Why we're active
Q: You have been describing this as a stock-picker’s market. Can you expand on that? It’s pretty easy to be right when the economy is stable and markets are calm and highly correlated. The challenges come during periods of elevated volatility, declining correlations and economic disruption. This has been the environment since the Covid crisis erupted in late February and a robust economy effectively stopped on a dime. Significant sources of corporate revenues and profits were obliterated. Earnings forecasts became meaningless.
As we have written before, this chaos has created winners, losers and survivors. The big winners aren’t hard to find. They are the ones, like Amazon,1 Microsoft and Facebook, with strong balance sheets and ample cash. They have continued to grow revenues and grab market share. The losers are pretty easy to spot, too. Their business models already were fighting to adapt to a changing paradigm brought on by the increasing digitization of the economy, and they entered this crisis with highly levered balance sheets. They don’t have much room to weather this steep but likely brief recession, nor the financial wherewithal to make necessary changes for the post-Covid world if they do. Think J.C. Penney.
It’s the middle group—the survivors—where many of the opportunities lie. And to find the potential gems among the economic detritus, it takes an active approach that puts stock-picking front and center. Another area ripe with opportunity are the several hundred smaller companies that could be next year’s big winners, usually in one of the newly emerging sectors of the economy such as biotech, software, technology and online services. Some of these companies might be the next Amazon or Facebook but like the survivors group, they’re harder to spot. Fortunately, stock picking is our wheelhouse at Federated Hermes. It is our long-held belief that fundamental research leads to active price discovery far more effectively than passive strategies that effectively invest in an array of securities regardless of quality.
Q: What makes Federated Hermes a truly active manager? The sole focus of our experienced equity analysts and portfolio managers is to find—and adjust as needed—the mix of stocks that fits their investment objectives. While they measure their performance against a respective benchmark, they don’t manage to a benchmark.
Passive strategies, on the other hand, seek to mimic a benchmark index (as do some so-called active strategies that simply hug the benchmark, i.e., don’t stray far from the index components). Because they hew to benchmark companies and their weightings in the index, these passive strategies aren’t nimble. They can’t quickly adapt to a changing environment, nor seek to find potential future jewels during disruptive episodes. They just stick to the benchmark, buying everything in it, whether it be an already fully priced winner, an attractively priced survivor or an overpriced loser
Our equity teams weigh a variety of qualitative and quantitative factors—the competitive advantage and position of the company’s primary products or services, the company’s growth rate and how it is financing that growth, the quality of the company’s management and strength of its balance sheet, along with the macroeconomic and sector/industry environment and outlook, the price of its stock on a variety of metrics, and the management effectiveness and adherence to environmental, social and corporate governance principles—before homing in on potential securities that best fit this broader analysis. A more intensive review follows before final selections.
Q: How has this process worked this year? With the provisos that it’s just one period and that past performance is no guarantee future performance, a number of our Institutional Share equity funds have outperformed their benchmarks year-to-date (YTD) through May on a total return basis, excluding fees. Longer term, relative to their respective benchmarks, Federated Kaufmann,2 Kaufmann Small Cap3 and International Equity Fund4 Institutional Shares had outperformed on YTD, 1-year, 3-year, 5-year and 10-year bases through May 31, net of fees.
This, in my view, reflects the benefits that can come with truly active management during periods of economic and market disruption. As I said at the beginning, it’s pretty easy to be right when everything is going smoothly. The challenge is to take advantage of the opportunities that arise when the environment is anything but smooth.
1As of March 31, 2020, Federated Kaufmann Fund owned shares in Amazon worth 0.85% of the total portfolio value as of that date.The holdings percentage may not necessarily reflect adjustments that are routinely made when presenting net assets for formal financial statement purposes. Portfolio composition is subject to change.The other companies are referenced as examples only and are not representative of holdings in the three cited Federated funds.
2 Russell Midcap Growth Index total returns through May 31, 2020: Year-to-date: 1.77% and annualized, 1-year: 17.03%; 3-year: 13.99%; 5-year: 10.72%; 10-year: 14.07%
3 Russell 2000 Growth Index total returns through May 31, 2020: Year-to-date: -6.65% and annualized, 1-year: 7.32%; 3-year: 7.72%; 5-year: 6.34%;10-year: 11.72%
4 MSCI ACWI ex-USA Index total returns through May 31, 2020: Year-to-date: -14.85% and annualized: 1-year: -3.43%; 3-year: -0.24%; 5-year: 0.79%; 10-year: 4.38%