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'2021 will be a much choppier year than 2020'

We speak to Thomas Davis, Managing Director and Global Equity Portfolio Manager, PGIM Jennison Associates about his investment philosophy

'2021 will be a much choppier year than 2020'

PGIM India Global Equity Opportunities Fund is an open-end international fund of fund that has returned about 63 per cent over the last one year (as of April 25, 2021). This fund invests in PGIM Jennison Global Equity Opportunities Fund, which is managed by Thomas Davis and Mark Baribeau. We speak to Thomas Davis about the market and how he manages his fund. PGIM India Mutual Fund is the arm of PGIM, the 10th largest asset manager globally with presence in 16 countries and an AUM of $1.5 trillion.

There are apprehensions that the US markets are ripe for a big fall, as the pandemic-induced easy-money policies have led them into a speculative zone. The bond-yield spike and its impact on equity markets provided some credence to that hypothesis. Do you think the inflationary concerns are big enough to derail the economic recovery and in turn cause the markets to tumble?
I think 2021 will be a much choppier year than 2020. Despite the pandemic, 2020 was actually a pretty good year for the markets. However, the economic impact from the pandemic was far greater on a global basis owing to the lockdowns. Now with the vaccines being rolled out, we are on a path of recovery. The employment levels are recovering, we've got consumers venturing back out to pre-lockdown levels and I think what we are seeing is a reflation from the depths of the 2020 COVID impact. With the demand and consumption picking up, we are also facing some bottlenecks in supply chain, logistics, etc., causing certain prices to push higher.

Some market observers are suggesting that this is an indication of impending inflationary problems. I would, however, argue that this is a reflation off the bottom of COVID, but it will normalise over the course of 2021. The supply chains, production levels and consumption levels will start normalising. By the end of this year, from the economic standpoint, it will start to look a lot more like it did over the last few years pre-COVID.

I don't believe that inflation should be of grave concern for the following reasons. Firstly, I believe that in the US, the current unemployment level of 6 per cent may decline by half over time, which will be similar to the level when we went into the COVID phase. Secondly, the monetary policy can be tweaked if necessary. We have been in a very accommodative monetary regime globally for pretty much the last decade coming out of the financial crisis of 2008. Third, I think a lot of the fiscal stimulus that's been implemented is really just trying to fill the hole created by the economic impact of unemployment and to keep economies out of a deep economic recession. Fourth, the fast pace of technology innovation and adoption is very dis-inflationary. This all leads to a reflation and recovery of the economy, continuing economic growth, but probably not a sustained inflation problem. While the markets may be choppy, given the mixed signals over the short-to-medium term, over the medium-to-long term, we will be looking a lot like we did pre-COVID.

There is a lot of talk about the big rotation from growth to value. As a pure growth investor, what are your views and are you making any shifts in your portfolio positioning in response?
I and my partner Mark Baribeau have been managing global equity portfolios since 2004 and hence have witnessed several rotations such as the changes in interest rate paradigms, the financial crisis of 2008 and its impact in the recovery and the market, Chinese growth scares where the markets feared Chinese economic growth would decelerate, referendums such as Brexit, etc. We've seen a US election in 2016 that provided the view that the Trump administration would be friendlier to financial institutions with less regulation and far friendlier to energy companies with less environmental regulation, leading to a rally in these sectoral stocks right after the US elections and causing a market rotation. However, the thing with rotations is that they don't tend to last too long.

So we've seen several market rotations over the years and we're in another one right now. The pandemic caused the spread between growth and value styles to stretch to almost historic levels over the second half of last year. The US 10-year bond yield really got to incredibly low levels towards the latter part of last year, and then bounced off a bottom around January and February this year with the revival in output levels as vaccines rolled out. The rapid bounce-off did raise concerns of inflation and economic growth. These are some of the combinations that probably proved to be the trigger point for the rotation we are currently in.

History suggests that these rotations last anywhere from a few weeks to a few months to maybe a quarter or two. During these rotations, the companies that were our biggest contributors to performance previously tend to become our pain points and our performance undergoes stress. However, in most of the cases, these same companies end up returning to a market-leading position in the future quarters and years, because what we find is that their actual underlying businesses were not impacted or had undergone a very minor impact throughout the rotation. This is because the businesses that we invest in tend to be very cutting-edge, having strong products or services that are in demand. For instance, during the 2008 crisis, customers lined up around the Apple store for the iPhone as it was such a new, innovative and differentiated product. Thus, if you are a company that offers a unique product or service or helps businesses lower their costs, you are bound to find customers irrespective of the Federal Bank policies or despite whatever a new presidential administration in the US might want to do.

Our analysts spend a huge amount of time making sure we understand the business model and checking in with the companies, their competitors, and their customers to ensure that the underlying trends remain strong. While we, as portfolio managers, sweat during these volatile periods, we also spend a lot of time going back and revisiting our investment theses, talking to the companies, double-checking things to maintain the high degree of conviction we had in the first place.

Thus, these debates around growth versus value, cyclical versus secular and cyclical versus defensive have been around forever. And the question comes up every few years or every few quarters. These rotations are completely normal. But what we have found is that we are better off not making major changes in the portfolio. We invest to our strengths and frequent changes in portfolio are not going to benefit us or our clients in the long run.

Do you like to put any kind of timeframe for any of the holdings with the potential for it to translate into stock price appreciation? You can often come across companies with great disruptive ideas, but somehow that does not pass through into what happens on the market. So is there any that sort of a metric that you look at that we wait for this much time and then move on?
As with everything in our approach, this is multifaceted, but we certainly don't have infinite patience. If our analysts have a high conviction in an idea, product or service being offered by a company, we build a strong investment thesis around it. We'd like to think that there's a reasonable duration to this opportunity. However, if for whatever reason, the stock just sits there or goes down, then after three to four quarters, we have to question whether somehow we've missed something or we didn't interpret something correctly. If it is just not working, we are going to move on because we have only 34-45 securities in our portfolio and there's always another opportunity. So you don't want the opportunity cost of staying in something that just isn't working after a reasonable time horizon. Nine months, a year or so, it's time to move on.

The flip side of that is that there's no set time limit or duration after which we want to exit a security long held in our portfolio. There is no rule that says if it has gone up 50 per cent over the time we owned it, it should be exited. Appreciation potential is always on the table if you have one of these really innovative businesses. For instance, Apple, MercadoLibre, they've all been long-term holdings, because they continue to earn those spots.

Also, we do a lot of analysis of the portfolio over time. And what we find is that over time, the biggest source of our excess return comes from companies or positions that we've held in the portfolio for multiple years. So just think about a chart with our holdings sorted into holding periods of approximately 0-2 years, 2-4 years, 4-7 years and 7+ years - the ones that are in the portfolio for less than two years actually cost us a little bit of performance. We don't make any money from them. So we want to make sure we minimise those. We don't actually start to generate meaningful excess return for our clients until we actually get more or less to that third bucket of 4-7 year holding. We are fairly neutral in that roughly three-year timeframe. And by the time you get to the longest holding period of 7+ years, there's a significant amount of excess return generation. Thus, that just goes to the point that some of the best companies, the really innovative ones, find new ways to grow and sustain their business. But if things don't play out the way you expect, despite being reasonably patient, you also want to cut that holding off at some point so that you don't sit with lost opportunity cost.

You've talked about the digital transformation, the direct-to-consumer models such as the e-commerce, technology facilitators like digital payments and cloud-based infrastructure as the disruptive ideas. They have substantial representation in your fund and they've proved very rewarding with the pandemic accelerating their adoption. What are the next big emerging disruptions or innovations that make you excited?
Technology and innovation is something that constantly evolves. I think we're in the midst of one of the biggest technology booms of our generation that has occurred in probably, at least, the last 50 years or more. And the speed with which it's happening is only accelerating. So we're always looking for the next theme, the next set of ideas that may lead to the next set of innovations and market share shifts. And what we held in the portfolio five years ago versus where we sit today, in many respects, is already showing signs of evolution. What we held in 2010 or 2006 is very different from what we hold today. So the portfolio gradually shifts over time as new things come along.

Today we are keeping an eye on the growth of EVs and electric mobility more broadly across all forms of transportation, whether it be a particular brand or actual vehicle and the battery technology. There are a number of companies out there doing really innovative things with batteries. Large global companies are innovating around the whole battery concept and not only for mobility, but battery storage for alternative energy sources, because that will also be a critical component of how we fight climate change. So electric mobility, energy storage and the intersections in some cases of both of those are areas of possible opportunity.

Similarly, artificial intelligence. I don't know exactly how that will evolve over time but it is going to change and be there. It's embedded in the autopilot system for the Tesla cars. It's embedded in aspects of Google or Amazon. It's embedded in the voice recognition commands that we use in a lot of different systems, whether it be our home automation systems or various other systems we use. A.I. is another area I think that is going to offer opportunities, perhaps indirectly over time, and is something that we are constantly looking at.

Also, it's not only the new technology that has growth potential. A lot of the stuff that we hold today still has a long runway of growth ahead in the digitalisation of the global economy concept, whether it be consumer-facing or enterprise-facing, it's still in its early stages. E-commerce penetration in the US is only about 25 per cent and about 10-12 per cent in Latin America. Thus, there's still a lot of room for growth on the e-commerce front. I think the adoption of cloud-based applications in the enterprise is still in very early stages. We only started investing in some of these types of businesses over the last few years.

Three quarters of our top 20 performers last year were actually in our portfolio at the end of 2019. COVID was effectively an accelerant for many of these trends. We fortunately were in the right place at the right time. But we still have a long way to go. For instance, the e-commerce number in the US, the 23-25 per cent penetration today was only at high teens at the end of 2019. So COVID pushed that penetration by 400-500 basis points. That's versus historical penetration improvement of only 100-200 basis points. While many of those names were in the portfolio pre-COVID, many of them are still in the portfolio post-COVID and will likely continue to be in the portfolio for the foreseeable future until new things come along.