Insights from SWS Partners

The following is an excerpt from our recently published SWS Growth Equity 1Q2022 strategy update, which is available in its entirety via pdf or audio stream. In the full piece, we provide our take on sifting through an increasingly volatile equity market backdrop, while assessing the strategic merits of our internally managed strategy for public growth-style equity.

Every couple of years, environments unfold that present significant challenges to certain portfolio construction practices. For active long-only public equity, namely ones populating portfolios with reasonable concentration, the current particular backdrop has stacked up a number of factors that make navigating entirely unscathed a mathematical challenge. As painful as the unrealized portfolio mark is to take at the end of the prior quarter, our constant effort to diagnose our forward path reveals a silver lining. We also see conditions for capital rotations into our targeted segment of public equity, one that has been long viewed by sideline observers as being top-heavy. We’ve been proactively repositioning our posture within the portfolio to take advantage of this, but we see areas of public equity that are also becoming increasingly compelling for reasons we dissect in this accountability update.
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Answering the Ultimate Question

As painful as market drawdowns are to endure, they afford us crucial opportunities to reassess tenets to our investment process. The ultimate question we currently face is whether the equity market dislocation is an overreaction that presents massive buying opportunities, or whether it’s a sign that we should retreat to the sidelines. We see all signs resoundingly pointing to the former and outline supporting evidence in this piece. We also chart proactive actions that we’ve taken. In the final analysis, the year-to-date equity pricing erosion has disproportionately been administered by valuation multiple erosion, despite a broad array of improvements to underlying fundamentals of our portfolio issuers. We also outline signs of green shoots formation that are exactly the mechanisms that cause equity pricing to eventually converge back to intrinsic value. Historically, these conditions have set stages for highly attractive returns over the medium- to long-term. We believe the current environment is no different.

Diagnosing the Pullback

When we evaluate the 13.4% pullback that we have seen in the S&P 500 Index since January 4th, it’s helpful to look at the different segments of the market to diagnose what has happened to date. The selloff first hit the growth and smaller-sized companies and did so in a disproportionate fashion, with the Russell 1000 Growth Index falling 20.6% and the Russell 2000 Growth Index falling 27.8% since their respective all-time highs in November 2021.

The equity market adage that “bears pounce, bulls grind” acts as a helpful reminder of the speed at which drawdowns can occur relative to upside realization. There’s also tremendous value in retaining historical context, namely how the markets ultimately sort out the source of fear that’s perceived to be unique or unprecedented. We fleshed out some of these themes during two prior major corrections endured back in December 2018 and March 2020, both of which diagnosed our take in the eye of each respective storm. This current bear market among growth and small caps, with subsequent spillover to the S&P 500, is no different. As inflation persisted longer than expected, causing fears to peak in late 2021, the Federal Reserve changed tone at its November meeting, indicating an end to its zero interest rate policy. On November 8, 2021, zero rate hikes were expected to occur by November 2022. Fast forward two months to January 2022, three hikes were quickly priced in, and then to today, the market has now priced in between five and six rate hikes (125-150bps) by November 2023. 
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The prior-year period, along with persistent volatility into 2022, reinforces our premise on relative return opportunities (aka alpha) in public markets. Outperformance opportunities are becoming increasingly less uniform, rarely available in even quarterly increments or succinct calendar years. There’s a silver lining to this though, one that also speaks to a core tenet: we see encouraging evidence of favorable conditions for value creation over longer-term periods. It requires a lens that an emotionally-driven equity market is incapable of identifying as necessary. It also entails rampant mispricings in the short term.

We can see how disproportionate the opportunity set for alpha is via our growth portfolio’s 2020 vs 2021 performance. SWS Growth Equity delivered 4-5x its typical base case excess return in 2020, fueled by a massive demand acceleration towards all-things-digital in the global pivot around the pandemic. The following period has given back some of this, yet we see zero change to the fundamental mechanics behind the ultimate exercise of the public marketplace: pricing future cash flows of its issuers. The weighing machine can and does get thrown out-of-whack, especially by outsized capital flow impacts by its participants.
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The following is an excerpt from our recently published SWS Growth Equity 3Q2021 strategy update, which is available in its entirety via pdf or audio stream. In the full piece, we provide our take on sifting through an increasingly volatile equity market backdrop, while assessing the strategic merits of our internally managed strategy for public growth-style equity.

Our read of the current fundamental signals continues to support that 2021 will be a grind-out period for active return generation. This in large part is due to a global macro dislocation that caused the most dramatic acceleration of digital transformations across all industries. The market is still undergoing a massive sortation of flash-in-the-pans from sustainable share-gainers as we edge closer to a post-pandemic environment. As active equity managers tasked with relative value creation, we remain optimistic on how our investment process is calibrated to generate attractive risk-adjusted outcomes in this backdrop.
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