Active funds set to shine in volatile times: Ned Bell

Quality and active management will shine in a more volatile stock-trading environment as interest rates rise amid inflation, says Bell Asset Management’s Ned Bell.

Ned Bell urges investors to switch from large-cap growth and emerging markets into small and mid-caps. Picture: Britta Campion

Bell Asset Management chief investment officer Ned Bell says active management – and investing in quality at a reasonable price – will shine in a more volatile environment with inflation and rising interest rates.

He’s telling anyone who will listen that they should be switching from large cap growth and emerging markets into quality small-mid caps on the basis that they are uncorrelated, with less valuation and a better earnings trajectory than mega-cap tech.

The US sharemarket has endured its first correction in the post-Covid bull market, with the Nasdaq 100 down as much as 19 per cent and the S&P 500 off 12 per cent from record highs.

“It’s ironic, since so many have gone passive, that this could be the year of active management,” he says.

His core strategy returned 34 per cent before fees in 2021 versus 29.3 per cent for the MSCI World.

“We’re actually very optimistic,” Bell says. “We feel these periods of volatility play really well for us, and I think the next two years are going to be a great period for active funds management more generally.”

Devastating falls in some “hyped-up meme stocks” with little earnings – such as Peloton and Zillow, both of which have dived about 80 per cent in the past year – remind him of the bursting of the technology, media and telco bubble in 2000.

Working in San Francisco at that time, he recalls seeing “the last hurrah and the lights turned off”.

“It’s just like the rug gets pulled out,” he says.

“One day the market wakes up and they just get sick of those companies almost instantly.”

Some of the “very large, very expensive, very crowded stocks” such as Netflix and Facebook-owner Meta Systems were seeing “some of the biggest earnings decelerations”.

“It doesn’t mean that they are turning into terrible businesses; it just means that the rate of growth is slowing” and the ultimate bottom in their share prices could be much lower, he says.

The market reaction has been exacerbated by rising interest rates as economic growth rebounds from Covid, hitting the shares of high-valuation IT companies more than others.

“When interest rates go up, the price-to-earnings multiples compress,” Bell says.

“It’s a bit like catching an elephant jumping off a building – it’s a long way down before you start finding value investors – so the big question now is, who is the marginal buyer?”

The other category of stocks that are vulnerable are the unprofitable companies.

“Profitability in a falling market is like a parachute – you either have one or you don’t,” he says.

“It’s very hard to know where the bottom is when these stocks start tumbling.”

But the flipside is that market sell-offs generated by sharp drops in overvalued tech giants can create buying opportunities for “QARP” investors like BAM.

“These sorts of drawdowns inevitably pick up some of the best buying opportunities and that’s absolutely what we are starting to see,” Bell says.

And while small-mid caps are “very inexpensive”, their earnings performance has been “terrific”.

“One of the biggest things you’ll see this year amid high inflation is quite a big dispersion in earnings performance,” he says.  “Value stocks tend to be more leveraged, with poorer pricing power, so they are more vulnerable because they can’t pass on this rampant inflation, and they’ve got more leverage.”

He warns the recent outperformance of value stocks will prove short-lived.

After almost two years of record-low official interest rates and Covid impacts which favoured expensive tech stocks and “meme stocks” with low or non-existent profitability, investors should look for companies with “very repeatable” earnings streams and reasonable valuations.

“We’re finding a lot of it again in SMIDs (small and mid caps) and some of the large caps outside of the FANGs,” he says.

His fund is currently trading on a forward PE multiple of about 22 times.

“There’s still good value out there if you lift the lid and look below the FANGs,” Bell says.

The SMID asset class has experienced a quite large divergence in expected earnings growth around the world.

BAM’s expects earnings growth of 31 per cent for the MSCI World SMID Cap index this year versus 21 per cent for the MSCI World Growth index, yet the SMIC Cap index now trades at a 46 per cent discount of 16.4 times versus 30.6 per cent for the large cap growth index.

That’s the biggest discount in a decade, according to Bell. The SMID index also trades on a 9 per cent discount to the MSCI World index, whereas it has normally traded at a 12 per cent premium over the past ­decade.

“It’s a pretty big disconnect and interestingly most investors don’t have anywhere near the exposure to this asset class that they should have, particularly now, when large cap growth is clearly crowded, challenged and expensive, and seeing decelerating growth.

“The other obvious one is emerging markets, which has been a very difficult place to invest in the last couple of years and is obviously facing a macro slowdown, particularly in China,” he says.

Bell dumped its Facebook holdings last October as competition threatened its growth ­outlook.

In the January sell-off, he topped up existing holdings as they offered the “best relative value”.

“Some of the companies on our watchlist have gone from being extremely expensive to very expensive, which doesn’t mean they’re attractive,” he says.

“They’re getting there, but there’s a way to go.”

At the quality end of “small and mid caps, he says people might not appreciate how “temporary” cost-cutting at the start of Covid has become “permanent”, giving a great deal of earnings leverage.