched the Russell 1000 over the 1-year period ending September 30, 2018, the Growth excess return, over the entire period, would be much more muted.
More importantly, long term performance of this style variable when displayed in an Information Coefficient (IC)1 format shows that buying securities that are highly ranked by this variable leads to follow-on negative returns. In other words, we should not be confused by the media previously telling us that Growth was great and now making a big deal out of its demise. Over the long-term the results simply don’t bear out this as a winning strategy. The October/November correction is simply taking us back to the long-term return profile of that variable; nothing more, nothing less.
On the other hand, MCM defines Growth akin to acceleration and believes that forward acceleration (think of this like a second derivative) does in fact lead to good relative returns. Recall that we define this growth as a combination of several proprietary variables; namely revenue, earnings and/or cash revisions, strong return-on-invested-capital, excellent breadth, good deployment of capital, research and development spending and often even significant CAPEX amongst other things; all of which lead to announcements and guidance that surprise the Street coming in better than expected. We call this factor, E’. Over time, this variable has three important characteristics; the first is that it is more lowly correlated to Axioma Growth then many people appreciate, which is a good thing given Growth’s poor performance as stated, the second is that it shows significant long-term excess returns in most markets and the third, and most important, is that it tends to do well during periods when Axioma Growth performs poorly. Figure 3 displays the correlation table of Axioma Growth vs E’. In the four major MCM investment universes of the US (Russell 1000), Global (ACW), XUS (ACWXUS) and Emerging Markets (EM), as well as in the MSCI Asia, Japan, Europe and Russell 3000 indexes.
Now consider the long-term IC profile of E’. Again, in the most relevant investment universes, it shows significant excess return when formulated as an IC table. Figure 4 shows that it does well over long periods and Figure 5 demonstrates how it performs when Growth turns down.
Now finally, let us review how it looks when overlaid on top of one another. Graphing Axioma Growth and E’ together in several universes allows us to see the impact of one definition vs. the other almost in live-time. Figures 6-12 show these universes to show consistency across the world. This is where the proverbial rubber meets the road, as they say. In fact, look down over the top of these graphs and see that the outperformance of the E’ variable does not always come at the same time in each universe. In other words, while it is still certainly cyclical, we can still move around the world because there is most always something somewhere with this type of Growth winning!
An investment process that seeks to identify companies with forward and acceleration prospects vs. absolute and historical prospects is most often a successful approach. It generates returns at slightly different times and it does not suffer to the extent of Growth sell-offs during severe drawdowns.
Although a short 2-month period makes not a conclusion, it is instructive to note that MCM actual portfolios, which are tilted heavily to E’ have with but one exception (highlighted), outperformed the most highly ranked securities, by market, as defined by Axioma Growth
Figure 3-12: Data source: FactSet Alpha Tester, Download date: 11/21/2018, Data Time Range: 12/31/2003 – 10/31/2018
Figure 13: Data source: Advent Portfolio Exchange, FactSet Screen, Download date: 12/3/2018, Data Time Range: 10/1/2018 – 10/31/2018, 11/1/2018 – 11/30/2018
Economically, we believe this belies an important market phenomenon; the efficient market hypothesis (semi strong version) discounts absolute and historical Growth too quickly to make money easily as such companies end up already implying that Growth in their valuation. During the rare and short periods of excess return, securities with these characteristics tend to get overcrowded by investors and then are subject to painful corrections. In contrast, forward and acceleration-based Growth is something, by definition, that the market does not know and therefore cannot discount readily. I like to think of the MCM investment process as something that underscores a basic economic rationale; buy a company that will have growth in the future as it is likely to be mispriced vs buying something that has already generated good growth and is priced accordingly. With all of the media attention talking of Growth failure and comparisons to all manner of Bear Markets and other downturns, don’t get lost in the noise. A focus, from the bottom-up, on companies that are accelerating, from wherever they are around the world, is one that has passed the test of time. Like all noisy situations, this too shall pass. Back to the parlance of the light in stormy weather …steady as she goes.
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