Exceptional conditions create opportunities for patient stock pickers

Everyone knows value managers have had a torrid time in the markets over the past few years. In uncertain times, investors like to reduce their risk.

Opting for “sure winners” like technology shares and perceived safe-haven assets seemed like a sensible strategy for a time. And it was.

Instead of market cycles turning, they persisted far longer than most had expected.

Distortions continued to build and helped to drive the prices of some assets to unprecedented levels.

Simply put: winners continued to win and losers were punished into extremely low valuations.

But well over a year into the pandemic, it is becoming much more difficult for the market to continue ignoring fundamentals and valuations.

The coming market recalibration is likely to cause some pain for the unwary — such developments always do.

However, it also is an immensely exciting time for those who are selective about how they construct portfolios.

What’s in a price?

High valuations for technology stocks have divided market pundits for some time.

The arguments for the ascendancy of technology are overwhelming.

The Covid-19 pandemic just lent more impetus to an already powerful and transformative wave.

However, a company is not its share price.

Rolled-up into high share prices are expectations for things to not just go well in the future, but to go even better than they have so far.

But even great companies can find living up to inflated expectations challenging at the best of times.

High expectations do not tolerate legislative upsets or disappointing earnings well.

In a volatile environment like the current one, doing so becomes even more difficult.

Disappointment is bound to happen, but when disappointments are coming off high valuation multiples, the readjustment to more realistic expectations can be painful.

Hidden opportunity

The good news is ‘the market’ is not a singular entity.

Behind the index numbers there hides a wealth of diversity and opportunity.

The biggest constituents of indices like the S&P 500 reached record levels as the share prices of a handful of shares continued to soar, but there are a wealth of other investment options for those willing to look just beyond these high levels of concentration.

However, at a time when it is critical to look beyond this artificial concentration in a narrow subset of past winners, investors have been doing the opposite.

Index investing is not riskfree

These days, investing in “the index” is the new safe bet and passive strategies have reached record levels (over half of equity fund assets in the US are now in index products).

However, consider what investing in an index means when those indices have become more concentrated than ever before.

There are many investment opportunities to invest in above-average companies at below average prices.

Typically, however, these opportunities are found further down the index ladder, or perhaps even in the mid-and small-cap universe.

While the S&P 500 makes for a fascinating case study, we have seen similar dynamics play out in the local market.

Rising inflation could also redefine equity market dynamics, forcing investors to be more selective about investments and the starting valuations of their investments.

Those who continue to opt for past (expensively priced) winners are not only exposed to risk should expectations be disappointed and the prevailing narratives begin to falter.

They also risk overlooking opportunities to invest early in the shares that could outperform when conditions change.

Patient stock pickers

These shifts happen so fast that waiting to be sure about the prospects for the out-of-favour shares can mean missing out.

It is far better to have an element of what is working now, and what is yet to work in your portfolio.

Investment managers who follow a differentiated approach have the potential to add value as part of a holistic portfolio, by actively exploiting the opportunities that index huggers and passive funds, by definition, cannot.

Current market conditions are unprecedented and the true significance of current events are only likely to be revealed in retrospect.

However, these exceptional conditions also create the opportunity for patient stock pickers to construct differentiated portfolios that are poised to behave very differently to the market.

With risks at elevated levels, a little differentiation could go a long way in securing long-term returns for patient investors.