PM Corner: In conversation with Susan Bao
Large Cap Core 130/30 portfolio manager Susan Bao explains how she captures consistent alpha and why she expects meaningful earnings growth over the next year.
Finding sustainable earnings growth in today’s market
Join Susan Bao, Portfolio Manager, U.S. Equity Group, for a discussion on the investment implications of trends accelerated by the pandemic, taking advantage of the recovery through quality cyclicals and the benefits short proceeds can have on the long-term.
As investors search for returns in a low return world, they’re looking for the best way to capture alpha. What’s your view?
I’m reminded of the 2004–10 time frame, post the 1990s bull market and tech boom and bust. We leaned into our process of bottom-up stock selection powered by our career research analysts. By identifying underappreciated stocks and successfully navigating shifting market environments, we were able to generate consistent excess returns vs. the S&P 500 Index. We believed that the process was working well, and it was then that we developed our Large Cap Core 130/30 strategy to more fully capture our analysts’ insights. The Large Cap Core 130/30 strategy’s goal is to outperform the S&P 500 through long and short investing while maintaining the same market exposure as a long-only equity fund. With the S&P 500 Index currently at above average valuations, expected future equity returns have declined. Being passively invested in the S&P 500 Index is just not enough anymore, and investors need to use every tool in the toolbox to generate excess returns over the market.
We’re all still sorting out the lingering effects of the COVID-19 shock. How did you navigate 2020, and how has your portfolio pivoted over the past year and a half?
Our portfolio was positioned for late cycle. So when the pandemic hit, our quality growth tilt better absorbed the first leg of the market dislocation. Then our bottom-up analysis gave us a very strong signal to pivot toward cyclicals, which contributed to strong alpha in the back half of last year. We covered short positions in restaurants and physical retailers, bought housing- and travel-related stocks, and took profits in tech. A key change to highlight is taking financials from a sector underweight to a decent-sized overweight. First, financials have positive and meaningful earnings revisions, as the credit cycle was less bad than feared. Second, they tend to outperform when the 10-year Treasury yield moves higher. Third, many of these stocks were very attractively valued. And finally, from a portfolio construction perspective, the financial sector provides the best hedge against high growth tech companies.
Beta is just not enough anymore. Investors need to use every tool in the toolbox to generate alpha.
Let’s talk about inflation and the impact on equity markets.
There’s a tug of war between earnings and inflation. We often say one person’s spending is another person’s revenue. Identifying companies that have pricing power and margin expansion is crucial to stock selection. Select companies in the energy, financials, consumer discretionary and industrials sectors exhibit these characteristics. We see plenty of opportunities in those four areas. For example, we are overweight railroads such as the Norfolk Southerns and Union Pacifics of the world. The market structure is an oligopoly, which allows for pricing power. Supply is inelastic, as it is hard to add rail lines in the U.S. Also, rails have been focused on increasing operating leverage, which will help in an inflationary environment.
Can you describe your ESG process?
ESG [environmental, social and governance] has become an integral part of our process across our entire global equity platform. We developed a proprietary 40-question questionnaire for each company under coverage. It aims to address the key E, S and G issues, using our analysts’ extensive and nuanced knowledge of the companies and sectors. We combine that with third-party data to come up with an internal ESG score. It’s a signal that helps us uncover risk and opportunities. For example, one of the top short positions in the portfolio today is an industrial company. Our analysts expect it might be on the hook for about USD 8 billion to USD 10 billion of environmental-related litigations, along with serious reputational damage. Stocks with better ESG scores over time are usually better-run companies. Often they benefit from tax credits, subsidies and investor support, which could translate into a lower cost of capital. The ESG process is a source of alpha over the long term.
The value vs. growth debate—what are your thoughts here?
At the beginning of an economic cycle, the value style typically works very well because of strong earnings revisions and operating leverage — Less bad is good. I believe we are now slowly transitioning from early cycle to mid cycle. Our portfolios still have a cyclical tilt, but it’s a little less pronounced than last year. The beauty of managing a core portfolio is that we can be growth- and value-agnostic and go where we see mispriced opportunities. We have the flexibility to select the best growth companies at a reasonable price, such as Alphabet and PayPal, and we can also choose the best value stocks, such as Morgan Stanley or Wells Fargo. Or we can stay in the middle by investing in the classic compounders, such as the railroads or health care providers.
In any stage of the economic cycle, the key for us is to follow the insights, conviction and valuation that bubble up from our bottom-up research. That approach has served us well both as long and short investors.
The companies/securities above are shown for illustrative purposes only. Their inclusion should not be interpreted as a recommendation to buy or sell. J.P. Morgan Asset Management may or may not hold positions on behalf of its clients in any or all of the aforementioned securities. Past performance is not necessarily a reliable indicator for current and future performance.