U.S. equities: The dawn of a new era?

Equity markets offer exciting opportunities to participate in the innovation and demographic themes reshaping our world. The recent Janus Henderson Global Investment Summit provided a timely mid-year update on the key investment themes likely to drive markets. Here we summarize takeaways on the key investment themes and opportunities across the U.S. equities market capitalization spectrum.

How do you view the current environment for large-cap equities?

Jeremiah Buckley: We see a lot to be positive about in the U.S. economy as we enter the second half of the year, with unemployment remaining low and job growth solid. Consumers are still feeling the impact of inflation, however, and being forced to make choices about how they spend as they absorb those higher costs. But we still believe consumer balance sheets are in a healthy place and that the overall backdrop is strong.

Equity markets have embraced this positive backdrop and priced in a soft-landing scenario, as evidenced by the 17% rally in the S&P 500® Index since 31 July 2023. Year-over-year S&P 500 earnings estimates are up over 10% this year and another 10% next year, which we feel are realistic assumptions based on our company interactions. We are, however, focused on two areas that we believe will determine whether those estimates are realized: productivity and innovation.

From a productivity standpoint, we are primarily interested in labor productivity and particularly focused on the metric of non-farm labor productivity, which year over year has been up 2.4% to 2.9% over each of the last three quarters. This bodes well for margins and companies, as well as for the inflation outlook.

On the innovation front, there has clearly been a great deal of discussion around AI, but innovation goes beyond just tech – it’s also creating opportunities in healthcare, for example. If that trend can continue, it will sustain our optimistic outlook for equities.

Shifting to the other end of the spectrum, do you think small caps are poised to make a comeback?

Jonathan Coleman: Historically, periods of small cap and large cap relative outperformance tend to occur in very long cycles, between six and 14 years. We are now in the 13^th year of a large cap outperformance cycle, so based on what we’ve seen over the past several decades, a period of extended outperformance for small caps could indeed be on the horizon.

It’s also worth noting that there are parallels in today’s market to the 1970s, which was a notable period of small cap outperformance. Both periods saw crowding at the top of the market – the “Nifty 50” in the ‘70s and the “Magnificent Seven” today – with high nominal GDP growth and persistent inflation.

Underpinning all of this are historically cheap valuations: The market is currently in about the ninth percentile of relative valuation of small caps versus large caps over the last 50 years.

And what are we seeing in between? How do you view the backdrop for midcaps, and what should investors be paying attention to?

Brian Demain: Even accounting for the large-cap rally of the past five to seven years, midcaps have historically outperformed both small and large caps over the long term. So, we think it’s a fruitful place to invest, but there are certain dynamics in the space that investors should be aware of.

One risk we’ve been highlighting as particularly acute in the midcap universe is stock-based compensation. It has become regular practice across Wall Street to exclude stock-based compensation as an expense in adjusted earnings. We are all in favor of growth companies using stock shares to motivate employees, but we very much view it as an expense.

Of course, stock-based compensation isn’t restricted to midcap companies. But a lot of the faster-growing tech companies – which make up a significant portion of the midcap benchmark – are heavy users of stock-based compensation.

In the Russell Midcap Growth benchmark, 6% of revenue and 36% of operating cash flow is paid in stock-based compensation, which means that the average company is effectively overstating earnings by over a third if that compensation is excluded. When you consider that some companies are granting this practice a lot more than others, potentially as much as 100% of a company’s cash flow could be coming from stock-based compensation, and we think that is leading to notable distortions in the midcap universe.

How is a higher cost of capital impacting companies in your space?

Coleman: Small-cap companies are on the tip of the spear when it comes to higher rates, and a potentially higher cost of cost of capital will create differentiation opportunities within the space. A company’s ability to self-fund its growth, for instance, is exceptionally important during a time when borrowing costs have increased.

That is why I view this as a compelling time for active management. While there is a historically high percentage of unprofitable companies in the small-cap indices, that does not fundamentally change our approach, which has always been to focus on companies that have high returns on capital and that are cashflow generative.

Demain: There are fewer companies in the midcap space that are not profitable, but we do see companies trading at extraordinary valuations. Over a third of the midcap growth benchmark is trading at over 40 times earnings, and these earnings have persisted despite a meaningfully higher interest rate environment, which is surprising.

Furthermore, to justify a 40x earnings valuation, our assumptions show that a company would need to compound earnings organically at close to 20% a year for 10 years. Only a low single-digit percentage of companies have historically been able to achieve that, and yet investors in the midcap growth space are essentially betting that one-third of companies can sustain this type of growth.

Despite some valuations that we find quite extreme, particularly in a world of higher interest rates where the discount rate on cash flow should be higher, we seek – through active management – to find companies at sensible valuations by focusing on quality.

Buckley: We maintain the same focus on quality in the large-cap space. We avoid companies that need to rely on capital markets to fund their growth, and we spend a lot of time assessing companies’ balance sheets and the consistency of their cash flows. In an environment where rates could stay elevated for a while, we think it’s especially important to understand those funding sources and needs for specific companies.

It’s also worth noting that we are seeing more pronounced differentiation in the market. For example, real estate, which is particularly hard hit by higher rates, is the worst-performing sector in the S&P 500 so far this year. Looking at specific companies within sectors, those with high levels of leverage have struggled to see growth and have been penalized more than other companies in the same industry that have less leverage. Paying close attention to these differentiating factors is key to identifying winners and losers in this market.

What industry trends are creating compelling investment opportunities in your space?

Demain: The biggest one for midcap is the growth in electricity demand. Electricity consumption in the U.S. was a growth dataset throughout the second half of the 20^th century. Then for the last 20 years, it has essentially been flat as the economy has become less power intensive.

We think that dynamic is changing dramatically, with estimates of between 1% to 4% growth in electricity demand over the next five to 10 years in the U.S. The biggest driver of that growth is AI datacenters, which are six times more power intensive than traditional computer datacenters. The hyperscale cloud companies are allocating billions of dollars in capital expenditures to AI datacenters, and that will drive tremendous power demand.

On top of that, the growth in electric vehicles, as well as other electrification trends such as heat pumps and induction cooking, puts more strain on the power grid. The use of renewables, which are often located far from population centers, doesn’t lead to more electricity demand, but it too places more demand on the grid.

All this increased power demand has awoken one of the most traditionally sleepy areas of the market: Regulated utilities. Given these demand drivers and the increased need for modernization of the grid, we expect to see sustained investment in electric utility rate bases, which is the asset base on which utilities can earn a regulated return.

Coleman: We’ve been identifying compelling opportunities in water quality and hazardous waste remediation. Several large-cap companies have settled major lawsuits over waste cleanup. Companies need advising and solutions on this front, and many small- and mid-cap companies play directly into that theme. With the increasing urgency and consumer awareness around cleaning up “forever chemicals,” we see investing in water infrastructure as a multidecade theme.

Buckley: In large caps, while there are some concerns that Generative AI (Gen AI) has played out, we believe we are still in the early stages of infrastructure buildout. There are additional benefits to be realized from a productivity and revenue growth acceleration standpoint. We are continually finding new and varied examples of companies using Gen AI to improve their business and become more efficient, which allows them to focus on areas of growth potential.

There are great examples of this within energy, financial services, and healthcare. Our healthcare team has surfaced a number of emerging innovations, such as gene editing and AI-based imaging and diagnostics, not to mention the GLP1 obesity drugs that have generated a great deal of attention. Healthcare companies may offer defense for a portfolio because the demand for their products is relatively consistent, but there are also many instances of innovation that may drive growth and differentiation by company. We are paying close attention to the investment in research and development within healthcare and are excited to see the results of that going forward.

In summary

While the small-, mid-, and large-cap spaces each have important defining characteristics, our discussion revealed many common themes across the market capitalization spectrum. Innovation, Gen AI, and healthcare emerged as key trends that highlight the dynamic nature of U.S. equities. Furthermore, the higher cost of capital impacts companies of all sizes and serves to widen the gap between winners and losers, underscoring the importance of active management and fundamental analysis.

IMPORTANT INFORMATION

Smaller capitalization securities may be less stable and more susceptible to adverse developments, and may be more volatile and less liquid than larger capitalization securities.

Health care industries are subject to government regulation and reimbursement rates, as well as government approval of products and services, which could have a significant effect on price and availability, and can be significantly affected by rapid obsolescence and patent expirations.

Actively managed portfolios may fail to produce the intended results. No investment strategy can ensure a profit or eliminate the risk of loss.