Portfolio Manager Brian Demain explains why we could see a renewed appreciation for moderately valued, sustainable growth companies in the mid-cap market.

Key Takeaways

• We anticipate that the potential rollout of a COVID‑19 vaccine could spur a return to normal levels of economic activity in the year ahead.
• This revival in economic growth could lead to more balanced performance in the mid-cap market and renewed attention to company fundamentals and earnings potential.
• The pandemic may have accelerated long-term trends or changed behavior, creating new opportunities for long-term investors.

Dangerous Imbalance

While 2020 was unprecedented for many reasons, one of the defining factors from an investment perspective was the unusual behavior in the mid-cap equity market. Throughout the year, we saw a small group of very expensive stocks far outperform the rest of the mid-cap market in a rally driven as much by momentum as by fundamentals. Historically low interest rates made it easier for companies to fund their growth while also driving investors to seek higher returns. Investors also rewarded companies they expected to benefit from the pandemic, including those with virtual business models, while they avoided stocks perceived as sensitive to near-term economic disruptions. The result was a narrow market rally that in our view left the Russell Midcap® Growth Index dangerously imbalanced. It also left many of the top-performing stocks in the Index trading at valuations well above their historic averages. A few of these stocks may warrant such valuations. But we believe it is incredibly optimistic to expect most to deliver the sustained rapid earnings growth needed to justify their valuations, especially when you consider historic growth rates.

In our view, this mid-cap market imbalance is not only unsustainable, it is also risky. It reminds us of the dot-com period of the late 1990s and early 2000s. Lessons learned during that period are a strong reminder of why valuations are an important consideration when it comes to evaluating risk. Disciplined growth investing doesn’t just require finding dynamic companies with above-average earnings potential. It also means not paying more for them than they are reasonably worth.

A Market Realignment in 2021?

While we see risk attached to the recent imbalance, we aren’t anticipating a broad-based market correction. Instead, we believe we could see a realignment and renewed appreciation for moderately priced growth companies — those with sustainable competitive advantages, strong market positions and experienced, visionary management teams.

We anticipate several developments that could lead to a realignment. For one thing, the rollout of a potential COVID‑19 vaccine could spur a return to normal levels of economic activity. This resurgence could boost revenue and earnings performance for a broader range of companies, especially those that depend more on face-to-face interactions. The U.S. Federal Reserve’s recent easy monetary policy could also lead to higher inflation as the economy improves. This inflation could raise expectations for higher interest rates, leading investors to rethink stock valuations. Negative earnings news from one of the high-flying companies mentioned above could also lead investors to rethink relative opportunities in the market.

Instead of trying to predict the timing of this realignment, we believe investors should instead focus on identifying reasonably valued, disciplined growth companies that have the potential to grow over the long term. We also think it’s worthwhile to look hard at what is driving this growth potential. How big is the company’s potential market opportunity, and what competition might it face? How durable are its profit margins?

We also recognize the pandemic may have altered behaviors or accelerated trends transforming our economy, including e-commerce penetration and the growth in cloud-based interactions. For example, we saw many consumers turn to online retailers even for big-ticket purchases during the pandemic. In many cases, these consumers have returned to the same retailer for a second or third time, a strong indicator of future customer loyalty. These buying trends may persist even after the pandemic ends, as consumers have become more comfortable with online buying. We believe there may be opportunities to capitalize on these and other changes in the coming year by investing in innovative but reasonably valued companies that may be positioned for strong relative growth over longer time horizons.

MARKET GPS

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