The term regime change within investment markets is typically associated with inflation and interest rates returning to pre-Global Financial Crisis (GFC) levels. We, however, believe the term also applies to how one should invest. A higher cost of capital changes how companies and investors alike are seeking returns. Notably, it puts the onus on selectivity and an active approach to investing.

The era of ultra-low interest rates distorted capital allocation processes. As we explored in our 2024 outlook, Navigating change: Three drivers for long-term investment positioning, whether an organization had a good or bad business model was almost irrelevant; inexpensive capital was readily available to support even the most unviable businesses. The return of higher lending rates has dramatically changed the landscape for companies, with funding now much harder to come by and investors more discerning about where they choose to allocate capital.

While we expect interest rates to recede from their current highs, the new normal looks certain to be higher than the unusually low pre-pandemic level. This will force companies to work harder to compete for investor capital and, with the bar raised, some companies will be more successful than others. Indeed, many companies will fail. Consequently, investors must take a more rigorous approach to security selection, increasing the importance of deep industry knowledge.

A higher bar for companies favors active management

The era of low rates also coincided with the growth of passive investment strategies designed to follow the market. Funds that closely track benchmarks have a place in meeting certain investment objectives. Yet, in a higher cost of capital environment, we believe an active approach to security selection is better suited to separating the winners from the losers and generating outsized returns.

This is borne out when looking at active versus passive returns within U.S. equities through different rate environments. Based on data going back to 1990, the average passive fund outperformed the average active fund when the yield on the 10-year U.S. Treasury Note was 3.50% or lower. However, when yields are higher than 3.50%, as we expect for the foreseeable future, the average active U.S. equities fund has historically been ahead. Of course, this is based on the average active and passive fund, and active managers with proven research capabilities and strong track records would aim to beat the average.

The innovation divide – amplified

It is not just a higher cost of capital that causes us to believe investors conducting in-depth research will be rewarded in the years ahead. The breadth of shifts occurring in the economy increases the potential divide between the secular winners and the companies at the highest risk of being disintermediated. For years this rift has been on display in the technology sector as innovative upstarts created entirely new industries or displaced slow-to-react incumbents.

This creative destruction has already spilled into other sectors, and rapid advancements in artificial intelligence (AI) and other novel technologies will likely amplify the divide. It is particularly evident in the healthcare space, where pharmaceutical and biotech companies are creating new classes of novel therapies at an increasing rate.

As with other waves of innovation, not all companies will adopt an effective strategy. Those that don’t are at risk of losing market share to peers or will put off investors by their inability to grow earnings as rapidly as evolving competitors. As an example, U.S. large-cap companies that committed research and development (R&D) funding to allow for innovation outperformed those that did not (see chart below). From an investing perspective, we believe a deep understanding of the structural forces at play combined with expert research into company strategy will be essential to navigate change and generate excess returns.

Innovation matters: The benefits of research and development on U.S. equity returns

The outperformance of highest quintile R&D to Enterprise Value stocks is the continuation of a decades-long trend, while R&D-to-sales outperformance reflects the more recent massive investment in the digitization of the global economy.

Source: Empirical Research Partners, April 2022. Large capitalization stocks, relative returns to the highest and lowest quintiles of select factors. Equally weighted monthly data compounded to annual periods. Ten years ending mid-April 2022. R&D Stock-to-Enterprise Value is capitalized stock of R&D expenditures, accumulated over trailing periods of three to eight years depending on the sector, relative to enterprise value.