Selectivity Matters in Periods of Market Turmoil

April 2023

Active management matters most, we believe, when navigating market turmoil, whether that turmoil is driven by swift changes in interest-rate regimes or by banking crises. The U.S. Federal Reserve’s current historically aggressive rate-hiking cycle started what we view as a rationalization in equity markets that depressed valuations from near all-time highs to levels near historical norms. More recently, signs of financial stress and deteriorating corporate profitability have emerged. In our view, these dynamics magnify the need to differentiate between fundamentally strong and fundamentally weak businesses, and these dynamics offer opportunities for investors with a selective approach and long-term perspective.

The recent bankruptcy of Silicon Valley Bank (SVB) was a notable sign of how the rapid rise in interest rates stressed the financial system. This event illustrates the evolving and often unpredictable nature of risks that can result from tightening financial conditions. Solvency issues at SVB were largely set off by declines in the bank’s deposit base, coupled with losses from poor interest-rate risk management. In contrast, losses from loan portfolios caused the majority of banking crises throughout history.

While regulators have taken initial measures to provide liquidity to banks, we see the potential for knock-on effects. In our view, profitability in the banking sector will be constrained as it deals with depositors flocking to higher-yielding assets, mark-to-market losses on assets, and the rising likelihood of further regulatory scrutiny. Subsequently, we believe banks are likely to limit credit creation, weighing on economic activity and increasing the probability of a recession.

Selectivity Matters

The recent valuation compression and the crisis in the banking sector emphasize the importance of selectivity for equity investors. In our experience, near-term shifts in macroeconomic variables, such as interest rates or commodity prices, are unpredictable. For this reason, we invest in businesses we expect to produce above-average earnings growth by providing innovative products or services. These businesses tend to be less susceptible to changes in economic activity compared to more cyclical, value-oriented market segments, such as the banking industry.

In our view, it is critical that portfolio businesses have the financial strength to withstand a challenging operating environment. In recent years, low interest rates supported fierce competition across several industries as businesses without the underlying profitability to fund their growth often received ample external capital. As access to capital becomes more limited in a higher-rate environment, many subscale businesses have been forced to reduce spending. Industry leaders with the financial strength to self-fund growth initiatives have benefited from this shift.

At Sands Capital, we seek to invest in businesses that are financially strong leaders in their fields. During periods of financial stress, we believe these select businesses will be able to use their competitive advantage to grow stronger relative to the competition. Businesses that outgrow competitors have the ability to achieve many benefits of scale, such as leverage on a fixed cost base. As a result, improving profitability can help the business reinvest to a greater degree than weaker competitors to potentially achieve lower-cost pricing, a growing suite of products and services, and a technological edge. These dynamics can be amplified in challenging operating environments, further reinforcing a business’ competitive advantages and improving the long-term economics of the franchise.

We’ve recently observed two industries in which businesses are extending their leadership. Within the ride-hailing industry, the market share leader’s cost and technology advantages have produced a virtuous cycle of rising driver supply, resulting in lower fares and attracting a growing pool of riders relative to its competition. Meanwhile, in the streaming video industry, the market share leader was profitable in 2022, yet by our estimate, its six largest competitors lost a combined $21 billion. We expect the competitive landscape to become more benign as competitors cut those losses.

Select Businesses Trade at Attractive Valuations

These examples illustrate the opportunity for fundamental security selection amid the indiscriminate selling that often accompanies periods of rising volatility. Over the past 18 months, investors have shortened their time horizons to preserve capital and bid up the valuations of stable-yet-slow growth businesses in areas such as consumer staples. Meanwhile, valuations have compressed significantly for high-growth, high-valuation businesses leveraged to key areas of innovation, with little differentiation between business fundamentals. As a result, the shares of many growth businesses trade at attractive valuations relative to our expectations for their long-term earnings power.

Similarly, we believe the decline in growth equities overlooks the outlook for secular growth in key areas of innovation. Enterprises are still early in their process of digital transformation, medical device companies are improving the standard of care, and semiconductor companies are benefiting as the growing adoption of artificial intelligence, autonomous driving, and the Internet of Things increase demand for computing power.

We believe a long-term focus on businesses benefiting from these secular trends is critical in this period of heightened uncertainty. Shifts in market sentiment can lead to volatile swings in share prices; however, share price declines often conflict with a stable outlook for long-term business fundamentals. In our experience, it’s these periods that can provide the greatest opportunity for investors that look through the noise of share price volatility and maintain a focus on areas with the greatest potential to sustain earnings growth.