A Tale of Two Baskets
In 2020, the performance of mid caps, in line with the stock market in general, was largely driven by the simplistic but practical division of equities into a pandemic basket and a recovery basket, depending on the conditions under which companies were likely to perform best. In the fourth quarter, COVID vaccines’ effectiveness moved forward the timeline for economic recovery and altered both groups’ short-term outlook.
However, whatever the specific timing, we expect the relative rate of growth for these two baskets to converge in 2021, as we believe the growth of the pandemic basket moderates and the recovery basket shows renewed signs of life.
On the Behavior of Tides and Boats
Virtually the entire market showed strong performance. However, several factors created a rising tide in the waning months of 2020 that carried all boats with it. The accommodative low-interest-rate environment temporarily levels the competitive playing field between low-quality companies that need access to cheap capital and high-quality companies that can self-fund growth. At the same time, M2 — the measure of economic liquidity that tracks cash, near-cash assets, and check deposits — has grown by 20 percent, or four times the average rate, for over seven months. This liquidity has helped fuel an across-the-board rise in the prices of stocks and other assets from real estate to collectibles.
We think neither of these factors will continue indefinitely. A waning tide has always followed a rising tide, which is when we believe mid-cap companies with strong balance sheets and profitability are likely to be better prepared to ride high in the water than leverage-laden, unprofitable competitors.
The pandemic accelerated many important long-term trends, such as eCommerce, cloud computing, the move to digital everything, and that progress is unlikely to backtrack. However, we see backtracking in the price of some disruptive companies in these fields from profit-taking by investors. That said, in our view many of these companies have plenty of room left to outperform expectations and be a significant source of alpha.
Simultaneously, there are many names that, while good quality businesses, were disproportionately affected by the pandemic environment. We believe the recovery is likely to help them shine again.
At KAR, we spend considerable time and effort seeking out factors that will support strong profitability and growth in good times and bad, no matter what the tide is doing. By taking a long-term view on investing, we strive to see past the short-term effects of factors even as disruptive as a global pandemic to the long-term prospects of high-quality companies.
This information is being provided by Kayne Anderson Rudnick Investment Management, LLC (“KAR”) for illustrative purposes only. Information contained in this material is not intended by KAR to be interpreted as investment advice, a recommendation or solicitation to purchase securities, or a recommendation of a particular course of action and has not been updated since the date of the material, and KAR does not undertake to update the information presented should it change. This information is based on KAR’s opinions at the time of the recording of this material and are subject to change based on market activity. There is no guarantee that any forecasts made will come to pass. KAR makes no warranty as to the accuracy or reliability of the information contained herein.