Spotting Long-Term Trends
Investing is about the future, and being able to distinguish true paradigm shifts from ordinary business cyclicality is important.
In this quarter’s outlook, we’ll consider examples of two long-recognized catalysts of fundamental market shifts — climate change and the internet — that again made headlines in the second quarter. We believe developments in both areas continue to shape winners and losers in the current market and beyond. Before we explain further, let’s review notable market performance trends through the second quarter of the year.
Non-U.S., Growth and Large Cap Extend Performance Leadership
The S&P 500 Index completed the first half of the year with a strong 9.34% return. While second quarter performance was a solid 3.09%, it did not match the torrid pace of the first quarter.
Growth stocks continued to outpace value in the second quarter by a wide margin (Russell 1000 Growth Index returned 4.65% vs Russell 1000 Value Index return of 1.34%). From a size perspective, large caps outperformed small caps, but only marginally.
Non-U.S. equities were the big story in the second quarter, with the MSCI EAFE Index returning 6.12% for the quarter, significantly extending its lead over the S&P 500 year-to-date (13.81% vs. 9.34%).
In June, there were indications that some changes in leadership may be taking place. Large cap value stocks bounced back strongly to outperform their growth counterparts, and the Russell 2000 Index strongly outperformed the large-cap S&P 500 Index. More importantly, broad market returns both in the U.S. and abroad were dampened compared to earlier in the year. We are closely considering whether lofty valuations and renewed concerns of rising interest rates are poised to slow the market in the second half of the year.
Climate Change Shift in Power
The ability of the public sector (government) to influence business financial performance is weakening in some areas. Climate change is a case in point. We believe the current shift of power from the Federal Government to local governments and business is more fundamental than a temporary deviation from normal. That is why we believe that the Trump Administration’s decision to pull out of the Paris Climate Agreement in June, while undeniably regrettable, will not undo the momentum that the private sector and local governments have garnered in transitioning to a lower-carbon world.
In the last decade, and particularly in the last few years, investors have increasingly seen climate change as a significant source of risk and opportunity. In contrast, in the first decade after the Kyoto Protocol entered into force, most investors either dismissed it or saw it primarily as only a risk factor for the largest greenhouse gas emitters. The force that drives action to mitigate climate change, to adapt to changes that are unavoidable, and to capitalize on opportunities created by the shift to a lower-carbon economy is increasingly in the private sector, and not in Washington.
Moreover, even within the public sector, there is increasing disunity between policies and regulations pursued by state and local governments and those advanced in the nation’s capital. For example, 20 U.S. states plus the District of Columbia have instituted their own Greenhouse Gas Emissions targets.1 When the Trump Administration announced that the U.S. would withdraw from the Paris Agreement, over 1,400 cities, states and businesses released a statement of continued support for the goals of the Paris Agreement and committing to take the actions necessary to significantly reduce emissions.
The market sees climate change as a risk, presenting opportunities for investment in companies providing solutions to mitigate and adapt to the impacts of this risk. Pure business economics are driving the merits of investing in these companies. The substantial decrease in the cost of renewable generation has increased their ability to compete with both coal generation and natural gas, providing opportunities to invest in companies contributing to power generation from solar and wind. Additionally, companies providing energy efficiency solutions are helping reduce costs while reducing emissions. Opportunities across energy efficiency abound — LED lighting, energy transmission, industrial processes and automotives to name a few.
Just as the shift in drivers to climate solutions creates opportunity, the pure economics of outmoded energy generation provide a guide post to investors on which companies to avoid. Coal is a prime example. Most analysts expect little or no impact from the Administration’s climate policies on the declining market for coal, including some of the CEOs in the coal industry itself.
We’ve long recognized technological and economic shifts from one model to another, like the shift from a transportation system based on horses to one based on fossil fuels, mean that some business models will prosper, and others will wither.
Today, the Internet of Things (IoT) is at the heart of a significant change in business model viability. IoT refers to an inter-connected network of devices able to collect and exchange data using embedded sensors. The concept and its various applications across industries has had a sweeping effect on company business models. At Pax, we seek companies that provide the technologies of the future, as well as those able to use it to enhance their own businesses, regardless of sector, from consumer discretionary to health care.
Amazon, which first used the internet to revolutionize how we shopped for books and has continually caused disruption across the retail sector through online shopping, extended its reach to groceries with its bid to acquire Whole Foods. Investors were immediately intrigued by the potential for lower costs in the grocery segment, enhanced distribution for Whole Foods and the combination of two strong brands, that are of particular interest to Millennials.
Investment results are affected not only by owning the right companies, but also by avoiding companies that are damaged by the “disruptive” technologies of other companies. When the Amazon-Whole Foods deal was announced, grocery stocks and food processing companies, as well as traditional retailers, lost billions of dollars in market value. Clearly, it is not only Amazon or Whole Foods shareholders that were affected. A recent article in Harvard Business Review noted that the announcement gave Amazon a 2.4% boost in stock price, while that of three more traditional grocery stores fell much more, from 6% to 14%. “Nobody in the industry,” said the author, “should be surprised that the future of retailing is moving toward a fusion of digital and physical experiences.”2
Some might call the sell-off in grocers, food companies and retailers such as Target a knee- jerk reaction and not a fundamental change in the way companies do business. We view it as more indicative of a long-term shift in how goods are sourced and sold. Even the initial public offering price (IPO) of Blue Apron, a meal-kit delivery service, was negatively impacted on the expectation that Amazon-Whole Foods could offer a similar service. At the very least, it should be a wake-up call for investors. Only time will tell.
Identifying Paradigm Shifts
Spotting the longer-term trends is a key factor in positioning portfolios, and while we also need to be aware of shorter-term trends, like recession indicators or inflated valuations, it’s important to distinguish paradigm shifts from cyclical movements. Recognition of these long-term shifts is key to identifying the stocks that will be winners and losers over the long run.
2 Darrell K. Rigby, “The Amazon-Whole Foods Deal Means Every Other Retailer’s Three-Year Plan Is Obsolete,” Harvard Business Review, June 21, 2017.
As of 6/30/17, Amazon, Inc. was 1.8% of the Pax Balanced Fund and 4.0% of the Pax Large Cap Fund, 2.3% of the Pax ESG Beta Dividend Fund and 2.6% of the Pax ESG Beta Quality Fund. Whole Foods Market, Inc. was 1.2% of the Pax Balanced Fund, 2.2% of the Pax Large Cap Fund, 0.2% of the Pax ESG Beta Dividend Fund, and 3.7% of the Pax Mid Cap Fund. Blue Apron was not held by any Pax World Funds. Holdings are subject to change.
The S&P 500 Stock Index is an unmanaged index of large capitalization common stocks.
The Russell 1000 Growth Index is a market capitalizationweighted index that measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth rates.
The Russell 1000 Value Index is a market capitalizationweighted index that measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth rates.
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.
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.