The Meaning Behind the Mean

The headline characteristics of today’s market obscure a wealth of opportunity, in both public and private markets.

Two weeks ago, we wrote about how the force of momentum can be strong enough to generate substantial short-term challenges for an investor’s strategic asset allocation.

One reason is that, at the margins, strategic asset allocation tends to be value-oriented—because value is one of the return sources that becomes dominant over medium-term, five- to seven-year time horizons.

Given the mean year-to-date returns and valuations of many equity indices, the uncertain economic outlook and the growing market consensus that policy rates will remain elevated for the foreseeable future, strategic investors might be forgiven for thinking that there are no opportunities for their capital.

On the contrary, we believe there is an attractive and growing opportunity set hidden behind the mean.

Laggard Stocks

What has really happened in 2023 is that the so-called “Magnificent Seven” largest U.S. stocks— Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla and Meta—have appreciated substantially, pulling up the market capitalization-weighted average return of any U.S. or global index they are in.

The median return and valuation for those indices is significantly lower. Strip the Magnificent Seven out altogether and you find that the indices are barely positive this year. The S&P 500 Index valuation falls from a steep 19 times forward earnings to a more reasonable 17 times.

Moreover, because the market rally has been so concentrated, and so focused on a combination of defensive quality and the single dominant growth story of generative artificial intelligence, the mean also obscures a high level of dispersion among the stocks that lie outside the Magnificent Seven.

Our equity portfolio managers are finding laggard stocks trading on free-cash-flow multiples that appear not only attractive relative to the 5% two-year U.S. Treasury yield, but may have room for multiple expansion even as persistently high policy rates and bond yields keep a lid on the mean, broad-market valuation.

Tuning the Growth Engines

At the same time, this effective limit on broad-market multiple expansion is focusing company managers’ minds on tuning and oiling their businesses’ growth engines.

Indeed, we think this has been another important ingredient in the Magnificent Seven rally: Artificial intelligence is one potential source of growth, but these mega-caps have also been redirecting capital away from plans hatched in 2020 and 2021 that were over-ambitious, or even outright vanity projects. The market has rewarded them for it.

It may also explain why the HFR Event Driven Activist Index has been one of the better performers in the hedge fund world so far this year. And while many merger transactions are failing due to an inability to agree on prices under the current uncertainty, our own Event Driven team notes that there wouldn’t be a large number of failed deals if no one wanted to do deals in the first place. They expect a pick-up in activity as economic uncertainty lifts, commensurate with the need to make value-accretive strategic changes in an environment where multiples are effectively capped.

In other words, we think active portfolio management, especially the search for value in an apparently overvalued market, is becoming more important; but we also think active company management is becoming more important, in the search for the growth to “fill” current valuations.

Skillful and Active

We see similar themes in private markets.

One can argue that higher rates and a lower scope for multiple expansion make life more challenging for private equity. We prefer to say that this environment helps the most skillful and active private equity managers stand out from the crowd.

Current transactions are not cheap, and, with the cost of debt where it is, we are also seeing a lot more equity in their capital structures—60% as opposed to the recent average of 30 – 40%. Despite these headline characteristics, however, we see these deals being underwritten with estimated returns that are similar to those that were used five years ago.

That reflects the way in which the current environment is reshaping the industry. Almost all the deals we see being completed are for high-quality companies, where the buyer has a well-worn, sector-specific playbook for unlocking cash flow, enhancing organic growth, achieving transformative growth via acquisition, or all three. That is what’s underpinning current return estimates, even when exit multiples are expected to be the same or lower.

The desire for proven growth-generating playbooks in an uncertain environment is also driving another key theme in the private markets: the rise of general partner-led secondaries and mid-life co-investment deals.

GP-led secondaries enable private equity managers to hold onto existing portfolio companies in a “continuation fund” with new investors. Similarly, a mid-life co-investment is a co-investment in an existing portfolio company, rather than a new deal. Both enable private equity managers to provide some form of liquidity to the original investors, and/or raise growth capital for investment or acquisitions in more mature assets without triggering the need to refinance in the costly debt markets.

What can the new investors get in return? Exposure to high-quality companies with which the sponsors have already been working successfully for years, a management team and playbook that have already been proven under the existing owner, and reduced fee structures compared with those found in traditional primary funds. Again, these opportunities may be hidden behind the average characteristics of the broad private equity market, and may be easier to underwrite in a more challenging macro landscape with higher interest-coverage requirements.

Selective

In short, we think there is a lot of meaning behind the mean.

Across public and private markets, we find that active management, by both portfolio managers and company managers, is becoming increasingly critical in the search for value, growth and return generation. For investors prepared to be selective and prioritize active management, we believe there is a lot more opportunity in the market than the current index and industry headline numbers might suggest.