Prayer, courtesy of central banks, may still be a "valid" investing strategy, but "growth" no longer is: for all the euphoria over the stock market outperformance in the last few days on the heels of one after another rumor of ECB intervention in the peripheral bond market (now largely denied by Germany's finance minister) one would think that managers of all funds would be delighted at the sudden reprieve they have gotten courtesy of the European central bank. One would be wrong: as GS' David Kostin calculates, at the end of June, 52% large-cap growth funds had underperformed the Russell 1000 growth fund, aka their benchmark index. Three weeks later, this number has soared to 68%, a 30% increase in underperformers, which means that despite the headline S&P print, the bulk of active stock pickers once again face that most dreaded of Wall Street possibilities: career risk. Said otherwise, while those positioned to outperform in an environment of global slowdown are celebrating, everyone else is again polishing their resume, as the following chart confirms.
July is proving to be an extremely painful month for large-cap growth fund managers. At the end of June, 52% of large-cap growth funds had underperformed the Russell 1000 Growth Index YTD. However, just three weeks later, with the Russell 1000 Growth index having dropped by 1.0%, fully 68% of growth funds now lag the industry benchmark. In contrast, large-cap Core and Value funds have both kept pace with their respective indices since the start of 3Q.
What happened? Four reasons seem to explain the underperformance.
First, a select group of glamour growth stocks plunged sharply this month: Chipotle Mexican Grill (CMG, down -24% in July, -14% YTD), United Continental Holdings (UAL, -21%, +2%); Las Vegas Sands (LVS, -16%, -15%); Fossil (FOSL, -7%, -11%) and Netflix (NFLX, -17%, -18%). In total, 50 other stocks in the Russell 1000 Growth index fell by more than 10% in July. These positions actually had only modest negative impact on aggregate fund manager performance because although Growth funds had allocation perhaps 2X the index weight of a particular security, the position sizes were often only 25 bp.
Second, the largest overweight positions relative to the benchmark lagged. Although some stocks that large-cap growth managers have consistently owned well above a benchmark weight outperformed (NKE, GOOG, QCOM) many other overweight positions lagged such as MA, AMZN, SBUX, CSCO, and PCLN. Along with the rest of the market many of these firms reported weak sales and EPS results in 3Q.
Third, the July underperformance of growth funds might also relate to another source of potential basis risk. Some managers might have unwittingly – or perhaps knowingly – embedded risk into their portfolio by ignoring the annual Russell Index rebalancing that occurred in late June. Major constituent changes occurred this year. For example, ExxonMobil’s (XOM) weight in the Russell 1000 Growth Index dropped from 419 bp to a zero weight. Medtronic’s (MDT) weight fell from 50 bp to 4 bp, Freeport McMoRan’s (FCX) weight dropped from 45 bp to zero; and IBM’s weight declined from 343 bp to 310 bp. Stock positions gaining in importance in the Russell 1000 Growth Index rebalance included Intel (INTC) from zero weight to 145 bp, Verizon (VZ) from 39 bp to 184 bp; Amgen (AMG) from zero to 83 bp, and Union Pacific (UNP) from 13 bp to 83 bp. Unfortunately, it is difficult to evaluate how much index rebalancing contributed to underperformance by Growth funds during July because holdings are released with a delay. However, Value fund relative underperformance did not change in July.
Fourth, large-cap Growth funds were underweight several key index constituents that outperformed in July. Examples include WalMart (WMT), Walgreen (WAG), Altria (MO), and Phillip Morris International (PM). These Consumer Staples firms are often viewed as unexciting. But the constant flow of weak macro and micro data makes it precisely the type of environment that is conducive to these shares outperforming.
Weak data abounds at the macro and micro levels. The 2Q GDP release showed the US economy expanded at a lackluster pace of just 1.5%, consistent with our view of a stagnating economy (growing, but at a below trend rate). Goldman Sachs Economics forecasts US GDP growth will average less than 2% in both 2012 and 2013. The ‘fiscal cliff’ looms less than six months away with an anticipated impact of $193 billion in our political analyst’s view.
Corporations corroborate the weak macro data. We expect the 2Q earnings season will lead to further erosion in CEO confidence. Executives across industries are highlighting the weak demand in their respective end-markets, not just in Europe but in Asia and the US as well. Negative sales surprises are occurring at twice the average rate during the past seven years while positive top-line surprises are half as frequent. Earnings results are more consistent with history as firms benefit from lower energy prices and take great effort to maintain margins. However, firms have slashed forward guidance and the commentary on conference calls has been decidedly downbeat with a few notable exceptions such as CAT and WFM.
It is not surprising stocks owned by growth funds have lagged in recent weeks. The premium P/E previously assigned to superior expected growth has been eroded as the economic and profit outlook has become more uncertain. We recommend high quality stocks to minimize the possible drawdown risk in the current market. So far, 293 stocks in S&P 500 have reported 2Q results (71% of total cap). Next week 117 firms (16% of market cap) will report 2Q results including: COH, ADM, PFE, AET, MA, PG and VIAB.