The Growing Appeal of Long-Term Fundamentals
In this paper, we discuss factors that contributed to the equities of companies with strong long-term fundamentals, such as earnings per share (EPS) and revenue growth, dramatically underperforming the broad market in 2021. We also explain why a handful of factors, such as macroeconomic changes, valuations and strengthening earnings, may potentially reverse this trend. In our view, conditions are particularly favorable for equities of high-quality, innovative smaller growth companies.
COMMENTARY
Signato
ry to the PRI and carbon neutr
al.
Market Update
THE GROWING APPEAL OF
LONG-TERM FUNDAMENTALS
Executive Summary
In this paper, we discuss factors that contributed to the equities of
companies with strong long-term fundamentals, such as earnings per
share (EPS) and revenue growth, dramatically underperforming the
broad market in 2021. We also explain why a handful of factors, such as
macroeconomic changes, valuations and strengthening earnings, may
potentially reverse this trend. In our view, conditions are particularly
favorable for equities of high-quality, innovative smaller growth
companies.
Highlights include the following:
•
In the first half of 2021, optimism about the economy caused a strong
shift in preference from secular growth stocks to economically sensitive
cyclical stocks.
•
In the second half of 2021, anxiety about tightening monetary policy
drove a violent rotation into larger, more defensive stocks.
•
Underlying both halves of last year was a duration trade in which long-
duration assets, or equities with potential for generating strong future
EPS growth or revenue growth, underperformed more established
short-duration companies, having higher current cash flows and slower
growth expectations.
•
The epicenter of the rotation occurred in the longest duration assets,
or small cap growth stocks, which by some measures are now the least
expensive on a relative basis in decades, potentially setting up strong
relative returns in the future.
Winter 2022
Daniel Chung, CFA
CHIEF EXECUTIVE OFFICER
CHIEF INVESTMENT OFFICER
PORTFOLIO MANAGER
Brad Neuman, CFA
SENIOR VICE PRESIDENT
DIRECTOR OF MARKET STRATEGY
COMMENTARY
2/8
Challenging Times Create Potential Opportunities
After falling out of favor among investors, equities of companies with attractive
long-term fundamentals have strong potential for outperformance in 2022, in our
view. To understand events of 2021 and why market conditions may change, it’s
helpful to look at specific market rotations that occurred in each half of the year.
Economic Outlook Leads to Cyclicals
Economically sensitive stocks such as Energy and Financials performed best
in the first half of 2021 as investors clamored for exposure to an accelerating
economy. The stage for this change in investor preference was set in late 2020,
when favorable COVID-19 vaccine trials sparked optimism about the pandemic
faltering and hopes that efforts to curtail the public health emergency would
be scaled back or eliminated. This optimism combined with record levels of
fiscal stimulus caused the economy to start rebounding after lockdowns had
previously sparked a deep recession. The optimism strengthened when the
Food and Drug Administration eventually granted emergency use authorization
of COVID-19 vaccines and by the end of the 2020, some 2.8 million Americans
had received their first dose —a slow start but a start nevertheless. The
aggressive ramping up of the vaccination campaign in the subsequent months
and continued economic growth sustained investor optimism and a selloff
in safe-haven Treasury bonds with the 10-year yield rising 53bps in the first half
of 2021.
A few points illustrate the dramatic strength of the economy.
•
At the start of 2021, consensus GDP growth forecast was 4.0%, an estimate
that increased 250bps during the first half of 2021 to 6.5%, according to
FactSet.
•
Unemployment dropped substantially from 6.7% to 3.9% by year end (see
Figure 1).
Figure 1
Seasonally Adjusted Unemployment Rate
3%
4%
5%
6%
7%
12/21
11/2
1
10/2
1
9/21
8/21
7/21
6/21
5/21
4/21
3/21
2/21
1/21
12/2
0
Sour
ce: Bur
eau of Labor Statistics.
U.S.
Unemplo
yment Rate
Tumble
s
Economically sensitive
stocks such as Energy and
Financials did the best in the
first half of 2021 as investors
clamored for exposure to an
accelerating economy.
Many equity investors reacted to economic optimism and higher long-term
interest rates by rotating into cyclical stocks or companies with earnings
growth that is closely or directly tied to economic expansion. We consider
these companies, which usually have weak long-term growth potential and are
typically found within the value category, to be lower quality, unlike secular
growth leaders that use innovation to disrupt their respective industries and
generate future earnings growth. The investor preference for these companies
can be seen in the performance of various corporate characteristics in the first
half of 2021 when factors such as high debt, low margins, high beta, slow long-
term growth and low shorthand metrics of valuation, such as price-to-book
value, outperformed (see Figure 2).
Rate Hike Anxiety Leads to Defensiveness
In the second half of 2021, inflation came in hotter than expected, topping 6%,
and the Fed signaled a desire to raise rates sooner than anticipated. As a result,
the yield curve flattened with yields of shorter term debt increasing rapidly. During
this period, the 2-year Treasury Bill increased nearly 50bps after only rising 13bps
in the first half. Investors responded by selling stocks perceived as riskier. This was
reflected in the market sensitivity factor or Beta underperforming the sector-
neutral S&P 1500 by a large 7%, after having outperformed in the first half.
Investors also sought safety in large companies with the small cap Russell 2000
Index underperforming the S&P 500 by nearly 1,400bps in the second half of the
year. This was particularly true in the large cap growth area of the market, which
is more concentrated than ever – the top ten companies accounted for nearly
half (48%) of the Russell 1000 Growth Index at the end of 2021. Indeed, for the
year we estimate that the top ten constituents accounted for 62% of the index’s
performance, thereby outperforming the rest of the index by a stunning
2,000bps, approximately. Accordingly, the average growth stock did not fare
nearly as well as the Russell 1000 Growth Index.
COMMENTARY
3/8
Figure 2
Lower Quality Economic Sensitive Equities Outperformed
-10
-8
-6
-4
-2
0
2
4
6
8
10
Long
Term Gr
ow
th
Gr
oss Mar
gin
Net Debt
to
EBITD
A
Beta
Lo
w P
rice/Book
Sour
ce: Corner
stone Macr
o.
Fact
or perf
ormance
re
lative
to
the S&P 1500
, which is sect
or neutr
al and is calcula
ted
by
taking the r
elativ
e perf
ormance of the t
op quintile of st
ock
s ag
ainst the bott
om quintile of st
ock
s f
or each
factor.
The constituents in the quintiles ar
e re
balanced monthly
. Net Debt/EBITD
A is defined as (T
otal Debt - Cash)/
LTM EBITD
A and Gr
oss Mar
gin is defined as (L
TM Rev
enue - L
TM COGS)/L
TM Rev
enue
. Beta r
epr
esents the slope
of the line thr
ough a re
gr
ession between the monthly stock
re
turn and the monthly mark
et
re
turn over the past
5
ye
ar
s. Book yield is book
va
lue per shar
e/
curr
ent shar
e pric
e. long
-term gr
ow
th is mean estimat
ed 5-
ye
ar EP
S gr
ow
th.
8%
8%
-4%
-8%
2%
Fir
st Half 2021
Fa
ctor
Re
turns
In the second half of
2021, inflation came in
hotter than expected, topping
6%, and the Fed signaled a
desire to raise rates sooner
than anticipated. As a result,
the yield curve flattened with
yields on shorter term debt
increasing rapidly.
Summing up 2021
In a word, much of the equity performance last year can be attributed to duration.
With investors seeking instant gratification from a one-time re-opening of the
economy in the first half to hiding in defensive businesses in the second half, the
one constant driver of stock prices was duration. Short-duration cash flow
stocks, businesses with limited opportunities to invest their earnings that instead
distribute their cash to shareholders, did very well at the expense of long-duration
cash flow equities that are more likely to reinvest for long-term growth.
Whether it was rising risk-free rates or simply higher risk premiums, many
investors adjusted their cash flow modeling by increasing the rate at which they
discounted future cash flows back to the present, thereby lowering the value of
long duration assets most, just as long-term bonds are impacted more by rising
rates than short-term bonds.
We saw this dynamic in the largest spread in performance between the small
capitalization Russell 2000 Growth Index and the S&P 500 in more than 20 years
(over 2,700bps). On a more granular basis, there was a very wide performance
spread between short-duration characteristics such as shareholder yield, which
measures the performance of companies with the highest dividend and share
repurchase yields, and long-duration characteristics, such as the long-term
growth factor, which measures the performance of those companies with the
highest forecasted long-term growth (see Figure 3).
-15%
-10%
-5%
0%
5%
10%
15%
Long-
Te
rm Gr
owth
Shareholder
Yield
12/21
11/21
10/21
9/21
8/21
7/21
6/21
/21
5
4/21
3/21
2/21
1/21
12/2
0
Period
-15
-10
-5
0
5
10
15
Cumulativ
e R
elativ
e Re
turn
■
L
ong
-Term Gr
ow
th
■
Shar
eholder
Yield
Sour
ce: Corner
stone Macr
o.
Fact
or perf
ormance
re
lative
to
the S&P 1500
, which is sect
or neutr
al and is
calculated
by
taking the r
elativ
e perf
ormance of the t
op quintile of st
ock
s ag
ainst the bott
om quintile of st
ock
s
for each f
act
or. The constituents in the quintiles ar
e re
balanced monthl
y. Shar
eholder
Yield is [L
TM Common
and Pref
err
ed St
ock
Pu
rchased - L
TM Common and
Pref
err
ed St
ock Sold + L
TM
To
tal Common Dividends
] /
Mark
et Capitalization.
Long
-term Gr
ow
th is mean estimat
ed 5-
ye
ar EP
S gr
ow
th.
COMMENTARY
4/8
Figure 3
Factor Performance in the Broad Market
Short duration cash flow
stocks, businesses with
limited opportunities to
invest their earnings and
instead distribute their
cash to shareholders, did
very well at the expense
of long-duration cash flow
equities that are more likely
to reinvest for long-term
growth.
As shown in Figure 4, this rotation to companies with high current shareholder
yields was apparent not only in the broad market but within growth stocks,
which helps explain why large cap growth, which tends to include more
companies with significant current earnings, was relatively strong in 2021,
with the Russell 1000 Growth Index generating a 28.7% return compared to
the 25.2% return of the Russell 1000 Value Index. On the contrary, small cap
growth tends to include younger companies that are aggressively investing in
innovation rather than generating earnings or paying dividends.
A Brighter Path Forward
While smaller growth company stock prices underperformed, their funda
-
mentals did not. The next 12-month (NTM) EPS estimates for the S&P SmallCap
600 Growth index catapulted forward 63%, according to FactSet data, easily
trouncing the still quite strong 36% increase in S&P 500 NTM estimates.
But what happens when price underperformance meets fundamental
outperformance? Compressed valuations ensue. The rotation away from
smaller growth equities juxtaposed with their strong fundamental growth has
resulted in historically attractive valuations in these types of companies. The
S&P SmallCap 600 Growth index valuation is 20% lower than the S&P 500, its
biggest discount in two decades. Typically, small cap growth equities trade at a
-10%
-5%
0%
5%
10%
15%
20%
Long-
Te
rm Gr
owth
Shareholder
Yield
12/21
11/21
10/21
9/21
8/21
7/21
6/21
5/21
4/21
3/21
2/21
1/21
12/2
0
Period
-15
-10
-5
0
5
10
15
Cumulativ
e R
elativ
e Re
turn
■
L
ong
-Term Gr
ow
th
■
Shar
eholder
Yield
Sour
ce: Corner
stone Macr
o.
Fact
or perf
ormance
re
lative
to
the S&P 1500 Gr
ow
th,
which is sector neutr
al and is
calculated
by
taking the r
elativ
e perf
ormance of the t
op quintile of st
ocks
ag
ainst the bott
om quintile of st
ock
s fo
r
each f
act
or. The constituents in the quintiles ar
e re
balanced monthl
y. Shar
eholder
Yield is [L
TM Common and
Pref
err
ed St
ock
Pu
rchased - L
TM Common and
Pref
err
ed St
ock Sold + L
TM
To
tal Common Dividends
] / Mark
et
Capitaliz
ation.
Long
-term Gr
ow
th is mean estimat
ed 5-
ye
ar EP
S gr
ow
th.
COMMENTARY
5/8
Figure 4
Factor Performance in Growth Stocks
The rotation away from
smaller growth equities
juxtaposed with their strong
fundamental growth has
resulted in historically
attractive valuations in these
types of companies.
COMMENTARY
6/8
premium to large cap stocks based on their superior forecasted fundamental
trajectory (see Figure 5).
The last time this occurred in February 2001, small cap growth outperformed
the broad market by over 50% in the ensuing five years. We maintain that the
potential normalization of the small cap growth price-to-equity ratio (P/E)
relative to the S&P 500 could provide a strong tailwind to small cap
performance. Additionally, long-term fundamentals for small cap growth are
compelling. Small cap growth EPS is expected to increase 17.4% over the next
two years compared to only 6.9% for the S&P 500.
We believe small cap growth stocks could also benefit from a rally in health care
and biotech in particular, with the S&P Biotechnology Select Industry Index
declining 24% in 2021, drastically underperforming the broad market and the
small cap category. This underperformance has resulted in the equity market
capitalization to net cash value ratio of the biotech group declining to 3x—its
lowest level in 20 years.
Potential for Shifting Sentiment
In our view, valuations, while compelling, may not be enough to drive a shift in
sentiment. To that end, we believe it’s important to consider that the economy
can only re-open once so the strong economic boost in the aftermath of the
pandemic is likely to be a one-time event. Eventually, we believe GDP growth
resulting from the re-opening is likely to weaken or a COVID-19 variant such as
-30%
-20%
-10%
0%
10
%
20
%
30%
40%
50%
2021
2019
20
17
2015
2013
2011
2009
20
07
2005
2003
2001
-15
-10
-5
0
5
10
15
S&P 600 G
row
th Pr
emium /
(Discount) to S&P 500
■
L
ong
-Term Gr
ow
th
■
Shar
eholder
Yield
Sour
ce: F
actSet
.
Figure 5
Small Cap Growth P/E is Cheap Relative to Large Cap
We maintain that the
potential normalization of
the small cap growth price-
to-equity ratio (P/E) relative
to the S&P 500 could provide
a strong tailwind to small cap
performance. Additionally,
long-term fundamentals
for small cap growth are
compelling. Small cap growth
EPS is expected to increase
17.4% over the next two years
compared to only 6.9% for
the S&P 500.
Brad Neuman, CFA
Senior Vice President
Director of Market Strategy
Daniel C. Chung, CFA
Chief Executive Officer
Chief Investment Officer
Portfolio Manager
COMMENTARY
7/8
Omicron may weigh upon economic growth. If either occur, investors may be
willing to pay a premium for companies that can grow earnings with innovative
products rather than cyclical growth. Additionally, the Federal Reserve’s
shrinking of its balance sheet and increasing of the fed funds rate could
potentially result in lower long-term interest rates, which would support the
equity performance of long-duration companies. Ultimately, irrespective of
changes in valuation, the potential for high-quality growth companies to
generate compound earnings and revenue growth should support strong
returns over the long-term, in our view.
The Road Ahead
In closing, since our founding more than 55 years ago, we have believed that
companies with strong long-term fundamentals offer the best potential for
generating attractive returns for patient investors. The significant rotation we
witnessed in 2021 hasn’t changed our strong conviction in using in-depth
fundamental research for finding secular growth leaders with potential for
generating long-term earnings growth. We continue to believe that our
investment philosophy is highly appropriate as historically high levels of
innovation, including the digital revolution that is disrupting all industries, are
providing leading companies with strong opportunities to generate secular
growth. We believe where there is growth in fundamentals, there will be solid
returns. Now it is the stock market’s turn to catch up.
We continue to believe
that our investment
philosophy is highly
appropriate as historically
high levels of innovation,
including the digital
revolution that is disrupting
all industries, is providing
leading companies with
strong opportunities to
generate secular growth.
The views expressed are the views of Fred Alger Management, LLC (“FAM”) and its
affiliates as of January 2022. These views are subject to change at any time and may
not represent the views of all portfolio management teams. These views should not be
interpreted as a guarantee of the future performance of the markets, any security or
any funds managed by FAM. These views are not meant to provide investment advice
and should not be considered a recommendation to purchase or sell securities.
Risk Disclosures:
Investing in the stock market involves risks, including the potential
loss of principal. Growth stocks may be more volatile than other stocks as their prices
tend to be higher in relation to their companies’ earnings and may be more sensitive to
market, political, and economic developments. Local, regional or global events such as
war, acts of terrorism, the spread of infectious illness such as COVID-19 or other public
health issues, recessions, or other events could have a significant impact on
investments.
Past performance is not indicative of future performance.
Investors
whose reference currency differs from that in which the underlying assets are invested
may be subject to exchange rate movements that alter the value of their investments.
Important Information for US Investors:
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Earnings per share (EPS) is calculated as a company’s profit divided by the
outstanding shares of its common stock.
The price-to-book ratio is the ratio of a company’s market price to its book value.
Price-to-earnings is the ratio for valuing a company that measures its current share
price relative to its earnings per share (EPS).
Free cash flow is the cash a company generates after taking into consideration cash
outflows that support its operations and maintain its capital assets.
EBITDA (earnings before interest, taxes, depreciation, and amortization) is a
commonly used accounting measure of a company’s overall financial performance.
COGS (cost of goods sold) is generally defined as the direct costs attributable to the
production of the goods sold by a company.
FactSet provides software and market data to financial professionals. FactSet is an
independent source, which Alger believes to be a reliable source. Alger, however, makes
no representation that it is complete or accurate.
Beta measures a portfolio’s sensitivity to market movements relative to a particular
index; a portfolio with a beta of 1.00 would be expected to have returns equal to
such index.
The S&P 1500 is an unmanaged index that covers approximately 90% of the U.S.
market capitalization.
The Russell 2000 Index is a small cap stock market index of the bottom 2,000 stocks
in the Russell 3000 Index.
The S&P 500 tracks the performance of 500 large companies listed on stock
exchanges in the U.S.
The Russell 1000® Growth Index is an unmanaged index designed to measure the
performance of the largest 1000 companies in the Russell 3000 Index with higher
price to book ratios and higher forecasted growth values.
The Russell 2000® Growth Index measures the performance of the small cap growth
segment of the U.S. equity universe. It includes those Russell 2000 companies with
higher growth earning potential as defined by Russell’s leading style methodology.
The Russell 1000 Value Index measures the performance of those Russell 1000
companies with lower price to book ratios and lower forecasted growth values.
The S&P SmallCap 600 Growth Index measures growth stocks using three factors:
sales growth, the ratio of earnings change to price, and momentum. Constituents
are drawn from the S&P 600.
Investing in innovation is not without risk and there is no guarantee that investments
in research and development will result in a company gaining market share or
achieving enhanced revenue. Companies exploring new technologies may face
regulatory, political or legal challenges that may adversely impact their competitive
positioning and financial prospects. Also, developing technologies to displace older
technologies or create new markets may not in fact do so, and there may be sector
specific risks as well. As is the case with any industry, there will be winners and
losers that emerge and investors therefore need to conduct a significant amount of
due diligence on individual companies to assess these risks and opportunities.
S&P Select Industry Indices are designed to measure the performance of narrow
GICS® sub-industries. The S&P Biotechnology Select Industry Index comprises
stocks in the S&P Total Market Index that are classified in the GICS biotechnology
sub-industry.
The S&P indexes are a product of S&P Dow Jones Indices LLC and/or its affiliates
and has been licensed for use by Fred Alger Management, LLC and its affiliates.
©
2021 S&P Dow Jones Indices LLC, a subsidiary of S&P Global Inc. and/or its
affiliates. All rights reserved. Redistribution or reproduction in whole or in part are
prohibited without written permission of S&P Dow Jones Indices LLC. For more
information on any of S&P Dow Jones Indices LLC’s indices please visit www.spdji.
com. S&P® is a registered trademark of Standard & Poor’s Financial Services LLC
and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC.
Neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their
affiliates nor their third party licensors make any representation or warranty,
express or implied, as to the ability of any index to accurately represent the asset
class or market sector that it purports to represent and neither S&P Dow Jones
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licensors shall have any liability for any errors, omissions, or interruptions of any
index or the data included therein.
Frank Russell Company (“Russell”) is the source and owner of the trademarks,
service marks and copyrights related to the Russell Indexes. Russell® is a trademark
of Frank Russell Company. Neither Russell nor its licensors accept any liability for
any errors or omissions in the Russell Indexes and/or Russell ratings or underlying
data and no party may rely on any Russell Indexes and/or Russell ratings and/or
underlying data contained in this communication. No further distribution of Russell
Data is permitted without Russell’s express written consent. Russell does not
promote, sponsor or endorse the content of this communication.
COMMENTARY
8/8
Fred Alger Management, LLC
100 Pearl Street, New York, NY 10004 / 800.223.3810 / www.alger.com
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