RCM Managed Asset Portfolio - Q4 2021
Investing In Growth and No Growth
By Christopher Chiu, CFA
This year the equity market index, the S&P 500, did better than 27% which was a very good year overall. But for many equity investors it was a turbulent year. If you look underneath the surface you will find that small and mid-size company stocks, foreign stocks, and other parts of the index did poorly. Many of the growth stocks that did well in 2020 performed poorly in 2021. This is not a result of the businesses doing poorly. In most cases their story continues unchanged. The digitization of commerce and social interaction remains a continuing trend as technology becomes an ever bigger part of our daily lives.
Why then did certain growth parts of the equity market do poorly?
They may have done poorly because the market was anticipating higher interest rates in 2022. Fed chairman Powell has spoken lately about accelerating the tapering of quantitative easing. Quantitative easing is a measure where the Federal Reserve Bank buys long term bonds from banks in order to increase the money supply in the financial system. Overall, this action is intended to bolster the US economy. But now that inflation has been on the rise, the Federal Reserve has begun tapering that purchasing program and even speeding up an end to it. This bodes for more aggressive monetary policy in the future because, of course, they wouldn’t want to accelerate tapering unless they were eager to get to the next logical step of Fed policy—raising interest rates.
Raising interest rates ultimately results in stocks and bonds being valued lower. While this has not yet harmed the equity market overall, this may have put specific pressure on growth stocks because their value comes from cash flows much farther in the future. When interest rates are rising and cash today can be invested at higher rates of interest, cash much farther in the future looks less attractive.
So why continue to be a growth investor?
Growth investing comes with some preconditions. If you are growth investor it is because you believe (1) the possibility of upside exists in your growth investment and (2) the possible upside is much higher than the upside that exists in alternatives like value stocks or bonds. Because value stocks and bonds do not grow or do not grow very much, their price generally stays about the same or only moves up slowly. In order to make good money in bonds and value stocks you would need to buy them when they are really cheap. Unlike growth stocks, their upside is limited.
Growth stocks are different. Because they grow, they can be worth much more in the future than investments that do not grow. But in order for this style of investing to work it must be given time because a growth company does not do all its growing in one year or even five years. It occurs over much longer periods. Some famous examples you know about are Apple, Amazon, Google, and Facebook which have grown a lot during the past decade. The continuing possibility of upside is why we are still invested in growth stocks even if some of them performed poorly in 2021 because if we are right you, as our investor, will benefit more than if we invested in nongrowth investments. Over time the difference can be huge.
While we are willing to hold onto growth investments for a longer period, our approach is different when investing in non-growth investments like bonds which offer little upside. What makes bond investing different from equity investing is that bond prices have a ceiling. Sure, bonds can be priced above par (the price at which they are issued) but not dramatically above this level. Unlike equities the principal invested in a bond does not have the possibility of expanding forever. In bond investing you only get gains on your principal investment by finding opportunities to buy at a discount (which we did in April of 2020) and then having prices climb closer to par in more favorable investing environments or when they get close to maturity. But once bonds reach par as they had this year, the only way of making further gains from them is from their income (yield.) When that happens, then it becomes a question of whether you are willing to keep the invested principal at risk for the fractional amount of income emitted every month.
Given the interest rate environment we will eventually be in, we were unwilling to continue to hold a lot of risk in the bond portfolio. In 2021 we had done better than the benchmark (almost 300bps) by holding a mix of risky and less risky bonds. In the case of the risky bonds, we were well paid to hold that risk. But with the current rate environment in mind, we sold off much of that risk. Favorable conditions for holding risky bonds no longer exist.
I’ll just illustrate the rationale of our decision with some examples from our portfolio. The risky type of fixed income in our portfolio were preferred stocks, high yield bonds, and international bonds. In the case of these “riskier bonds,” the income they emitted per year was a 4-5% yield. Having researched potential drawdowns of risky bonds in a rising interest rate environment, we knew that the risk from a drawdown from any of these was 8-10%. So we were unwilling to risk losing 8-10% of your bond investment in order to possibly gain 4-5% through income. Instead, by shifting to less risky bonds like TIPs and mortgages, the risk-return scenario we find ourselves in now with the current bond portfolio is closer to getting a 3% yield from income and a potential principal loss of around 3%. While the 3% income yield is not great, at times you have to be willing to play defense until a better risk-reward scenario emerges.
Eventually the risk-reward scenario will improve in the bond world, but it won’t be until the Fed signals that rates will no longer be raised. The last time this occurred was in December 2018 and the next year was a banner year for bond investing. This time around for that to occur, we would have to see signs of inflation diminishing significantly and economic growth slowing. But so far that hasn’t been happening.
All of this is to say, not all investing situations are the same. As portfolio managers our main powers come from recognizing different risk-reward situations and acting accordingly. While many growth stocks had a bad year in 2021, we still recognize that in the long run the world continues to change toward a more digital future and these investments will allow us to benefit from this change. But where the upside is capped as they are with most bonds and prices can no longer get better, then we have the responsibility of changing the portfolio toward something safer and waiting for better, cheaper prices ahead, when we can again pursue the upside.