We have begun to reallocate to emerging markets: Alex Tedder on tech stocks

Alex Tedder is CIO, Head of Global & Thematic Equities at Schroders Investment Management

‘Value’ can still be found among tech stocks in the US, says Alex Tedder, CIO, Head of Global & Thematic Equities, Schroders Investment Management. In an interview with Business Standard, he says long term returns from global equities have been revised lower in recent years to reflect the impact of falling rates. Emerging market equities, however, offer attractive valuations and strong structural growth dynamics compared to developed market economies. Edited excerpts: 

Q. Technology stocks have led the market rally in the US amid the pandemic. Apple now commands a $2 trillion valuation. Do you see a bubble building up in the space? 

Optically, there is no question that large-cap tech names appear over-valued on many metrics. However, it is important to remember, particularly in this environment, that ‘price is what you pay, value is what you get’ to quote Warren Buffet. Large-cap tech trades a premium because of its compelling revenue, cash flow, and earnings fundamentals. Rolling earnings and cash flows forward just one or two years, would see multiples adjust significantly lower, and as a consequence headline valuations look much more reasonable. It is also very easy to generalise by looking at the multiple for the sector and infer that all tech stocks are expensive. There is significant variance across the sector, and ‘value’ can definitely be found. 

Q. The S&P 500 has given high double-digit returns annually for the last 11 years. What are your expectations for equity returns in the US for the next decade? 

The US equity market has been the standout market for much of the last 10 years. There are a few reasons for this, which also underpin a constructive view of the market over the next decade. First, it is important to acknowledge the strength and dynamism of the local economy. Domestically exposed names have benefited from an expansionary policy which has supported employment growth, the housing market consumer spending, and capital investment. There is little reason to expect this to change.

But of course, it's not just about the domestic economy. Over 50 per cent of the market's earnings are derived overseas, and in this regard, the US enjoys a large number of genuinely world-class brands and leading technologies. Nowhere, is this more apparent than in the IT sector. The composition of the US equity market and its structural exposure to high growth industries is another key reason for the market’s strong performance over recent years and our belief is that this performance can be sustained in the longer term. 

Q. Which are the sectors or pockets of the market that you like in the aftermath of the pandemic? Which businesses have fallen out of favour or face bankruptcy?

There are three distinct pockets of investment opportunities arising from the crisis. First, and perhaps most surprisingly, the crisis has served to re-enforce the growth in a number of industries for companies that were already benefiting from structural tailwinds. Most visibly perhaps, our reliance on technology has been amplified by the crisis, with strong growth in demand for enterprise software and cloud-based applications. Elsewhere, the trend towards e-commerce and electronic payments has also been given a boost; a necessity of lock-down for many which will likely be sustained. Secondly, there have been a number of industries that have suffered disproportionately during the crisis. Some of these industries will be structurally impaired, but for others, there will be a visible path to recovery. For these there have and will continue, to be the opportunity to buy into the recovery potential ahead of inflection in the operating performance of these businesses. Examples of such can be found in leisure and lodgings, business services, and retail. 

And finally, stocks that have demonstrated a high degree of resilience during the crisis will continue to be attractive while ever the trajectory of the recovery from the crisis remains uncertain. With the risk of an escalation in the virus, and the second wave in some of those economies that were first to enter lockdown, industries such as food and beverages and personal hygiene provide defensive qualities.   

Q. Do you think investors should temper their returns expectations from global equities in the years ahead? 

Our forecast long term returns from equities have been revised lower over recent years. This largely reflects to impact of falling rates which anchor our forecasts for the risk-free return. 

Q. What are your views on emerging markets?

In aggregate, emerging market equities offer attractive valuations and strong structural growth dynamics and comparison to developed market economies. At the same time, a relatively stable US dollar could provide a supportive backdrop on a tactical basis.

However, we do not consider emerging markets as a homogeneous collection of markets.  As global investors, we consider the market of listing of secondary importance to the geographic source of companies’ revenues and earnings. As bottom-up investors, this is our primary focus. That said, currently, we are seeing an increasing number of emerging market listed stocks highlighted by our global sector analysts as demonstrating improving fundamentals and attractive valuations. 

Q. What about India?

India remains an attractive market for us. As active investors, we at Schroders are stock-specific investors rather than region-centric investors. Across funds today, we hold several companies where we find long term value. In the aftermath of the pandemic, we were selective in emerging markets rather than focusing on themes in the developed world. The tilt towards developed markets has to some extent normalized as we have begun to reallocate to emerging markets including India.

Q. Axis Asset Management Company has launched the Axis Global Equity Alpha Fund of Fund that would invest in Schroders International Selection Fund Global Equity Alpha. Could you tell us a bit more about the fund? 

The Schroders ISF Global Equity Alpha looks to hold 40-60 stock ideas across the globe with an intention to leverage growth and market inefficiencies. We believe markets today incorporate three persistent inefficiencies: failure to look far ahead when appraising company earnings, failure to extrapolate historic growth and correctly interpret catalysts that change the trajectory of growth, and overreaction to short term news flow.  

These inefficiencies often drive material differences between underlying company fundamentals and market estimates. We call this the ‘Growth Gap’. By following a disciplined investment philosophy and the research-driven process we believe the strategy can identify stocks that deliver positive earnings surprise and deliver consistent outperformance over time.

Q. US business activity has snapped back to the highest since early 2019, according to reports. What is your assessment of the US economy at this juncture, given that Covid-19 cases continue to rise at an alarming rate and the possibility of a second wave? Is decoupling the US economy from China a good idea or a bit premature at this juncture? 

The rebound in economic activity in the US was perhaps somewhat predictable given the collapse in industrial production, manufacturing, and discretionary expenditure in Q2. The subsequent recovery, returning many of these indicators to pre-pandemic levels reflect but substantial pent-up demand and some degree of optimism (from the depth of despair) for the recovery in economic activity. 

The question we have at this juncture is whether the recovery can be sustained in light of an uncertain outlook and still significant and accelerating the incidence of the virus. The one certainty is that the Fed and central banks globally will do everything within their power to support the global economy and stave off the impact of a second wave.

China, first into the crisis and first to emerge, has also seen a strong recovery in economic activity. Its efforts to mitigate the spread of the virus and a widespread second wave appear at the time of writing to have been more successful than those seen in other economies which may contribute to a faster and more sustainable economic recovery.

Q. What do you make of the stimulus measures worldwide in the aftermath of the pandemic?  

Central banks and governments have recognised that they have a key role to play in this crisis, and have responded accordingly. We have seen a rapid loosening of monetary conditions globally, with the Fed slashing rates to the lower bound and announcing unlimited quantitative easing. 

The recent unprecedented moves in monetary and fiscal policy around the world -- and potential for more to come -- provide an important safety net to cushion the economy and limit the damage from the economic shutdowns. It is vital that the financial system continues to provide liquidity to firms and households, to compensate for the disruption to their cash flows. Without this support, this temporary hit could cause permanent damage to the supply side of the economy - widespread closures of businesses would leave little left to support the recovery. In this respect, lower interest rates are less important than measures to ensure banks have the confidence to lend rather than foreclose on borrowers, and liquidity continues in commercial paper and credit markets. 

Q. Will the emphasis on environmental, social and corporate governance (ESG) investing pick up globally amid the pandemic? 

Increased emphasis on ESG has already been evidenced by the increase in the number of new ESG funds and net inflows into funds with explicit sustainability and ESG objectives. Although these flows have in part been driven by the strong relative performance of ESG strategies over recent years -- and through the crisis itself -- it also reflects the growing appetite of investors to invest responsibly.  Regulation, in Europe most specifically, is also contributing to this trend and creating a framework in which investments in ESG strategies are tacitly encouraged. Here, environmental stewardship – and climate change more specifically – are the primary area of focus. Social policy also became much more relevant during the Covid crisis, with a focus on employers’ treatment of their employees both from a health and safety perspective but also in terms of protecting jobs in the face of the collapse in the global economy. There is good evidence to suggest that those companies taking positive actions to protect their workforce through the crisis were rewarded by stronger relative share price performance.

Q. BlackRock and Vanguard have topped the leader board of best-selling mutual fund managers globally this year, benefiting as investors fled well-known active investment houses in favour of cheap passive products. Would you still make a case for active funds, given the flight of capital to passive strategies in the past few years? 

After a number of years in which the validity of active management has been questioned, active management can be demonstrated to have outperformed the market in most geographies over short, medium, and longer terms. The strong performance of active managers, in aggregate, through the crisis, has certainly contributed to this improving picture, but it is also a change in the market dynamics which have seen strong earnings fundamentals being reasonably well rewarded by the market. It also reflects the increased breadth of the market, most notably in the US, affording active managers greater scope to add value from good stock selection. In previous years, notably, 2016, sector allocation was a much more important driver of return than the selection of stocks within sectors. Whether this is enough to reverse the flows away from active strategies into passive remains to be seen. However, in our view, there remains a place for both approaches.