Key trends could favor active managers over the long term.
Years of cheap money helped fuel a historic bull run that swelled passive index vehicles such as exchange-traded funds (ETFs)—until 2022, when rising inflation, tighter monetary policy and declining growth crashed the stock party, most recently in the emergence of a bank liquidity crisis. As highlighted in our Solving for 2023 outlook, we believe a new economic regime, marked by higher rates and resurgent economic volatility has begun. This is a fundamental reversal that, in our view, highlights the importance of thoughtful and selective active management in portfolios.
We see four major, unfolding long-term trends that active equity managers could be positioned to exploit:
Earnings Quality Matters Even More
Over the past 60 years, companies with lower operating margins generally tended to underperform their more profitable peers in the stock market. In addition, those that relied on aggressive accounting techniques generally suffered relative to their conservative competitors. We believe these methods are likely to earn extra punishment in both the current downturn and over the longer haul.
The Return of Value
Value stocks outpaced growth for 80 years until easy money flipped the script. We believe higher domestic inflation and a potentially weakening U.S. dollar (now near historical highs) will likely usher in a period of global reflation which, in our view, could bode well for value stocks.
Small Companies Over Large
Similar to the long-term “value vs. growth” trend, small capitalization stocks typically edged out large caps until 2008. Our research suggests that small caps could be on their way to a revival.
Non-U.S. Assets Could Lead
Historically, as the U.S. dollar has weakened, international and emerging markets have tended to outperform domestic counterparts—a trend that we anticipate could emerge over time.
Let’s take a closer look at each of these trends:
1. Earnings Quality Matters Even More
Over the last 60 years, higher-quality companies—meaning those with higher operating margins—have outperformed lower-quality companies by 3.6% per year. And during 13 out of 15 economic downturns since 1963, companies with top-quintile earnings quality outperformed those in the bottom quintile by a median of 15%.1
That in itself helps make the case or quality, but we believe that the case goes beyond such traditional measures. While profits are the lifeblood of shareholder value, not all reported earnings are created equal. Aggressive use of accounting accruals—essentially best-case financial assumptions—can lend a rosy, and potentially misleading, hue to a company’s reported numbers, thus calling their quality into question.
Aggressive accounting tends to proliferate as corporate optimism swells—a late-cycle development witnessed in the late-1990s, mid-2000s and today. The chart below illustrates that the use of accruals has rarely been more widespread in the last 30 years, suggesting that earnings quality is at a low.
We believe aggressive accounting matters even more during economic downturns because accruals can quickly translate into write-offs that can hammer equity returns. After years of ignoring aggressive accounting, it looks like investors are starting to pay attention; we think companies that lean heavily on accruals could suffer similar fates in the ongoing earnings-driven phase of the current downturn.
This suggests that security selection could be increasingly important in seeking risk-adjusted return—something that, in contrast to index funds, active managers are in a position to provide.
CORPORATE EARNINGS QUALITY IS AT A 30-YEAR LOW
S&P 500 Accruals
Source: FactSet, Piper Sandler, Neuberger Berman. Data as of February 2023. Accruals are the inverse of earnings quality.
2. The Return of Value
Value stocks used to be valuable. In fact, for eight decades until the 2008 crisis, value stocks outperformed growth companies by 3% a year. But when the Federal Reserve slashed interest rates to revive the economy, the equity market—especially growth stocks—went on a tear. From December 31, 2008, to October 31, 2022, growth, helped in part by benign inflation, trounced value by 3.2% per year.2
However, when viewed through a longer-term lens, we believe this last bull market was in many ways a Fed-generated anomaly. In our view, both the extraordinary post-COVID fiscal stimulus and an extended period of highly accommodative monetary policy in the aftermath of the 2008 financial crisis—domestically and globally—served to create excess liquidity, turbocharged growth stocks and, ultimately, unleashed inflation. And when inflation has struck, value has tended to trump growth. As highlighted below, over the previous seven decades, value stocks outpaced growth stocks by 9% per year during periods when inflation was north of 5%. Value has been leading growth in the recent climate—a trend we expect to continue.
VALUE HAS SHOWN STRENGTH IN TIMES OF HIGH INFLATION
Value vs. Growth and Inflation Regimes, 1950 – 2023
Source: Bloomberg, Robert Schiller CPI data at Yale University, and Kenneth French data library. Analysis period from June 1950 to January 2023. Value – Growth spread shows excess return performance. It represents the difference in total return between the Fama/French Large Cap Value Research portfolio and the Fama/French Large Cap Growth Research portfolio over a one-year rolling window. Information on historical observations about markets, asset or sub-asset classes is not intended to represent or predict future events. Historical trends do not imply, forecast or guarantee future results. Past performance is no guarantee of future results.
Higher inflation often comes with higher interest rates. Growth stocks are more sensitive to higher rates than value stocks because growth companies tend to generate more of their earnings in the future—and discounting those future earnings at higher rates lowers their present value. Also, value stocks tend to include many financial services firms, which can outperform when rates are higher (although exposure to financials and energy has been detrimental in the wake of banking issues).
Could inflation cool over the next 12 months? Perhaps, yet we believe the economy has entered a new regime marked by historically higher structural inflation that tends to bode more favorably for value strategies over the long term.
The U.S. dollar can offer useful clues about value stocks’ potential outperformance. Since 2008, value stocks have lost ground to growth, roughly in line with the 2008 cycle trough in the nominal dollar index. The dollar, meanwhile, began its steady ascent in early 2011 and is now far more expensive than we believe is warranted.3 Dollar cycles tend to last seven to 10 years, implying that the tide may be ready to turn. While calling precise inflection points is virtually impossible, we believe a weakening dollar would be consistent with multiyear historical regimes during which value outperformed growth.
Due to the policy-driven gains of many growth companies, major stock indices today tend to have a growth bias, which even after the 2022 declines is particularly concentrated in a handful of leading name companies. Moving toward value-oriented active strategies can enable investors to participate in the growth trend, while seeking to avoid the dangers associated with exposure to the “value traps” of less fundamentally sound companies that by definition will be present in value indices.
3. Small Companies Over Large
Outsized returns used to come in small packages. Over the eight decades prior to 2008, small-cap stocks outperformed large caps by 2.3% per year. Then, as in the value-versus-growth story, the script flipped: Starting in 2009, large edged out small by 0.7% per year through October 31, 2022.4
We credit that shift, in part, to the emergence of “Big Tech” and its relative dominance within market-capitalization-weighted indexes. In the new economic regime, however, we think history could have its due.
In particular, we note the performance history of small versus large caps when the difference between their valuations has growth particularly wide. At current levels, the price-to-earnings (P/E) ratio of the S&P 600 Small Cap Index trails the P/E of the S&P 500 Index by about seven points. A plot of the indexes’ relative returns over the 10 years after a given difference in P/E (plotted below) implies the potential for small caps to outperform large caps by a significant amount per year over the next decade.
SMALL VS. LARGE COMPANY STOCKS, 10-YEAR ANNUALIZED RETURN
Small vs. Large Company 10-Year Annualized Return Based on Price/Earnings Difference (January 1994 – February 2023)
Source: FactSet, Neuberger Berman. Analysis period from January 1994 to February 2023. Valuation calculations exclude negative earners. Information on historical observations about markets, asset or sub-asset classes is not intended to represent or predict future events. Historical trends do not imply, forecast or guarantee future results. Past performance is no guarantee of future results.
The small-cap universe is sometimes considered an equity market “wild west,” with many unprofitable or low-profit companies with business models that are just starting to be tested by a higher interest-rate regime. Moreover, analyst coverage is spotty at best, and often biased based on investment-banking considerations. In this arena, we believe there are substantial advantages for active, independent asset managers who can apply a disciplined fundamental lens to assess companies.
4. Non-U.S. Assets Could Lead
As with small caps, relative-valuation comparisons appear to indicate good news for non-U.S. equities relative to domestic stocks. Since 1970, developed markets outside the U.S. have outperformed the U.S. market by 1.2% a year.5 Now, relative valuations appear to have moved even more favorably toward non-U.S. developed markets, a characteristic that that historically has tended to favor returns in those markets relative to the U.S. over subsequent 10-year periods.6
TIME FOR INTERNATIONAL?
Non-U.S. vs. U.S. 10-Year Annualized Return Based on Price/Earnings Difference (January 1995 – January 2023)
Source: MSCI, FactSet, Neuberger Berman. Analysis period from January 1995 to February 2023. Valuation calculations exclude negative earners. Information on historical observations about markets, asset or sub-asset classes is not intended to represent or predict future events. Historical trends do not imply, forecast or guarantee future results. Past performance is no guarantee of future results.
In essence, we see non-U.S. markets as something of a value-versus-growth story playing out on the global stage. In addition, historically, when the dollar has weakened, unhedged U.S. investors have often benefitted from rising foreign exchange rates.
All told, we believe international exposure in portfolios is important again, and we see a potentially compelling global opportunity set.
Like small-caps, non-U.S. markets tend to be less efficient than major U.S. large-cap companies. Looking at analyst coverage, for example, while only 5% of U.S. large-cap stocks are covered by 10 analysts or less, the figure is 16% for non-U.S. developed markets and 24% for emerging markets.7
This stands to benefit managers who can generate meaningful insights on companies based on fundamental research. More broadly, we believe that investors should be careful about the unfiltered exposure that non-U.S. indices may provide. Understanding the various crosswinds affecting countries, sectors and individual companies is, again, something that an active manager can provide.
CONCLUSION: A PREMIUM ON SELECTION
For many years, loose monetary policy often valued the broad market exposure provided by passive investment vehicles. Moving forward, however, higher interest rates and more mixed growth trends are likely to put a premium on the ability to discern important, often subtle differences associated with quality, valuation and market capitalization, as well as the impacts of economic events on specific investments. In our view, long-term investors should consider making adjustments to their portfolios in light of the trends we have discussed, which could provide compelling opportunities for fundamentals-driven active managers in seeking attractive risk-adjusted returns.
FIXED INCOME: WHY ACTIVE?
Active management shouldn’t end with your stock portfolio
In the midst of the multidecade bull market in fixed income, the formula for success for many investors was often pretty straightforward: look for central banks to reduce interest rates and thus enhance total returns. However, in the face of higher interest rates and stubborn inflation, things have become more complex. Investors may wish to take a more opportunistic and risk-aware approach afforded by active managers in seeking to achieve investment goals for fixed income portfolios.
Active bond managers come with a range of advantages. They have the potential capitalize selectively on a range of markets and sectors to generate potential return. In some cases, lower transparency and/or liquidity may provide a premium for those in a position to capitalize. Moreover, in employing credit research, active managers can avoid riskier segments and issuers that may be present in the indexes mimicked by passive investment vehicles. They can also choose the level of interest rate risk in portfolios to adapt to macro trends and seek to capitalize on structural issues associated with fixed income markets.
More generally, by leveraging the various tools at their disposal, active fixed income managers can more effectively navigate market volatility, potential economic slowdowns, credit deterioration and default risk than passive vehicles, which typically cast a wide, yet undiscerning, net.
1 Source: Neuberger Berman research, Institute for Supply Management, FactSet, Fama French Database. Analysis period from June 1963 to November 2022.
2 Source: Bloomberg, Kenneth French data library; analysis period from June 1926 to October 2022.
3 Source: Neuberger Berman research, IMF, FactSet. Calculation based on DXY weights using data going back to 1980.
4 Source: Bloomberg, Kenneth French data library.
5 Source: MSCI World ex-U.S. Index, MSCI World Index, FactSet, Neuberger Berman. Data as of November 30, 2022.
6 Source: MSCI, FactSet, Neuberger Berman analysis. January 1995 – February 2023.
7 Source: Bloomberg, analysis by Neuberger Berman. As of February 23, 2023. U.S. large caps represented by the S&P 500 Index, non-U.S. developed markets by the MSCI EAFE Index and emerging markets by the MSCI Emerging Markets Index.
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