With a higher cost of capital and ongoing innovation, two professionals have argued that active investors have unique opportunities to differentiate between companies that are well-positioned for the new regime and those that are not.
While the term “regime change” within investment markets often refers to inflation and interest rates returning to pre-Global Financial Crisis (GFC) levels, Janus Henderson chief executive Ali Dibadj and global head of solutions Matt Peron believe it also signals a fundamental shift in investment strategies.
A higher cost of capital forces both companies and investors to be more selective and strategic in their pursuits of returns, the pair argued.
They explained that while the era of ultra-low interest rates distorted capital allocation, allowing even unviable businesses to thrive, now, with funding harder to secure, investors must be more discerning.
“Just over two years ago, whether an organisation had a good or bad business model was almost irrelevant; inexpensive capital was readily available to support even the most unviable businesses,” Dibadj and Peron said.
“The return of higher lending rates has dramatically changed the landscape for companies, with funding now much harder to come by and investors more discerning about where they choose to allocate capital.”
Moreover, the pair explained that while historically, passive investment strategies have thrived during periods of low interest rates, as they closely track market benchmarks, in a higher cost of capital environment, active management becomes crucial.
Citing data since 1990, the professionals said that when the yield on the 10-year US Treasury note is above 3.50 per cent, the average active US equities fund outperforms the average passive fund. This trend, according to Janus Henderson, suggests that active managers with deep industry knowledge and strong research capabilities can generate superior returns in a higher rate regime.
But the increasing economic shifts, exemplified by the technology sector’s innovative upstarts outpacing slower incumbents, suggest that investors who conduct in-depth research will be rewarded not just due to higher capital costs, the pair outlined.
This “creative destruction”, the professionals said, has already spilled into other sectors and rapid advancements in artificial intelligence (AI) and other novel technologies will likely amplify the divide.
“As with other waves of innovation, not all companies will adopt an effective strategy. Those that don’t are at risk of losing market share to peers or will put off investors by their inability to grow earnings as rapidly as evolving competitors.
“As an example, US large-cap companies that committed research and development funding to allow for innovation outperformed those that did not. From an investing perspective, we believe a deep understanding of the structural forces at play combined with expert research into company strategy will be essential to navigate change and generate excess returns.”
Staying nimble in markets
As the knock-on effects of a higher cost of capital and innovation plays out, the duo expect to see greater dispersion within equity returns.
“Growth companies will have to ‘earn’ their multiple, meaning that, without the tailwind of a low discount rate supporting valuations, they will have to prove they can grow earnings faster than the market over a sustained period,” they said.
“Companies that rely upon debt markets for financing recognise that investors now have alternatives. No longer can they count on an eager market as they roll over maturing debt.”
Instead, Dibadj and Peron countered, such companies will need to show that they can generate sufficient cash to cover their obligations and, in cases where debt financing is required, have the discipline to judiciously manage their balance sheet.
“Many investors have grown comfortable with top-down, momentum, and passive strategies. Going forward, we believe such strategies will face challenges, as a higher cost of capital and rapid innovation will likely lead to diverging fortunes between visionary companies and also-rans.”
“Distinguishing between these two camps by leveraging fundamental research and industry expertise should enable expert investors to resume their historical role of allocating capital to its most productive use. In the process, investors who understand this imperative and successfully navigate this regime change should be rewarded,” they concluded.
Similarly, research conducted by Natixis Investment Managers earlier this year revealed that, with rates likely to remain higher for longer, 68 per cent of fund managers say markets now favour active managers.
While asset allocations to passive increased about 7 per cent over the past three years, fund managers currently allocate 64 per cent of assets to active investments and 36 per cent to passive, with the former set to rise.
“With rates looking to remain higher for longer, 68 per cent of fund managers say markets now favour active managers. And given an uncertain outlook, 75 per cent believe active investments will be essential to finding alpha in 2024,” the global asset manager said.
“Should recession fears be realised, not only do 61 per cent of fund managers think it will show the inadequacies of passive investments, but 53 per cent also think investors who rely solely on passive are likely to learn some hard lessons.”
