Momentum Maintains Grip Near Term; Sustainability and Valuation Holds Sway Long Term
U.S. Equities deliver strong performance again
Buoyed by continued strong economic data and company earnings, U.S. equities had a strong third quarter. The S&P 500 Index delivered a 7.71% return, its strongest quarter in five years. Small-cap companies lagged large-cap companies, but still delivered a solid return, with the Russell 2000 Index returning 3.58%.
Growth stocks resumed their 2018 dominance over value stocks after a brief reversal in June and July and finished the third quarter significantly ahead of value for the quarter. The Russell 1000 Growth Index rose 9.17% while the Russell 1000 Value was up 5.70%. Small cap value was the laggard among U.S. companies across style and capitalization, with the Russell 2000 Value returning just 1.60%, even as small cap growth stocks as represented by the Russell 2000 Growth returned 5.52%.
In contrast to U.S. equities, international equities did not fare as well. Non-U.S. developed market equities as represented by the MSCI EAFE Index returned 1.35%, while emerging market stocks were negative. Political uncertainty in Italy and surrounding Brexit, and more vulnerability to a trade war were among the factors weighing on Non-U.S. developed market stocks, particularly in Europe.
Growth, momentum and valuation
Looking at the S&P 500 Index as a proxy for the U.S. equity market, a small percentage of growth stocks are driving a disproportionately large percentage of the return year-to-date — five stocks are responsible for 44% of the return to the S&P 500 Index. These stocks tend to be some of the most expensive on traditional valuation metrics.
In small caps, growth stocks with grossly inflated valuations are the dominant driver of returns to the Russell 2000 Index. Stocks in the top price-to-earnings (P/E) quintile have an extraordinary median forward P/E of 50x 2019 earnings and have returned 24.7% vs. 11.5% for the Russel 2000 Index in 2018.
Figure 1: There is a 23% difference in performance between expensive and cheap within the Russell 2000 Index for the year-to-date period as of 9/30/18. The gap in valuations stands at 40 multiple points.
Past performance is no guarantee of future results.
Momentum continues to be a main factor driving growth stocks higher. Momentum is an indicator that stocks that have been performing well will continue to do so with little regard for valuation.
While momentum can persist for significant periods of time, valuation is a central component of longer-term investment success. Whether you are a core, growth or value investor, determining the appropriate price to pay for a stock is a fundamental tenet of successful long-term investing.
ESG Issues have long-term value to economies and investors
We believe integrating sustainability into an investment strategy is also central to long-term investment success. The world is confronting challenges now that will, if we don’t take positive corrective action, threaten our economies, civil society, and livelihoods.
“If we don’t reduce greenhouse gas emissions effectively, deeply, and soon, the economic costs are staggering.”
Estimates of the impact of unchecked climate change range from 5% of gross domestic product (GDP) to 20% — in perpetuity. Eliminating gender gaps in the private sector could add $28 trillion to global GDP by 2025.
If we do not address problems of fresh water access, two-thirds of the world’s population will face water shortages, also by 2025. Rising inequality — illustrated starkly by statistics like the fact that the richest 42 people in the world have the same amount of wealth as the 3.7 billion poorest — stokes conflict, populism, and tribalism.
Tackling these issues — reducing greenhouse gas (GHG) emissions, eliminating gender and racial/ethnic discrimination, using water more efficiently and protecting regenerative capacity, and assuring economic opportunities for everyone — are all things that have long-term value to economies and investors alike.
We believe that investing in companies that help solve these problems, as well as those that take care not to exacerbate them, is always a good idea, no matter what short-term factors are pushing stock prices up or down.
Evaluating what makes a company sustainable
We also know that evaluating what makes a particular company sustainable isn’t something that comes neatly packaged in Sustainable Investing for Dummies. Answering the question “what makes a company sustainable?” is a lot like answering the question “what makes a company a good investment?” It’s never a simple list. It takes effort, analysis, knowledge, and insight.
So when you hear, as one often does these days, that “sustainability can’t be integrated into investment because there isn’t agreement on what constitutes sustainability,” or “company sustainability ratings disagree, which makes it subjective and not useful for investors,” don’t believe it. You could write the same glib non-facts about financial variables. There’s no one sterling definition of what makes a company fundamentally sound, and there can be disagreements among the financial ratings for companies. Yet no one questions the value of financial reporting, data, or analysis.
Having practiced sustainable investing for decades, we know that we should never expect global agreement on assessing sources of value. Anyone can look up what companies’ GHG emissions are, if the companies report them. Similarly, anyone can look up company earnings and revenues and countless other financial statistics. Turning those figures into estimates of future risks and returns is what separates good investment managers from everyone else.
What matters in the long-run
We believe disciplined adherence to both valuation and sustainability are central to long-term investment success. Despite the fact that investors may differ in their approach to each, the real key is employing rigor and insights to identify sound fundamental companies that can be purchased at prices that do not fully reflect long-term value.
For additional reading on two topics addressed in this quarter’s outlook, the following articles are available at the Pax Insights blog: “How Climate Change Affects Financial Performance” and “Sustainability Ratings Disagree. This is Not a Problem.”
The S&P 500 Stock Index is an unmanaged index of large capitalization common stocks.
The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership.
Russell 1000 Value Index is a market capitalization-weighted index that measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth rates.
The Russell 2000 Value Index is a market capitalization-weighted index that measures the performance of those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth rates.
The Russell 2000 Growth Index is a market capitalization-weighted index that measures the performance of those Russell 2000 companies with higher price-to-book ratios and higher forecasted growth rates.
The MSCI EAFE (Europe, Australasia, Far East) Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of the following 21 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom. Performance for the MSCI EAFE Index is shown “net”, which includes dividend reinvestments after deduction of foreign withholding tax.
One cannot invest directly in an index.