2020 has been a tough year for many investors and SKAGEN Vekst has felt the stock market effects of COVID-19 more than most. Several of the fund's recent challenges, however, can be traced back to its success the previous year when it returned a healthy 24.6% in NOK terms, broadly in line the benchmark.
Despite this strong performance, the portfolio's valuation remained relatively cheap (between 1.0x and 1.25x P/B) as capital was reinvested from the strongest performers (typically high quality, growth companies) into more attractively valued stocks. Against a backdrop of equities becoming increasingly expensive (the benchmark P/B rose from 2.2x in January to 2.5x at year-end), this disciplined approach reflected SKAGEN's long-term philosophy – Vekst is our oldest fund – and the team's investment process. There were also signs that many of the headwinds value stocks had faced for a number of years were starting to abate towards the end of 2019 as global growth accelerated, a US-China trade deal looked likely and interest rates were starting to rise.
We believe Vekst should be able to generate positive returns regardless of whether we face a calm autumnal season or further turbulent months ahead.
Unfortunately, COVID-19 then appeared at the start of 2020 and the macro environment quickly deteriorated with economic output, long-term interest rates and oil prices all retreating dramatically. Portfolio companies considered resilient to normal economic pressures such as Carlsberg (beer) and ISS (office cleaning services) were severely hit by abnormal and widespread lockdowns. Many of the fund's largest holdings also belonged to sectors hit hardest by the pandemic such as energy (Shell, Gazprom) and financial services (Citigroup, AIG), which augmented the losses.
These factors inevitably hurt the fund's absolute return, while avoiding popular (i.e. expensive) technology companies and those in the other growth sectors which benefitted from the pandemic hit relative returns. This 'perfect storm' has been difficult for most value-focused managers, against whom Vekst has performed relatively well, and Portfolio Manager, Søren Milo Christensen, is confident that better times lie ahead: "The portfolio is priced at a solid discount to the market when we look past the current depressed earnings. We believe Vekst should be able to generate positive returns regardless of whether we face a calm autumnal season or further turbulent months ahead."
A source of potential turbulence is the US as the election looms large and COVID-19 cases continue to rise. Vekst is significantly underweight US stocks with 14% of the fund invested there, compared to 29% for its benchmark, which should provide downside protection. Boosted by the changes to work and home life during the pandemic, US tech companies now represent the world's five largest stocks (see figure 1). However, this dominance is unlikely to persist, as Christensen explains: "History has shown time and time again, that conventional economic theory works - sectors earning above average return will attract significant investments which eventually drives down profitability. The political sentiment towards some of these companies has clearly also shifted, and stricter tax treatment combined with increased regulation could also place further strain on their business models."
Avoiding the growth bubble
The increasingly high price investors are willing to pay for growth companies also looks unsustainable. While the return on equity (ROE) of the MSCI global growth index has remained fairly stable over the past twenty years, both in absolute terms and compared to the value equivalent, the valuation of growth companies relative to value stocks has climbed from 1.5-2.0x historically to 4.0x at present (see figure 2.1). Similarly, the sales multiple that shareholders are prepared to pay for growth companies has more than doubled recently versus its 20-year average (see figure 2.2).
Extreme valuation spreads between value and growth stocks have historically been followed by periods of strong value performance. The economic stimulus packages required to continue the fight against COVID-19 should also be supportive for traditional value sectors such as Industrials and Financials, where Vekst currently has its largest portfolio exposure.
From a risk perspective the portfolio managers also believe that continuing to avoid the growth bubble is in clients' best interests and they will continue to tilt the portfolio towards classic value stocks with a focus on capital return. The fund added three new positions at attractive valuations during the third quarter – AkerBP, OHT AS and Hitatchi – see our Q3 update for more details.
This prudent approach and focus on tangible shareholder value in the face of increasingly stretched valuations should maximise their long-term risk-adjusted returns.
NB: Figures as at 30/09/2020 unless stated