Investors seeking to dampen the impact of market volatility on their portfolios frequently overweight defensive sectors or industries, such as Real Estate, Telecommunications and Consumer Staples. We believe this practice can potentially lead to underperformance during certain periods of market declines as well as during longer time periods. In this paper, we discuss this observation and propose an alternative for managing risk. The Nuts and Bolts of Defensive Sectors Defensive sectors and companies are called non-cyclical because they provide products that are essential throughout economic cycles. • Businesses require offices and other buildings and consumers require housing, which can support the performance of the Real Estate sector when the economy slows. • The Telecommunications industry experiences steady demand for telephone communications and networks for transmitting data. • Consumer Staples are also non-cyclical with demand for food and household items persisting throughout economic cycles. Defensive sectors often provide consistent earnings rather than potential for strong revenue growth and accelerating profits. Some investors believe the steady results of non-cyclical companies can be appealing during market dips or when the economy weakens. Downside capture ratios illustrate this perceived appeal. A downside ratio simply measures the decline in a stock’s price relative to the decline in the market—a ratio of 0.80 implies a stock’s price decline has been 80% of the decline of the market. Upside ratios measure the percentage of market gains that a stock captures. Certain stocks with low downside capture ratios can potentially outperform when markets decline, but not always. In some instances, stocks of companies that are benefiting from secular growth, such as the rapid adoption of software, can outperform sectors with low downside capture ratios as illustrated by Figure 1.
Matt Weatherbie, CFA CH I E F E X ECU T I V E O F F I C E R CO - CH I E F I NV E S TMEN T O F F I C E R WE AT H E RB I E CA P I TA L , L LC
H. George Dai, Ph.D. S EN I OR MANAG I NG D I R ECTOR CO - CH I E F I NV E S TMEN T O F F I C E R WE AT H E RB I E CA P I TA L , L LC
Joshua D. Bennett, CFA S EN I OR MANAG I NG D I R ECTOR D I R ECTOR O F R E S E A RCH WE AT H E RB I E CA P I TA L , L LC
Figure 1: Performance During Bear Market (3 years ended 12/31/2009)
-20% 0% 20% 40% 60% 80% 100% 120%
● Annual Return ■ Downside Capture
2% 3% 4% 5% 6%
-2% -1% 0% 1%
Source: FactSet.The figures presented are provided for illustrative purposes.They include examples of the performance of two industries with downside captures above and below 100%, respectively. Please note that using dierent industries or dierent time periods might have materially dierent results than those shown above. Annual Return The performance data quoted represents past performance, which is not an indication or a guarantee of future results. Telecom Software
By capturing market share, innovative companies, including those with high downside capture ratios, can potentially benefit from secular growth that may occur even during periods of economic weakness.
Even though the downside capture ratio of the Software industry was substantially higher than that of Telecommunications, Software’s high upside capture ratio resulted in strong gains on days when markets rallied during the bear market referenced in Figure 1. Those gains resulted in Software outperforming. A Better Approach to Risk Management? We believe investors should seek companies that have potential for generating earnings acceleration and revenue growth. In many instances, these companies use innovation to develop products or services that disrupt their respective industries. By capturing market share, innovative companies, including those with high downside capture ratios, can potentially benefit from secular growth that may occur even during periods of economic weakness (See Figure 2). EATHERBIE CAPITAL
Figure 2: Innovation Prevails
130% 140% ■ U.S. Internet Ad Revenue ■ U.S. E-Commerce ■ U.S. Total Retail Sales
Source: Bureau of Economic Analysis, PwC, Census Bureau. *See Alger’s white paper“The Enduring Force of Innovation.”
The most innovative companies as determined by the percentage of revenues invested in research and development have transcended market volatility associated with the Great Recession and have outperformed (See Figure 3).
Figure 3: Innovative Companies Outperformed During the Great Recession (From December 2007 to June 2009)
Cumulative Excess Returns
S&P 1500 Index
The performance data quoted represents past performance, which is not an indication or a guarantee of future results. Source: Factset. Most/least innovative stocks excess performance is derived from highest and lowest S&P 1500 quintiles based on R&D as % of sales, normalized for market value, using one-month returns for period from 2008 to June of 2009.
HEICO Corporation, which provides aircraft parts, is benefiting from an increase in air travel, but we believe the company’s strong commitment to research and development has positioned it to continue its sales and earnings growth momentum throughout economic cycles.
Innovation Is Transforming Health Care Insulet Corporation has developed Omnipod, a tubeless insulin system for treating diabetes. It is a wearable and waterproof pod that delivers insulin for up to 72 hours. Insulet is also expanding the types of drugs that can be administered with Omnipod. For diabetes patients, Omnipod is a more convenient option than administering insulin with syringes, which can require keeping the medication on hand around the clock. The device can also deliver more accurate dosages at a steady rate, which improves treatment efficacy. These attributes, we believe, can potentially support growing demand for Omnipod throughout economic cycles. Public Safety Gets a Boost from Digitization Government agencies and employers need to respond promptly to weather emergencies, infrastructure failures, civil unrest, health threats and other events. To that end, Everbridge, Inc. offers cloud-based technology for disseminating alerts via text messages, emails, telephone voice messages and the web, including social media. Its technology also helps governments and employers better manage crises, including deploying and coordinating first responders. By providing innovative products that help governments and employers better respond to events, we believe Everbridge has potential to continue increasing its sales and produce earnings expansion. Research and Development Thrives in Aviation HEICO Corporation, which provides aircraft parts, is benefiting from an increase in air travel, but we believe the company’s strong commitment to research and development has positioned it to continue its sales and earnings growth momentum throughout economic cycles. The company specializes in private manufacturer authorization parts that replace original equipment manufacturer parts. It sells parts at substantially lower prices than original manufacturers. It has considerable resources such as engineers and testing equipment for developing replacement parts that meet strict Federal Aviation Administration requirements. Conclusion Identifying smaller high-quality companies that are leaders in secular growth trends requires in-depth fundamental research. Such a process, we believe, can potentially identify companies that will generate attractive returns for investors throughout economic cycles. At the same time, having an in-depth knowledge of portfolio holdings and unique characteristics that can allow each company to grow its earnings is crucial to managing portfolio risk.
Matt Weatherbie, CFA Chief Executive Officer Co-Chief Investment Officer
Joshua D. Bennett, CFA Senior Managing Director Director of Research
H. George Dai, Ph.D. Senior Managing Director Co-Chief Investment Officer
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It includes those Russell 2500 compa- nies with higher growth earning potential as defined by Russell’s leading style methodology. The Russell 2500 Growth Index is constructed to provide a comprehensive and unbiased barometer of the small to mid-cap growth market. S&P Composite 1500 is an unmanaged index that covers approximately 90% of the U.S. market capitalization. Investors cannot invest directly in any index. Index performance does not reflect deductions for fees, expenses or taxes. Performance data quoted represents past performance. Past performance is not a guarantee of future results. The following positions represented the noted percentages of Alger assets under management as of 6/30/2019: Insulet Corporation, 0.8%; Everbridge, Inc., 0.7%; and HEICO Corp., 0.4%. All information regarding firm history, biographies, and Fred Alger Management, Inc. (“FAM”) and Weatherbie Capital, LLC performance are maintained by FAM. 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