Paul and Brett's Alpha
Rigor Mortis or Felix Emptor?
The anatomy of a market panic is, by its very nature, hard to describe or to analyse. Nevertheless, that does not stop any of us from trying, in order to gain some kind of an edge for the (inevitable) next such drama. Rarely is there a clear precipitating event, but rather a nebulous collection of concerns that gradually build. For a time, sometimes a long while, everyone seems happy to ignore these issues, until they don’t anymore and the market goes into a tailspin. One generally sees a disorderly and outsize downside reaction in those situations.
There is a common misperception that such events unfold quickly and decisively. Looking back to recent market corrections such as Q4 2018 or Q1 2020 would affirm this view. Incidentally, “market corrections” is an interesting choice of terminology; it implies a rationality or higher purpose to market behaviour that is often lacking.
Coming back to the anatomical analysis; these things can go on for much longer than one may realise. For you striplings not long enough in the tooth to remember the 2000 “tech crash”, it is a classic example of prolonged suffering. Those who bought the ‘dip’ after the Nasdaq’s 34% fall in March 2000 would have found themselves out of pocket by May 2000. Perhaps they held fast and made a nice 28% profit by July 2000.
However, all of this volatility proved to be a mere amuse-bouche. The main course was served in the form of a protracted 61% fall from the end of August 2000 to April 2001. The market would again touch a new low in September 2001 (for obvious reasons) before starting its long rehabilitation. It was the summer of 2012 before the Nasdaq again surpassed the May 2000 level and 2015 before the index again made new all-time highs.
All jokes about age aside, it is worthwhile considering that the Federal Funds Rate (i.e. the US central bank rate) was last above 5% in 2007. Thus, anyone under the age of 33 working in the capital markets has not experienced a material tightening or loosening of interest rates and the potential impact on various asset classes. To have seen a full cycle you would need to be in your late 30s and to have seen more than one cycle you would need to be in your late 40s.
In the face of a market sell-off, there are only really three potential courses of action: de-gross as far as your mandate allows to preserve capital, utilise the opportunity to buy assets at what you believe are attractive and probably temporary valuations, or just sit there like a corpse and do nothing. The last of these is the least likely to be the best course of action, although of course these things can only ever be judged in hindsight.With the caveats about ascertaining the fundamental nature of whatever market gyration one finds oneself at the mercy of, we think there are three principle questions that determine the appropriateness of ‘buying the dip’: 1) Is there a change to the environment that argues for a fundamental re-assessment of the key assumptions driving models of net present value for the equities that you are following? 2) Regardless of your personal views on their merits, are the most likely factors driving market behaviour likely to be of limited duration? If so, can you identify a clearing event? 3) Can you identify a share price level where all of the potential risks are sufficiently discounted?
If the first question is answered positively, then hopefully the situation can be analysed to some extent and a ‘worst reasonable case’ elucidated. If share prices reach a level where this is the case then clearly it has become a buying opportunity. The March 2020 sell-off around COVID-19 is an example of such a situation. At the point where share prices were discounting a contraction in the volume outlook for the healthcare system with no subsequent recovery, it was obviously time to buy.
The second situation is a more complex one. In a healthcare context, we can look to the 2008/9 financial crisis. Lehman collapsed on 15 September 2008 and the prior day marked a seven-year high for the Nasdaq Biotech Index (NBI). By late November, the index was 33% lower and many people were arguing that the problems in the banking system would weigh on the ability for biotech companies to raise money and investor appetite to back them.
Bear Stearns collapsed into the arms of JP Morgan in March 2008 and, although the NBI lurched down, it recovered within two weeks, making it very tempting to buy this second dip. Although the post Lehman situation persisted for about a year, the NBI surpassed the September 2008 high by March 2010 and went on to make new all-time highs in 2010, 2011 and 2012. It took a fair amount of time for investors (i.e. no clearing event) to be satisfied that the sector was going to be able to fund itself in this new environment, but it was nonetheless correct to buy the dip because the industry fundamentals were intact.
The third scenario is the one investors hope never to see; where the market has fallen to such an extent that it really doesn’t matter what the cause was – asset prices are unarguably cheap.
Dissecting the data
Regular readers will be painfully aware through our constant carping that the market has for some time exhibited certain size factor behaviours that we do not think are justified by any changes to fundamentals or easy to understand. Figure 6 below serves as an illustration comparing the GBP performance of the MSCI World Healthcare Index to the Russell 1000 and 2000 indices and BBH share price. The Russell 2000 is the small-cap brethren of the Russell 1000.
As the chart clearly shows, size factor has been a major performance determinant for some time. The Russell 2000 Indices have lagged the 1000 and the effect is even more pronounced comparing within healthcare. Against this backdrop, we understand that our strategy will struggle to keep up with the broad MSCI World Healthcare Index and if there were an obvious reason for size factor to play such a significant role, we would begrudgingly accept this situation. The other notable observation is that the magnitude of the size factor effect has grown materially in 2022.
It would be reasonable to ask why we do not willingly accept this size-driven dynamic. The simple answer is that it is without precedent. As we have noted before, it is intuitive to think that innovation in an R&D-led sector is going to occur more readily and have greater materiality for smaller companies focused on those areas of innovation, as opposed to the more diversified mega-cap companies that dominate the sector from a market value perspective. Indeed, this is why the BBH strategy focuses on such companies.
Long-term data proves this intuitive notion to be factually correct. Figure 7 illustrates the relative performance of two US indices; the broad S&P500 healthcare benchmark and the Russell 2000 equivalent. We have taken the data from the beginning of 2009; as far as we can go back without bumping into a market correction event (the previously mentioned 2008 banking crisis).
If one ignores the data from H2 2021 onward for a moment, there are two very clear patterns here: firstly, SMID healthcare outperforms large cap healthcare. Secondly, when there is a retrenchment, the SMID Index bounces back much faster, rapidly re-asserting its leadership over the broader gauge. Surely then, it becomes obvious that the current dynamic is rather odd.
That leaves us with a pattern that is out of the ordinary and for which we can find neither fundamental justification for, nor precedent. Consequently, we have used this as an opportunity to add to our gross exposure, albeit at a measured pace because we cannot find an external driver and thus a crystallising event with which to be confident that the market has found a bottom. That having been said, the intersection of these two lines on the chart seems like a compelling signal to us.
As a final observation, we wanted to expand upon the previously made comment regarding the accelerating severity of this size factor effect. Below are four charts that compare the fall of various indices during prior crises by using the preceding index high as a starting point.
Figure 8 uses the broad S&P500 healthcare index. We have included this because it is such a long-standing data series that we can include the most singular existential crisis the modern healthcare industry has faced – The Clinton administration’s ill-fated 1992/3 proposal to create a national healthcare system in the United States. We have also included the 2000 tech crash and the 2008 banking crisis and compared these to the current sell-off. We will leave it to readers to decide if today’s situation merits comparison to the 2000 crash or the planned obliteration of private payor healthcare in the US, or if the 2008 situation is a more appropriate example.
Figure 9 covers the mid-cap focused Russell 2000 healthcare Index. This time series does not go far enough back to include the Clinton era, but we can cover the 2000 and 2008 crises. The Russell 2000 Healthcare’s high was also in mid-2021, so we can see the sell-off unfolding over a longer time period and this also allows us to illustrate that marked acceleration in the downside in recent weeks. Again, this data is suggestive of a pattern that is becoming more extreme than historical precedents, despite the absence of a clear external stressor.
Figure 10 covers the Nasdaq Biotechnology Index. This is somewhat of a misnomer these days, as the index includes some large-cap pharma companies and Tools and Diagnostics plays such as Illumina and Guardant Health. Whilst it is probably the least relevant correlate to our strategy, it is nonetheless indisputably an index focused on healthcare innovation and thus a useful illustration of the current market fall versus prior crises.
Our final chart (Figure 11) illustrates the same data for the broad MSCI World Healthcare Index. As we have noted before, this is a free-float weighted index of the world’s largest healthcare companies and, as such, has very limited exposure to what we would consider small and mid-cap healthcare. A time series comparison is also somewhat problematic because the market’s recent market high was at the end of 2021, so there is little data to track. Broadly though, it does illustrate how much better the larger capitalisation stocks have fared throughout these difficult weeks.
There are various and rather childish stock market aphorisms involving monkeys and picking bottoms, with the pithy observation that engaging in such an activity in public is unseemly and likely to cause embarrassment. This may well be true, but in the end it is part of a portfolio manager's job to do so and it is also true that embarrassment can often be quelled with sufficient pecuniary reward.
We cannot be confident that the mid-cap healthcare rout is close to its denouement, but we can objectively discern value when we see it, and that time is now. We enter February with a portfolio of undiminished quality and an unchanged investment strategy, but one that is re-weighted to take maximum advantage of any return to more typical market dynamics and enhanced with an increased level of gearing that reflects our conviction in the opportunity that lies before us.
We remain optimistic not because we are optimists, but because we are realists.
We always appreciate the opportunity to interact with our investors directly and you can submit questions regarding the Trust at any time via: email@example.com
As ever, we will endeavour to respond in a timely fashion.