U.S. Large Cap Equity Investing in Volatile Markets
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Jim Sakelaris: Welcome everyone. Thank you for taking the time today to join us. My name is Jim Sakelaris. I'm a Client Advisor from (North America Institutional) from JPMorgan Asset Management. I'm pleased to introduce my colleague Giri Devulapally, Performing Manager within the US Equity Group. Over the next hour we'll shed some light on what we are seeing in the market and how it's impacting US equities. To facilitate this discussion I'm going to pose some questions I've prepared for (Gary). So (Gary), welcome. I hope you are well.
Giri Devulapally: Thanks (Jim). Happy to be here.
Jim Sakelaris: Good. Tell us a bit about your background, (Gary).
Giri Devulapally: I'm an Engineer by educational spending. And after college I worked in Software Design and Development for (computers). During that time I became more and more interested in investing and ultimately decided that it was the career path I wanted to follow. Having never taking any finance courses in my undergrad, I realized that I'd have to get an MBA to make that transition and I went to the University of Chicago for business school.
After business school I worked at Hugo Boss from 1997 to 2003. I covered mostly technology companies for the (unintelligible). In 2003 I was recruited to JPMorgan by a Portfolio Manager who had moved from Hugo to JPMorgan in 2002. I've had good relationships with him and a fair good of success supporting him. And he wanted me to come and be the number two on the JPMorgan Large (Growth) Strategy. And I came over in July of 2003.
And in 2005 he ended up leaving for another opportunity and I was asked to head up the strategy. So I've been leading these Large CAP Growth strategies since 2003. And I really tried to take the lessons I had when I was at (Hugo). I was there doing (unintelligible) -- in the late 90's -- (unintelligible) up and ran until I was at the epicenter of one of the biggest busts in the investment history from 2000 to 2003. And also the lessons I learned as an engineer plus have discipline and have continuous improvement in what I do.
And so I've taken my life lessons, my investing lessons and practically bringing them to bear over the last 17 years I've been at JPMorgan and the last 15 years I've been the lead manager on the strategy.
Jim Sakelaris: That's interesting because given your educational background and your engineering background, what is your philosophy and process you use in selecting stocks for the Large CAP Growth strategy?
Giri Devulapally: Yes. I think it's a reflection as you alluded to of all my experiences. I start with a plain work of risk management and the three key risks that were focused on navigating, are first, in growth investing I think it's critically important not to miss the truly outstanding stocks. These are the stocks that can be the mega winners, the ten baggers and so on. And we think that in order to outperform over time, we can't miss those mega winners. So the first two risk is don't miss the truly outstanding stuff.
The second key risk is having lived through the tech bust from 2000 to 2003 and watching some stocks go to zero and a lot of stocks go down over 90%, it's mitigating the damage from the poor stock selection. So mitigating the damage from the losers is critically important for long term success. And then the third risk is really understanding when our process is in favor in the market and to really drive out performance and asset generation in those stable environments. And then in more challenging environments realizing that we may give some asset back but try not to give too much back.
So those are the (unintelligible) risks that we try and navigate. And what we're trying to do to translate that to stock selection is what we call our three legged stool framework in identifying the really big winners. That three legged stool framework, first when we're looking for our companies that are going after large investible markets that are undergoing change. Second, we're looking for companies that have a competitive advantage. So something that will allow them to (claim) market share relative to (unintelligible). And this could be technology, it could be distribution, it could be caused by regulation.
And then finally we look for companies that have good price momentum. And we look at price momentum as allowing us to manage a couple of risks. One is time value of money. It could be a great idea fundamentally but if we believe it but if the market doesn't it could be a while before we get the reward for that. And second it's a way of embedding humility in the process because we may think it’s a great idea but we could be wrong. There's a lot of collective intelligence in the market and we want to harness that intelligence.
And so I think that idea of humility is something that's very important to what we do both imagination and humility are a couple of characteristics that we try and do within the process in multiple ways. So that's a brief description of the philosophy and process.
Jim Sakelaris: Yes. Given your three legged stool philosophy, if you will, can you walk us through how you have the portfolio positioned and the actions you have been taking given the recent spike in volatility?
Giri Devulapally: Yes. I think if we look back at 2019, we had a very strong year in 2019, we were up almost 40%. And in February at the peak of the market and the (unintelligible) returns for the year, we were up over 70%. We were up about 72% from the Christmas Eve 2018 (low) to February 19 of this year. So coming into this year we've had quite substantial gains in the overall portfolio. And then there were particular (stocks) that were even much better than that.
And so we were taking some chips off of the table in stocks that had done exceptionally well starting in mid-January. And as we've progressed through January the markets have been going up and some of these stocks kept going up into February, we actually ended up with what for us is a fairly high level of cash. We normally were about 1 to 1.5% cash in the strategy and we got to 5 or you know, a little over 5 in February.
And then as the market started correcting quite severely in February and then into March, we put that cash to work. So at the end of February we were at about 5% cash. At the end of March about at .5% cash. So we went from well above normal levels of cash to well below normal levels of cash in a rapid period of time. And so that gives you a sense of what we've done in terms of broadly speaking over the last three months or so.
Jim Sakelaris: (Gary) you put quite a bit of cash back to work. So where in particular where you putting that cash to work? Talk about some of the stocks or industries for example, that you may have applied it to such as semiconductors or Biotech, et cetera.
Giri Devulapally: Yes, I think you actually touched on two of the areas that we added a good bit to semiconductors and within healthcare especially Biotech were two big chunks of cash. And then we also added idiosyncratically across a variety of stocks that we have a lot of confidence in and we thought were being unfairly hit in the market meltdown. Maybe I’ll go into a little more detail in semiconductor and Biotech.
So there's two main reasons why we added semiconductors. First, semiconductors broadly as an industry tend to benefit from typical recovery. And so we recognized that the economic backdrop was likely to be quite weak this year and that as we looked into next year it was going to rebound quite a bit from next year and then possibly in 2022 as well. And so one of the industries that's a big beneficiary of that is semiconductors. And within that we added to semiconductors capital equipment. A couple of companies that were, we call fundamentally super well positioned without getting into any particular names.
So one of these companies is really well tied to the (unintelligible) market. They're equipment has shown a consistent competitive advantage versus other equipment bankers. And another semiconductor companies has the latest and almost a monopolistic position in a part of the semiconductor capital equipment markets and we think that's going to be one of the biggest growth areas going forward. And so that was part of it.
And then the other part of it was in the devices, in the actual manufacturing of semiconductors. And those areas were the semiconductor companies focused on data analytics and artificial intelligence. That's where we really added to because we think that data analytics is one of the key enablers of competitive advantages for companies across a variety of industries.
So when we look at some of the biggest wins over the last decades whether it's Google or a Facebook or an Amazon or a Netflix, we knew a big part of the competitive advantage is having come from the ability to analyze data, come to better business decisions which allows them to gain better market shares and gather more data, analyze that and it becomes a virtual cycle. And so these other semiconductor companies that we invested in March, we think are really enabling data analytics.
And then in terms of Biotech, we think that this is a - part of the market that's been out of favor really since 2015. So it had been out of favor for about five years but these are companies that have continued to invest in research and development of drugs. The pipelines are good and there was a lot of pressure on them in 2019 and the year before the election when a lot of people were concerned that there would be further pricing concessions that would need to be made. But we looked at them and we thought that they were individual companies that had very good pipelines and had success in moving from phase two to phase three or phase three to the market.
And we saw that some of those companies drugs which were going to be much bigger than anticipated at the same time that those stocks had done quite poorly for four or five years. And so we saw that the combination of low expectations that were going to be beaten by the company's fundamental performance made them quite attractive. So those were the two big sectors or sub-sectors within the market that we added to in the down draft.
Jim Sakelaris: Thank you for that (Gary). What are your thoughts about the process of asset management in the current market?
Giri Devulapally: Well (Jim), you're asking an Asset Manager what do you think an Asset Manager does. Like asking a barber if he needs a haircut and...
Jim Sakelaris: I do.
Giri Devulapally: Right now I definitely need a haircut right now. But definitely in all seriousness, one of the things to consider if I was in the shoes of the folks that are listening is that right now the top ten weight in the (unintelligible) represent 41% of the benchmark. Now I've looked at stats going back over the last 20 plus years and this is the largest weight in the top ten that we have in the last 23 years I've looked at. And some of these stocks have had exceptional performance and that's how you get to this really high weight. And so if I'm listening to this call and I just believe that these are the things that are going to continue to win, then maybe I feel pretty good about owning an ETF or passive.
I on the other hand think that some of these stocks - so I'll take Amazon as an example. Early in 2015, the stock was under $300. Just recently it was over $2,400. And so it's up 800% in the last five years. Now it's a great company and we still own some of Amazon but it's one of our largest underweight. And the reason is that in our process we're looking for where companies can exceed market expectations. This company has gone from 150 billion dollars of market CAP five years ago to 1.2 trillion of market CAP. That's a huge amount of incremental market CAP that was added.
So as we think about the next five and ten years, is this going to be one of the really big winners. But like, in our judgment there are other companies we get really excited about. I just laid out a case why I think (unintelligible) could be a ten bagger or more over the next ten years. It's difficult for me to make the case that Amazon is going to be one of the extraordinary stock over the next five to ten years. They might be a fine stock but if we look at collectively the 41% that's in the top ten of the (unintelligible) growth, I have some similar concerns with some of the other companies.
And so right now we have the biggest underweight relative to the top ten in the (unintelligible) that we've had since I've run this strategy. So we're -- as I said -- about 41% is in the top ten and we're at about 25%. So we have an almost (50) basis point difference. So this is the most pronounced difference we've had. And I'm finding a lot of other companies that I think are pretty attractive. So I think that's the way I would think about it if I was an institute client listening to this call is, do I want to make a bet that the 40% that's massively out performed over the last five to ten years is going to persist in the outperformance going forward? And as I've said from my perspective we have the largest underweight and we're finding a lot of attractive ideas that are not already a huge part of the benchmark.
Jim Sakelaris: We want to thank you (Gary) for giving people to think about, that's for sure. In 2019 you offered a paper titled We We're in the Early Innings of a Secular bull Market where you predicted the S&P 500 would reach 10,000 by the end of this decade. Given all that's been transpired (Gary), where's your view today?
Giri Devulapally: I think I said by the mid-2030's. So just to be clear here. Which is still a long ways from now. And one of the things I talked about in there is that it's not to say that we're not going to have correction, we absolutely will. But within secular bull markets, they tend to be really great buying opportunities. So let me step back and say what we really wanted to in that paper. And it's that there's four key reasons why I think that we're in what I call a secular bull market. And the (core) definition states, I separate periods going back about 100 years in the S&P into secular bear markets and secular bull markets.
A secular bear market, the way I defined it is a prolong period of time where the market makes the terms below normal. So when you think of normal it's 7% and a couple percent in terms of dividends. So if you're talking about 15 to 20 years, what do you make below that, that's a secular bear market. And then those have been followed by 15 to 20 years where you make above that, above the normal historical returns and that's what I call a secular bull market.
So from market 2000 when the S&P was at 15 50 until February of 2016 when it was at 18 10, so you went 16 years where you made about 1% price return in the S&P's. So that was a secular bear market the way I defined it. And so I believe that we're looking at 15 to 20 years so somewhere between the mid-2030s of above average returns. There's no magic about S&P 10,000 but if you followed that logic you would end up with something like 10,000 plus in the early mid-2030s. So that was the first reason is if you look at historical returns that would lead you to think that the S&P was going to have good returns going forward above historical normal returns.
The second was, that if you believe that (unintelligible) were treated best and I look at equities and the (unintelligible) yield you can get at the S&P 500 versus whether it's corporate bonds or government bonds or cash, by far this is one of the most attractive relative free-tax yields of equity. So pretty (unintelligible) that people believe that capital goes where it's treated best is all to go into equities. So independent of what's happening historically this is a point in time.
And then third, when you look at secular bull markets and bear markets in the past, one of the hallmarks of that is money flows really to the thing that's in favor and money flows out of the asset that's out of favor. And so, flows into equities have been really weak over the last decade plus while flows into fixed income have been very strong. Whereas at the end of the secular bull market in the late 90's that was the last secular bull market in 1982 to 2000, flows into equities dominated flows into fixed income. So investors have not shifted their allocations into equities. So from a behavioral perspective, beyond where everyone is already into equities.
And then the fourth thing is about demographics and productivity. As I read about what most people are writing, demographics is viewed as the negative. And in the paper I go through the rational for why demographics are actually a positive. And related to that is not only are demographics going to be a positive but correspondingly productivity is likely to surprise to the upside going forward. So the four key reasons again are in critical pattern of relative return, the pre-tax (lien) of the equities relative to all other assets flows into equities being much (easier) flows into fixed income and demographics and productivity being positive tailwinds as opposed to negative tailwinds. And then finally I would say is that that is very much out of consensus.
So history suggests very clearly that returns ought to be above normal but while history suggests that, the consensus opinion is for much lower equity returns going forward. And so I thought it was useful for me to layout the historical case for why equities ought to do better than historical norms going forward. But I do want to point out that I talk about from 82 to 2000 which was the last secular bull market, that you have the (crafts) of 87, you have the Gulf War, the recession in 1990, you had the FNL prices, Japan in the 90's was a debacle in terms of the stock market. You had the 80's in financial crisis, you had (LTBM) in the (western) debt crisis.
Bad things can happen in secular bull markets like a pandemic but that doesn't mean that that is the end of secular bull markets. Those tend to be great opportunities. You know, there's more detail about each of these points in the secular bull market paper that I wrote and there's a lot of pictures in there so it's not too much heavy reading (unintelligible).
Jim Harris: Thank you. I appreciate that. Your analytical acumen is definitely the center of the earth investing philosophy but we appreciate that. (Gary), thank you so much for your time, comments and insights. We truly appreciate it, thank you.
Jim Sakelaris: Thanks everyone for your time today.
Jim Sakelaris: Thank you (Gary). We hope today's call we can fast forward to you and thank you all of your time. And (unintelligible), if you need any additional information on anything that was discussed, please reach out to your JPMorgan Client Advisor. Thank you again for participating today. Stay safe and thank you again.
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