January 31, 2014
The U.S. Large Cap equity market was strong in 2013 (see Table 1). The Russell 1000 Index was up 33.13% for the year, while the Russell 1000 Growth Index was up 33.48%. The McKinley Capital U.S. Large Cap Representative Account (the “Representative Account”) was up 31.86% for the year on a gross basis. An expectation of renewed U.S. economic growth was a major contributor to the strong 2013 market.
McKinley Capital constructs U.S. Large Cap portfolios to be systematically exposed to risk-adjusted price momentum, earnings acceleration and growth factors like upward analyst earnings revisions, positive earnings surprise history, and strong return on invested capital. McKinley Capital constructs comparatively concentrated U.S. Large Cap portfolios (often less than 60 stocks) resulting in stock specific exposure.
During the first part of 2013, these growth and momentum factors were moderately out of favor. As a result, the Representative Account underperformed the Russell 1000 Growth Index by 282 basis points through the end of April (see Table 1). During the beginning of the year, value oriented and high dividend paying stocks were the best performers. Typically, these types of stocks do not rank high in McKinley Capital’s investment process.
As the year continued, with rising interest rates and growing expectations of U.S. economic growth, the conditions changed. Stable dividend paying and value stocks became less interesting and growth stocks began to improve. In this environment, McKinley Capital’s investment factors began to engage. From the end of April through the end of December, the Representative Account outperformed the Russell 1000 Growth Index by 158 basis points on a gross basis (see Table 1).
Specific stock selection was slightly negative for the year. Stock picks in the technology sector accounted for approximately140 basis points of negative performance. Some of the underperforming technology stocks held in the Representative Account included EBay, Maxim Integrated Products, and Autodesk. Also, avoiding or holding underweight positions in strong performing technology stocks like Microsoft and MasterCard contributed to portfolio underperformance. The best performing stocks were in the health care and financial sectors. For the year, the stocks which contributed most to relative return included drug makers Biogen, Actavis, and Gilead Sciences, and fund manager Ameriprise Financial.
McKinley Capital believes that the strong relative performance of the Representative Account, which started in May 2013, can continue. McKinley Capital’s research along with recent articles published by Nomura (“Global Quantitative Strategy”, 1/7/2014), Instinet (“Will Active Managers Succeed”, 11/25/2013), Merrill Lynch (“The Return of Stockpicking”, 10/7/2013) and Russell (“The Cycle of Success”, June 2013) detail some of the reasons for these expectations.
McKinley Capital’s research, which is supported by Nomura’s published results, reflects that the relative valuation of U.S. high momentum stocks is near a post 1990 low. The price/book (“PB”) ratio of the highest price momentum stocks at the end of 2013 is barely above the PB ratio of the lowest momentum stocks (see Chart 1). Further, as of December 31, 2013, the median stock in the Representative Account had a 2012 to 2013 earnings growth rate of 17.77% compared to a growth rate of 12.09% for the median stock in the Russell 1000 Growth Index. At the same time, the 12 month forward forecasted price/earnings ratio of the median stock in the Representative Account was 18.23% compared to 20.20% for the median stock in the index. Given these statistics, there is reason to believe that both U.S. momentum and U.S growth stocks are relatively undervalued with room to outperform going forward.
The McKinley Capital investment process is designed to identify companies that should have superior relative investment returns over time. Using this process, McKinley Capital has successfully found companies that announce positive earnings surprise at a higher than market rate. When earnings surprise is a valued factor, McKinley Capital managed portfolios tend to outperform. When earnings surprise is less important, McKinley Capital managed portfolios may underperform. Earnings surprise appears to be less important early in new bull markets as many companies surprise, albeit from a lower base. As the economy continues to expand and mature, growth in earnings and the frequency of earnings surprise become more volatile. In these environments, McKinley Capital’s ability to find the better earnings companies can lead to differentiated and positive returns. The U.S. economy is possibly in that phase now.
Another indicator of potential strong future performance is the low percentage difference between positive and negative analyst earnings revisions in the high price momentum stocks in which McKinley Capital invests. When there are many more positive revisions than negative revisions there is less room for positive surprise. According to global Nomura data, the percentage difference between positive and negative revisions (as of January 7, 2014) is just 18%, which is comparatively low 1. The current revision picture may indicate uncertainty in earnings prospects and analyst opinions. This uncertain environment has often been favorable for earnings based stock picking firms such as McKinley Capital.
Many analysts believe that active managers have more opportunities to outperform when stock returns have lower cross sectional correlations. When cross sectional return correlations are high (stocks are moving together) there is less opportunity to “pick the winners”. When cross sectional return correlations are low, some analysts believe that stock specific factors are the more important drivers of performance. These conditions give stock pickers the opportunity to outperform. Nomura found that the Russell 1000 stocks had a low cross sectional return correlation of 0.304 as of the end of November 20132. This compares to a longer term median of 0.393 (See Chart 2 below).
Note: Note: Shows 21-day stock correlation within sector, where the averages of all pair-wise stock correlations are calculated within GICS 10 sectors in Russell 1000 universe using 21-day total returns and these correlations are averaged over all GICS 10 sectors. Period of analysis is from 2 January 1987 through 22 November 2013.
Source: Instinet, LLC, Compustat, Russell, IDC. © 2014 Instinet, LLC, All Rights Reserved. (November 2013). See page 6 for Instinet Disclaimers.
How does a rising interest rate environment affect the performance of McKinley Capital managed U.S. Large Cap portfolios? Analysts often believe that interest rate increases occur later in the economic growth cycle as the Federal Reserve seeks to moderate growth expectations by returning interest rates to “normal” levels. This economic environment seems to favor McKinley Capital’s U.S. Large Cap portfolios. Since 1995, McKinley Capital U.S. Large Cap portfolios have outperformed in rising interest rate months (as measured by the change in yield on a 10-year U.S. Treasury Note) versus the average of all months (48 basis points on average in rising interest rate months compared to 19 basis points on average in all months). The factors articulated above give McKinley Capital reason to believe that it has entered a period where favorable performance results can persist in its U.S. Large Cap portfolios.
Regardless of the economic environment, McKinley Capital invests in research to ensure that its factors remain robust and implements enhancements where it can demonstrate a likelihood of improved return prospects. In addition, McKinley Capital works to analyze and develop the most efficient risk and portfolio construction models as well as trade timing and execution analytics. Some current research areas include possible sales growth variables, portfolio stock weighting methodologies, and factor crowding penalty functions. Besides conducting research to improve its current models, McKinley Capital continues to engineer custom solutions for its customers with specific needs. These solutions can take the form of new custom portfolios or of overlays to current portfolios. Some of these solutions include utilizing derivatives, investing in dividend strips, and creating long/short dynamic momentum based portfolios. McKinley Capital representatives stand ready to discuss any of these or other customized solutions with its clients or prospective clients.
McKinley Capital Management, LLC (“McKinley Capital”) is a registered investment adviser under the U.S. Investment Advisers Act of 1940. McKinley Capital is not registered with, approved by, regulated by, or associated with the Financial Conduct Authority (“FCA”) or the Prudential Regulation Authority (“PRA”). Neither the FCA nor the PRA have commented on the firm, the content of any marketing material or any individual suitability assessments.
All information contained herein is believed to be acquired from reliable sources but accuracy cannot be guaranteed. This presentation is for informational purposes only, and was prepared for academic, financially sophisticated, and institutional investors. It is not intended to represent specific financial services or recommendations for any targeted investment purposes. This material may contain confidential and/or proprietary information and may only be relied upon for this report. The data is unaudited and may not correspond to calculated performance for any specific client or investor in referenced disciplines. McKinley Capital, nor its employees, makes any representations or warranties as to the appropriateness or merit of this analysis for individual use. Investors must seek individualized professional financial advice before investing.
Investments and commentary were based on information available at the time and are subject to change without notice. Any references to specific indexes or securities are for informational purposes only, may or may not have been owned by McKinley Capital in the past, may or may not be owned by McKinley Capital in the future and may or may not be profitable. No single security, discipline, or process is profitable all of the time and there is always the potential for loss. Past performance is not indicative of future returns. All returns are gross of investment management fees, broker commissions, taxes, and all other fees, costs and expenses associated with client account trading and custodial services, and therefore individual returns may be materially negatively affected. Returns do include the reinvestment of gains, dividends and other income.
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1 Global Quantitative Strategy “Time to Buy the Winners, Upgrading Momentum” (Nomura, January 7, 2014).