The Nature of Drawdown

Chief investment officer of equities, John Porter, gives his perspective on the nature of drawdown as an inevitable element of long-term investing.

Key Points

• We anticipate that the real economy will experience a spending boom for an extended period over the next few years.
• For US small and mid-cap stocks, we believe the best growth over the coming months and years may not come from traditional high-growth sectors but from some relatively unloved ones. 
• As active investors, we must be brave enough to try to use periods of market volatility to reposition to find the next compelling growth opportunities.
• Investors must have the self-awareness to understand what their specific investment strengths are and not to chase momentum.
• No matter how much you love a stock or a story, it is important to remember that every stock has a fair value.

Drawdown is an inevitable part of any long-term investor’s experience, but we believe it can also play a useful role at times of market dislocation for those repositioning portfolios for future long-term growth. 

As growth investors ourselves, focused on the small and mid-cap areas of the US equity market, our job is to find what we believe to be the best long-term opportunities regardless of the sector. Historically, sectors of the market such as technology, biotechnology and consumer-facing areas have appeared to do well over the long term. Currently, however, in the face of dramatic economic and societal shifts, we are agnostic as to where future growth will come from and believe the best opportunities over the next three or four years may well come from some relatively unloved areas of the market. 

Over a Decade of Underinvestment

We say this because we have just witnessed what we perceive as at least a decade of underinvestment in the real economy in the US, which has contributed over the last 12 months to supply-chain issues and commodity-price inflation. In fact, we see a very tangible possibility that the real economy experiences a spending boom for an extended period over the next few years.

As small and mid-cap growth investors with a mid to long-term horizon, we believe that might mean that the best growth over the coming months and years may not be derived from traditional high-growth sectors but from some relatively unloved ones.  

We all know that the current market volatility has created a challenging environment for investing, and especially for growth investors. Part of being a manager with a growth-orientated process is having to accept that volatility and drawdowns come with the territory when you run an active portfolio with high active share (a measure of the difference between the portfolio’s holdings and the constituents of its benchmark index). After a period in which many small and mid-cap portfolios have benefited from broadly growth-orientated markets, we find ourselves in a period of drawdown, but view such market shakeouts as allowing us to start positioning for future growth opportunities.

Differentiated Returns

As investment managers, it is our duty to take the capital entrusted to us by clients and allocate it as thoughtfully as possible to produce differentiated returns. To do that, we sometimes need to have the conviction to go against the crowd and invest in securities that may be unknown to some. It may mean using fundamental top-down and bottom-up research to identify and invest in businesses where others may have overlooked or underappreciated future potential growth.

Inevitably, any time that you take a meaningfully different stance from others, there will be periods of volatility as we are seeing today. In 2017, 2018, 2019 and 2020 we experienced market conditions that were broadly positive for growth markets, and this aligned well with our investment philosophy and process.

Even in 2018, however, there were periods when markets endured drawdowns which affected some of our portfolios before they began to recover well once the headwinds had died down. Some investor concerns back then echoed some of the current concerns that we see in financial markets; most notably the Federal Reserve was accused of being behind the curve in terms of the rate cycle, and there were also fears about a looming recession and inflation. All those concerns passed more quickly than we are experiencing in today’s market backdrop, but they remind us that we have been here before and must be brave enough to try to use such periods to reposition to find the next compelling growth opportunities as volatile markets reveal them.

When I started my investment career as an analyst at Fidelity, I was fortunate enough to have well-known fund manager Peter Lynch as a mentor. Peter had a quote which I think about often and have stuck to my computer. It feels especially pertinent in today’s choppy markets. He said: “Everyone has the brainpower to make money in stocks. Not everyone has the stomach.’

Know Your Process

The point is that in difficult markets such as we see currently, investors must have self-awareness and understand what their specific investment strengths are. We believe the worst thing to do is to chase the market and go to where the action is, especially if momentum is occurring in an area of the market not consistent with your investment approach or philosophy.

Part of our job can sometimes be simply to try and preserve capital. What we have seen over the last six to twelve months is that inflation was less transitory and more stubborn than we initially believed. As investors, we need to be comfortable enough to say that the most interesting areas for alpha opportunities may not be in areas where we are experts. At that point, it can be best to try to preserve your capital and position for where you believe the most compelling future growth will be.

We believe we can derive differentiated returns from all corners of the small and mid-cap universe. Historically, such returns have often been derived from technology stocks, but now we see opportunities elsewhere and have dramatically reduced our exposure to this sector.

Reallocating for Future Growth

We saw some of our small and mid-cap competitors who were heavily exposed to technology repeatedly increasing their exposure to the sector, even as valuations kept on rising. We believe that, in some cases, they failed to step back and consider that no matter how much you love a stock or a story, every stock has a fair value. At that point, we believe it is an investment manager’s duty as a capital allocator to ask “how does it get any better than this?” and switch capital from a business where they believe the best-case scenario has been largely discounted to one where they see a better risk/reward balance.

Historically, we have felt most comfortable in the technology sector, but we are not going to force exposure to it if we don’t see compelling stories there, or we see downside risk which we do not believe is fully priced in. Instead, we will continue to use our investment themes and fundamental research to identify those companies and sectors where we anticipate the most compelling future growth.

We know that drawdown is a normal, albeit painful, part of long-term investing, but we also know that what is crucial is how one recovers and repositions to unearth future growth opportunities. We believe we may now be closer to the point in the cycle at which valuations of selective quality small and mid-cap stocks are starting to look compelling again. We will continue to seek them out in order to secure future long-term growth.

Authors

John Porter III

Chief investment officer, head of equity