Morgan Stanley IM: Equity Market Commentary - June 2024

The following views and perspectives are formed by the work of the Applied Equity Advisors team in managing assets for investors.

1. Please join us next month on Wednesday, July 17th at 4:15pm ET for Applied Equity’s Q2 Portfolio Review and Market Outlook.
   
   
2. “Slimmon’s TAKE” and other forms of communication between quarterly reviews are opportunities for us to update investors on our positioning or thoughts on the current market environment. Frequency of communication tends to be correlated to the present volatility in the market.
   
   Year-to-date, the market has performed much as we had anticipated, and our strategies have delivered on both an absolute and relative basis. Lately, for that reason, your inbox has received less from us.
   
   We simply think it is more important for us to be highly visible in the tough times than in the good times.
   
   However, do not misconstrue fewer emails with complacency on our part! A permanent sense of “what dangers are lurking” is part of our daily dialogue even when the portfolios are performing well.
   
   
3. One of the best performing factors year-to-date is earnings revisions.¹ Simply put, the better the earnings revisions, the better the stock‘s performance. Likewise, the worse the revisions, the worse the stock has performed.
   
   Given stock prices are the present value of future earnings, better-than-expected company fundamentals should be rewarded by investors. Likewise, the reverse holds true.
   
   In our opinion, the current environment is symptomatic of an equity market acting extraordinarily rationally.
   
   
4. Currently, it is difficult to find a company with better earnings revisions than Nvidia. Over the past year, research analysts revised their FY24 earnings estimate for Nvidia by 170%.² Clearly, Wall Street has dramatically underestimated the current earnings power of this company and, as a result, the stock has soared.
   
   As much as Nvidia has captured most of the media attention, it is not the only company with excellent earnings revisions. Other companies simply do not get the coverage Nvidia does.
   
   As Nvidia stock price has levitated relative to the rest of the market, so has its single stock risk. And let us not forget, Nvidia has had ten 50% stock price declines since going public in 1999.³
   
   But with other companies also performing fundamentally well, there are plenty of opportunities to offset this single stock risk. We would highlight the Infrastructure Act and the Chips Act beneficiaries as very straightforward themes. A second opportunity would be the current developments in the wealth management industry. For a third, in our opinion, weight loss/diabetes drugs are still in the early stages of broad acceptance.
   
   
5. Back on February 22nd, I was interviewed by Barry Ritholtz on Bloomberg’s Masters in Business podcast. The interview was a primer on how Applied Equity Advisors invests. Thanks to all of you who listened, he asked me back for two short At the Money snippets, “Avoid Closet Indexing” (April 17th) and “Building A Concentrated Portfolio” (May 8th).
   
   Here are three key high-level comments from the two podcasts:
   
   1. I have no problem with indexing. What I intensely dislike is “closet indexing” active management. If a fund owns many stocks, its unlikely to differ enough from its index to outperform after fees. As legendary investor Bill Miller once said:

The shift from active to passive has not been properly framed. It is simply switching from expensive passive investing to inexpensive passive investing.⁴

For this reason, I am not at all surprised that so much money has moved to passive ETFs.

2. Keep in mind, as much as a sizable portion of active managers have struggled to outperform the index, 100% of pure passive strategies underperform after fees. Especially if an advisory fee is tacked on. Negative alpha is pretty much guaranteed.

3. Statistically, high active share⁵ managers, on average, outperform over the long-term, net of fees.⁶ However, high active share comes with a wider dispersion of return to the index than closet indexing. This can cause great happiness at times and consternation at others. When investors get on the scales and evaluate returns on a very regular basis, the dispersion of returns can cause poor investment timing decisions.

Unfortunately, therefore, the higher the active share, the more likely investors are to pull money at the exact wrong time.⁷ (I can see the flows from both the advisory and self-directed routes. It's such an argument for investors to use professional advice!)

In effect, I believe high active share strategies, on average, can add alpha to passive portfolio allocations that have locked in underperformance. However, to be effective, the period for evaluation for high active share strategies cannot be short-term.

Andrew

¹ Bloomberg. Current year earnings per share, three-month change.
² Bloomberg, June 11th, 2024.
³ Bloomberg.
⁴ Bloomberg, October 2016.
⁵ Active share is the percentage of the portfolio or fund that is invested differently than its benchmark as of the last day of the reporting period.
⁶ Antti Petajisto, “Active Share and Mutual Fund Performance,” January 15, 2013. Study of performance of 1,124 U.S. long-only equity mutual funds from January 1990 – December 2009, net of fees and transaction costs.
⁷Morningstar Research Services, LLC, “Why Fund Returns are Lower Than you Might Think”, Amy Arnott, CFA, August 30, 2021, and ING, adapted from Petajisto (2011): “How Active is Your Fund Manager? Active Share and Mutual Fund Performance;” Martijn Cremers, Professor of Finance, University of Notre Dame.

^{RISK CONSIDERATIONS}

^{There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. Natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. Portfolio liquidity) of events. Accordingly, you can lose money investing in this portfolio. Please be aware that this portfolio may be subject to certain additional risks. In general, equities securities’ values also fluctuate in response to activities specific to a company. Stocks of small-and-medium-capitalization companies entail special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. Investments in foreign markets entail special risks such as currency, political, economic, market and liquidity risks. Illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Non-diversified portfolios often invest in a more limited number of issuers. As such, changes in the financial condition or market value of a single issuer may cause greater volatility.}

^{INDEX DEFINITIONS}

^{The indexes are unmanaged and do not include any expenses, fees or sales charges. It is not possible to invest directly in an index. Any index referred to herein is the intellectual property (including registered trademarks) of the applicable licensor. Any product based on an index is in no way sponsored, endorsed, sold or promoted by the applicable licensor and it shall not have any liability with respect thereto. The S&P 500® Index measures performance of the large cap segment of the U.S. equities market, covering approximately 75% of the U.S. market, including 500 leading companies in the U.S. economy.}

^{IMPORTANT INFORMATION}

^{There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market.}

^{A separately managed account may not be appropriate for all investors. Separate accounts managed according to the particular Strategy may include securities that may not necessarily track the performance of a particular index. Please consider the investment objectives, risks and fees of the Strategy carefully before investing. A minimum asset level is required.}

^{For important information about the investment managers, please refer to Form ADV Part 2.}