- Head of Manager Research
Italy, Institutional
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iStrat Factor insights, part 1
- Co-Head of Investment Strategy
Strengthening your equity core: A market efficiency framework
As markets weigh the pros (vaccination progress and reopening economies) and the cons (worries about inflation and policy tightening) of the evolving macro environment, we are fielding many client questions about the backdrop for active management. As managers of multi-manager and multi-factor portfolios, we use our market efficiency framework to address the allocator’s perennial pursuit of balance between the cost of asset management fees and the benefits in terms of risk-adjusted returns. The least efficient markets, in our view, should be the best hunting ground for active managers and therefore command the largest part of the fee budget. In contrast, we tend to allocate less fee budget to the most efficient markets. But we also sharpen the focus of our manager research efforts in these efficient areas, to help identify the most attractive opportunities and improve the likelihood of alpha generation — an approach we call “reinventing the core.”
Our market efficiency metrics
We define efficiency using four key metrics (detailed in our paper, “Reinventing the core: Alpha opportunities in an evolving market efficiency landscape”):
- Consensus: Dispersion in analyst forecasts and large differences between median forecasts and announced results suggest opportunities exist for skilled portfolio managers to identify differentiated ideas through fundamental analysis.
- Idiosyncrasy: The higher the average level of idiosyncratic risk for stocks across a market, the more fertile the opportunity for active managers. We quantify this metric as the intersection of how many big winners exist in a market (i.e., stocks that outperform by more than 25% over rolling one-year periods) and how much of the risk attributed to each stock is company-specific (and not style, industry, country, or currency risk, based on Barra’s risk model).
- Accuracy: A high level of analyst forecast error over a one-year horizon and a low number of analysts covering each stock in a universe would tend to indicate that individual names may be poorly understood and that deep fundamental analysis may provide an edge in generating alpha.
- Substitution: The higher the cost and the higher the tracking risk of passive exposure to a market beta, the more attractive it may be for an allocator to invest in an active strategy.
A global overview of efficiency
Using this framework, we can arrange equity market exposures along a continuum from most to least efficient (Figure 1). We would expect emerging markets, China, and Japan to be some of the most attractive exposures to implement through fundamental active management, given that passive ETF exposure may be relatively expensive, with high tracking risk; sell-side analyst coverage may be lower, with wide estimate dispersion and significant forecast error; and idiosyncratic risk may be high. At the other end of the continuum, the US large-cap market is relatively more efficient, with low-cost passive alternatives, low tracking risk, broad sell-side coverage, greater consensus, and less forecast error.
Figure 1
Reinventing the core in the most efficient areas
Does that mean we are advocating a shift to passive investing in US large-cap equities? Far from it. Rather, we use this framework to guide how much of our fee budget to allocate across regions based on the idiosyncratic opportunity within each region and to shed light on areas where manager selection may have the greatest impact.
In more efficient markets, manager research may have a larger impact on the portfolio if investors are able to either expand the opportunity set or find niche alpha opportunities. Examples of strategies that may help expand the opportunity set include:
- “Extended strategies,” which pursue a beta and risk profile commensurate with a core long-only equity allocation, while potentially benefiting from alpha across a wider spectrum of ideas through short selling.
- Portable alpha strategies, which can seek fundamental alpha from less efficient markets while hedging beta risk from those markets and porting the market-neutral alpha onto a beta of the allocator’s choice.
Niche alpha opportunities include highly idiosyncratic strategies that traffic in segments of the markets that are not well known and are typically not well modeled by quantitative firms and risk models. These exist even in efficient markets, though they may be harder to find. Examples include strategies focused on founder-based businesses, capital-compounding franchises, and brand value. These strategies tend to be mid-cap heavy and own stocks in sectors/geographies not typically known for consistent capital generation (cyclicals, financials, brands in non-consumer areas), which is why they can be difficult to assess in risk models. In more efficient areas, these strategies may allow allocators to introduce significant idiosyncratic risk into portfolios while maintaining the desired geographic exposure.
iStrat Factor insights, part 2
- Head of Manager Research
- Co-Head of Investment Strategy
Is it time to be all in on equity income?
Across global equity markets, dividend levels have been driven to lows not seen since the late 1990s (Figure 1). What does this mean for income-oriented equity strategies going forward? We consider the answer through our team’s factor lens.
Figure 1
What went wrong with high-yield stocks?
Our contrarian instinct led us to examine the highest-yielding stocks in the US, Europe, and Japan. In 2020, these stocks saw their worst performance since the inception of our Fundamental Factor team’s “factor library” (2002), during a synchronized developed market drawdown for the dividend yield factor (Figure 2). We think this poor performance was driven by a combination of several effects that all hit at once. First, the regulatory scrutiny on dividend payers in parts of the market caused extreme negative sentiment (e.g., for European banks). Second, during the pandemic, there were “going concern” questions about many dividend payers and whether dividends would have to be suspended to preserve cash flow for operations. Third, there was a clear style and sector impact as higher payers tend to be later-stage companies with lower growth, more leverage, and higher capital expenditure intensity. In the end, most investors were not looking to buy companies in highly regulated industries with cash-flow commitments to a high payout and with sector/style characteristics that were in the crosshairs of COVID-related economic and policy developments.
Figure 1
In short, the struggles of high-yielding stocks in 2020 were driven by unique macro circumstances, suggesting that performance has dislocated and should mean-revert. In fact, we have already started to see this trend reverse as the percentage of non-payers and dividend cutters comes back down — but not yet back down to pre-pandemic levels, suggesting that there may be more runway for this opportunity.
We think the broader fundamentals for these stocks look attractive in a historical context, as well. While dividend payouts haven’t returned to previous levels, many companies are flush with cash and have improving earnings. This is unlike what we have seen after prior downturns, when companies, having depleted their cash and taken on leverage to sustain themselves through a recession, have taken a while to recover. This time, the recession was short and the recovery was quick, suggesting that we may be poised for dividend payment reacceleration.
How we think about income as a factor
Our work with fundamental portfolio managers at Wellington has led us to believe that some pitfalls of passive equity income investing (e.g., exposure to high-dividend payers with solvency risk) can potentially be mitigated by considering not only the dividend yield but also the ability of companies to maintain their dividends. Fundamental managers typically do this through deep dives into company balance sheets. Based on our collaboration with fundamental managers, we have constructed a proprietary Sustainable Income factor that incorporates the highest-yielding names that also have a historical track record of maintaining dividend commitments, the “ability to pay” based on cash flow, and a lower expected likelihood that leverage may present a risk to the business and its future dividend payments. We find that these criteria have historically tended to point to more profitable sectors such as consumer staples and health care (versus less profitable sectors such as energy and materials) and to more established, larger-cap stocks.
Using our Sustainable Income factor, we considered the attractiveness of the opportunity across different regions, taking into account capital distribution in relative and absolute terms, quality and profitability, revenue growth, and valuation (current and relative to history). Based on the results, we maintain our conviction in the opportunity for equity income investing, albeit with some nuances and caveats. To highlight a few of our findings:
- Europe may be most attractive if an investor’s focus is on the absolute level of income. It has had the highest level of yield overall, supported by strong valuations.
- Japan may be more of a value play, with the lowest dividend yield and low profitability (i.e., cash-flow returns barely above the cost of capital), but also strong valuations and a high market-implied discount, suggesting there may be runway for improvement.
- The US may be more attractive than Europe to investors willing to sacrifice some yield in exchange for strong fundamentals (e.g., strong cash-flow returns).
We would welcome the opportunity to share additional details on our factor research and the equity income opportunity.
Emerging markets insights
- Investment Director
China, India, and thematic opportunities
Evolving political environments and diverging COVID-19 recovery paths are among the drivers of dispersion between and within emerging markets (EMs) as we approach 2022. Meanwhile, technology adoption, infrastructure development, and urbanization are a few of the trends fueling growth across many of these markets. In this outlook, we explore how these factors impact opportunities and risks in Chinese equities, the potential for a bright future in India, and several enduring themes across EMs.
China
Chinese equities were often in the headlines in 2021 driven by geopolitical tensions, substantial regulatory shifts, and high-profile debt concerns.
We expect volatility will remain elevated in 2022, driven by the Chinese political cycle and continued international tensions, potentially yielding significant longer-term opportunities.
More broadly, some of the tailwinds that have supported Chinese growth over the past decade are fading. Demographics, for example, will soon begin to dampen growth potential. The government is working to lower health care costs and make education more affordable in an effort to mitigate the social impact of slowing growth.
Importantly, however, lower aggregate economic growth does not directly translate to lower equity returns. Within China’s now vast public equity markets, we see attractive and enduring investable themes — including consolidation, localization, and a growing focus on margins — with the ability to drive China’s upside potential in the years ahead.
Consolidation — Many sectors remain fragmented with thousands of players with weak bargaining power. But pricing power, excess capital, and consumer taste are becoming more differentiated. We believe these large markets are facing consolidation pressures and market share winners stand to benefit.
Localization — Supply-chain disruptions have driven business to local players — particularly in technology, industrials, and health care. These companies are investing more into research and development and thus are closing the gap on leading multinationals. So, even if the pie isn’t growing as much, local leaders can meaningfully grow the topline by taking share from international peers. Local players are supported by an ability to offer better customization and customer service and may also benefit from favorable policies as governments continue to regionalize global supply chains.
Margin improvement in operations — Chinese companies were historically focused on topline growth but are increasingly shifting governance and corporate cultures to drive margin improvement.
For many investors, the question is whether China can generate excess returns versus the rest of world going forward. We believe Chinese equity returns will be driven by the quality of the underlying companies and the price paid for ownership stakes. Critically, we think current Chinese valuations reflect the underlying political and regulatory risks, which contrasts with many developed markets and the US in particular, where valuations have become increasingly extended.
We expect continued volatility next year as President Xi positions himself to be appointed to an unprecedented third term and other senior party leaders vie for key positions coming into the 2022 National People’s Congress. Notably, some of the politicking that typically occurs on the election year has shifted earlier compared to previous cycles. We believe this headline volatility offers significant opportunities for investors to build exposure in China’s compelling underlying structural tailwinds.
India
Looking to 2022, India continues to offer investors a large and diverse economy and equity market supported by stable democratic institutions.
Importantly, India may be the world’s single greatest COVID beneficiary over the long term.
India is the world’s leading vaccine manufacturer and will produce many of the low-cost (non-mRNA) vaccines needed for the developing world. Moreover, as digitization rapidly increases both domestically and internationally in 2022 and beyond, India’s deep technology talent market will be a major beneficiary.
Furthermore, India is poised to benefit from other significant long-term structural tailwinds like demographics, labor shifting away from agriculture into higher productivity sectors, urbanization, an aspirational and entrepreneurial population, and low household debt. Finally, significant reforms such as the Goods and Services Tax and the new bankruptcy code — alongside an unprecedented focus on economic reform and privatization initiated in the Modi government’s 2021 National Budget — have begun to bolster its economy.
Momentous changes have taken place in India over the past 12 months that I believe have helped to fast-track the country’s nascent growth story. It’s now clear that Indian Prime Minister Narendra Modi is going all out to spur an economic renaissance.
India’s private markets also signal its promising future. Estimates range from 40 to 100+ unicorns (private companies with >US$1 billion valuations) that are beginning to IPO.1 As this listing trend continues, US$250 billion or more of new market cap may be created.2 These companies will further diversify the public markets and offer attractive opportunities to public market investors.
Thematic investment opportunities
Across the diverse range of countries within EMs, many of our investors are finding attractive opportunities for the year ahead within a common set of thematic areas.
For instance, the impacts of smart data and the growing access to quality health care are among the long-term opportunities we find attractive in EMs in 2022.
Smart data: As EMs continue their transition away from manufacturing economies to service/digital economies, they increasingly look to unlock productivity gains from enterprise intelligence. This trend has seen software spending steadily increase, following a similar path to developed markets (DMs), but from a much lower base. In China, for example, public cloud spending was only 11% of the US equivalent in 2020.3 Notably, the growth of cloud computing is driving greater affordability and availability of software solutions and, when combined with rising labor costs and more data to process, is accelerating this structural shift. In our view, software spending across the stack — in things like Enterprise Resource Planning and cybersecurity — has a long runway for growth across EMs in 2022 and beyond.
Health care inclusion: The vast majority of the world’s population lives in developing economies and most still have inadequate access to health care. Health care spending across low- and middle-income countries was only US$264 per capita in 2018, compared with US$5,665 in high-income countries — a difference of more than 20 times. However, between 2000 and 2018, spending grew almost twice as fast in low- and middle-income countries relative to high-income countries.4 This was driven in part by an increasing government policy focus on supporting investment in public health. In addition, medical research spending is rapidly accelerating, particularly in China. We believe these factors make health care inclusion a significant long-term thematic opportunity.
Other broad areas of interest for our EM investors in 2022 include the deepening of financial markets (driving inclusion and supporting development), digital connectivity (e.g., the growth of e-commerce and online leisure), and environmental consciousness (a rising focus in a world of climate change).
Bottom line
In our view, emerging markets offer equity investors high growth potential and significantly lower valuations than developed markets looking to 2022. For long-term investors that are willing to use volatility as opportunity, we see a range of investment opportunities within the diverse EM universe.
ESG considerations in emerging markets
Supply-chain risks related to modern slavery — a term encompassing forced labor, child labor, debt bondage, and human trafficking — are a growing priority for many of our clients globally, particularly in the current COVID-heightened environment. Though these unfortunate and illegal practices take place across the globe, they are often most prevalent within developing countries and commodity industries.
In 2021, our Sustainability Team initiated a new survey-based initiative to better understand the management of human rights and modern slavery risk within public companies globally. We aim to collect and maintain survey data from 2,000+ public companies globally. This will help us improve our emerging markets investors’ ability to productively engage with company boards and management teams as we seek to combat modern slavery by improving companies’ risk-management policies in 2022 and beyond.
In the coming year, we will begin to harness our unique insights into labor market policies to understand and promote best practices. Beyond our work on this important social factor, our teams will continue their research and engagement on other ESG factors, including leveraging our growing climate change forecasting ability to identify opportunities and risks across emerging markets.
1Sources: Bloomberg, Credit Suisse, March 2021. PitchBook, September 2021. Wellington Management, November 2021. | 2Source: ibid. | 3Source: International Data Corporation, 2020. | 4Source: World Bank, 2021. Data as of 2018 (latest data available).
Infrastructure insights
- Global Industry Analyst
Three arguments for electric utilities equities in 2022
As we approach 2022, we believe — that electric infrastructure is critical to facilitating the energy transition and is therefore one of the most attractive sectors within the infrastructure universe. In this short piece, we highlight three reasons why we believe electric utilities look promising in the years ahead, as well as share our views on what the market is missing. This includes comments on key issues for 2022 like sustainability, regulations, inflation, and rising rates.
Investment in electric grids and renewables is set to accelerate
Infrastructure businesses are, by definition, capital-intensive. So, all else equal, the higher the future capital investment, the greater the future growth potential. Notably, the International Energy Agency estimates that over the next 20 years, electric networks and renewable energy will require US$517 billion and US$585 billion of annual global investment, respectively (Figure 1). We believe this trend of increased investment is secular, not cyclical, which should result in higher prospective earnings growth rates for electric utilities for decades to come.
Figure 1
What the market gets wrong: Counterintuitively, we find that the utilities in the process of decarbonizing their electric mix have a higher potential earnings-growth profile compared to those that have already decarbonized. In other words, a company that is 100% green today cannot become 101% green tomorrow, whereas a company that is only 50% green today likely has more growth potential, in our view, as it works to further decarbonize its current business mix. As a result, we believe it is more insightful to emphasize future capital allocation to clean energy as opposed to focusing solely on a company’s current clean energy exposure.
Political and regulatory support is stronger than ever
All across the world, we see recent evidence of supportive policies from politicians and regulators, which could help drive accelerated growth for electric infrastructure and the broader energy transition.
- US: Solar and wind tax credits were extended in December 2020, and President Biden’s US$1.2 trillion infrastructure bill allocates significant capital toward a lower-carbon economy. In addition, the pending Build Back Better framework would further strengthen the support for clean energy in the US. While we believe the energy transition can occur without subsidy, this US policy will make funding the energy transition even more affordable for consumers.
- Europe: The EU’s European Green Deal targets carbon neutrality by 2050. In late 2019, each country submitted a unique national energy and climate plan, with a focus on decarbonization.
- China: In September 2020, President Xi Jinping pledged to target carbon neutrality by 2060, a monumental task given that China is the world’s largest carbon emitter.
- India: During the recent COP26 summit, Prime Minister Narendra Modi set out targets for India to obtain half of its power needs from renewable sources by 2030 and to reach net zero by 2070 — the first time India has ever established a net-zero target.
Japan: In October 2020, Prime Minister Yoshihide Suga pledged to reach carbon neutrality by 2050.
What the market gets wrong: While strong regulatory support is helpful, we believe there are some unintended consequences of the energy transition. Specifically, there are times when focusing too much on the “E” (environmental) can have negative consequences on the “S” (social). As an example, in Europe we are currently seeing record-high electricity prices for consumers, which is a result of skyrocketing natural gas and carbon prices.
- The surge in natural gas prices is largely due to supply constraints, which are partly caused by the public markets disincentivizing fossil fuel production.
- The massive increase in carbon prices is due to the EU gradually reducing the number of carbon certificates in an effort to boost decarbonization efforts.
Though this is proof that the measures being taken to help the “E” are working, the record-high power prices are terrible for the “S,” especially given the regressive nature of higher electricity bills. In instances like this, we believe that the “S” deserves more attention because high electricity bills for consumers can lead to negative intervention by regulators. To mitigate this risk, we believe investors should focus on situations where positive “E” characteristics can be achieved at low relative prices to minimize any potential negative impacts on the “S.”
Valuations of electric utilities are close to 15-year relative lows
Global electric utilities are trading at a P/E ratio of 0.92 times relative to the MSCI All Country World Index, close to a 15-year low (Figure 2). Considering the significant expected capital investment, supportive government policies, and potential for stable returns over time, we find this particularly compelling.
Figure 2
What the market gets wrong: The most often cited reasons for the cheap relative valuation of the electric utility sector are: the risk of inflation, the risk of rising interest rates, and the lack of cyclical upside. While we don’t take these risks lightly, we believe the market is overlooking the fact that (a) some utilities have inflation-linked regulation that allows them to earn higher returns when inflation rises, (b) many utilities are able to pass on much of the cost of higher interest rates to customers, and (c) the potential decades-long secular growth should prove to be more powerful and durable over time compared to the current shorter-term cyclical economic upswing.
For these reasons, we continue to believe that the electric utility sector is the most attractive area within the infrastructure universe as we head into 2022.
ESG considerations in infrastructure equities
Looking to 2022, we continue to believe that the key fundamental qualities we value in infrastructure businesses — stability, growth, and value creation — are highly correlated with favorable ESG factors.
Stable, predictable infrastructure: We seek to avoid companies with substantial commodity and economic sensitivity, companies that have a high likelihood of receiving poor future regulatory treatment, and companies where it’s unclear if their businesses will be needed in 20 years. We think infrastructure firms embracing the energy transition (e.g., electric utilities, renewable developers) are much more predictable than old-world infrastructure (e.g., midstream oil and gas).
Infrastructure that is growing: Within infrastructure, future growth is largely dependent on policy. When we look at the world’s infrastructure policies, we believe that companies investing in the secular trend of decarbonization have far more future growth potential compared to those investing in old-world infrastructure.
Incremental returns > cost of capital: We believe infrastructure companies adapting to the energy transition benefit from a lower cost of capital (e.g., lower debt costs, lower equity risk premiums). This leads to a higher potential spread between incremental returns and cost of capital (i.e., higher value creation).
Lastly, we believe that investors must balance the interaction of ESG factors because at times, positive environmental impacts can run counter to social impacts (i.e., by driving higher costs to consumers).
Health care insights
- Investment Director
Health care in 2022: Innovation and opportunity
As 2021 comes to a close, the world is in various stages of recovery from the global COVID-19 pandemic. Notably, though the health care sector has performed well since the start of the crisis, it has lagged the broader market as consumer-oriented and information technology sectors benefited more from the reopening of the economy. While COVID-19 disruptions will continue for months, we believe strong fundamentals and robust innovation will fuel growth across health care sectors in the year ahead.
Breakthrough innovation in the biopharma industry — particularly in oncology, immunology, and certain rare diseases — is generating a rich opportunity set for specialist investors. Key medical technology companies are also facilitating significant drug development and are benefiting from the increased spending and proliferation of new drug candidates. Finally, diagnostics companies are helping with widespread COVID-19 testing while also creating more convenient routine medical tests and, increasingly, enabling early cancer screening.
Importantly, the overall delivery of health care continues to evolve. The US, for example, is experiencing a decades-long transition toward a fee-for-value payment system from a fee-for-service approach. This shift encourages new business models and supports substantial growth potential for lower-cost care models.
These tailwinds across the various health care subsectors, coupled with strong valuation support, leave us with a more positive outlook for the sector than ever before.
Biopharma
Entering 2022, the opportunities for value creation in the biopharma industry are especially strong. A last-minute compromise on drug pricing in President Biden’s US$1.75 trillion social spending bill in November was an important step toward lowering out-of-pocket drug costs for seniors in the US and addressing high drug prices generally. The threat of reform, in the form of greater industry subsidies and reduced pricing power, has been a risk to biopharma for much of the last decade. Valuations of large-cap biopharma companies in aggregate have been at historic lows in part for this reason. Progress on this issue should now help refocus attention on company pipelines and overall R&D productivity.
Among small- to mid-cap biopharma companies, 2021 was a challenging year. A significant pullback started in February, perhaps triggered by some high-profile clinical setbacks, unexpected regulatory decisions, high valuations, and a volatile market backdrop. However, looking to 2022, we remain very encouraged by the state of pipelines across the industry.
Today, advances in basic science, the advent of new drug discovery tools, and entirely new treatment modalities are enabling the development of high-impact drugs for critical diseases. For example, antibody-drug conjugate technology allows more potent and less toxic treatment of more types of cancer, as evidenced most recently by a groundbreaking new drug for breast cancer. In addition, the once science-fiction concept of gene editing was recently validated for the first time in humans with the rare disease transthyretin amyloidosis. Lastly, the COVID-19 pandemic has notably rekindled interest in vaccine development, including for common respiratory viruses like flu and RSV.
Medical technology
We are just as enthusiastic about the opportunities within medical technology. Many life science tools and diagnostics companies excelled during the pandemic. Companies involved in the development of diagnostic testing equipment were in high demand, as were those selling critical care equipment to help hospitals cope with the surge in COVID patients. Life science tools companies, in particular, have strong fundamentals as they support both increased biopharma R&D and robust bioprocessing demand that helps bring advanced therapeutics to the market.
Importantly, many of these companies will exit the pandemic stronger than they entered, as a rise in their installed customer base should lead to increased recurring revenue in the years to come. Additionally, the pandemic has spurred governments globally to reassess their emergency preparedness. This should provide new sources of demand for many diagnostics companies as well as increased government funding for life science research.
Medical device companies lagged relative to other parts of medical technology in 2021 but are poised for outsized growth in 2022 and beyond. The pandemic caused a halt in elective procedures, brought on first by hospital cancellations and compounded later by patient skittishness to schedule elective care. However, this drop in demand did little to slow the prevalence of underlying disease across patient populations. We expect to see strong multiyear demand in categories such as aortic valve replacements, cataract surgeries, colonoscopies, and others that have been deferred since the pandemic.
Notably, lost in the short-term implications of COVID is the fact that innovation pipelines across medical technology firms have never been stronger, with far more attractive medical device categories poised to accelerate in the 2020s compared to the 2010s. In the coming years, we believe many firms will grow their addressable market through geographic expansion, new technologies, and the use of existing technologies to treat new patient populations.
Importantly, many of these companies will exit the pandemic stronger than they entered...
Health care services
The health care services subsector is also exiting the pandemic in a better position than it entered. The early stages of the pandemic were challenging for business models leveraged to underlying volume trends, such as post-acute care, hospitals, dialysis, and others. Conversely, managed care companies performed well initially, as an overall reduction in health care utilization resulted in falling costs and rising profits.
We believe health care service companies are well positioned to help solve one of the greatest societal challenges we face for the future: rising health care costs. One of the silver linings of the COVID-19 pandemic is that we believe it has accelerated a structural change in human behavior, as customers are now willing to consume health care in lower-cost settings and will become less reliant on hospitals. We believe this shift in behavior will benefit companies involved in home health, ambulatory care, IT solutions, and telehealth.
This transition is part of a broader trend that will see health care delivery change from fee-for-service models to fee-for-value models. In recent years, we have seen business models emerge where primary care physicians and other health care providers work together to provide care to individuals throughout their health care journey — potentially improving outcomes and reducing costs. Importantly, risk is shifted from payers to providers, allocating primary care physicians a fixed dollar amount to treat patients, with the goal of incentivizing more prudent, cost-effective care.
Health care ESG considerations in 2022
As we look to the future of health care, drug pricing and the affordability and accessibility of health care coverage in the US are two potential risks. While these risks can be simply thought of as political risk, we believe a wider ESG lens is warranted for a more complete evaluation.
Drug pricing
We have long believed that some level of drug price reform will occur in the US but believe large-scale changes are unlikely. Recent legislative updates have confirmed our view that any measures passed into law will likely be manageable for the biopharma industry as a whole, and that innovation will still be rewarded. Proposed solutions, which have yet to be signed into law, include capping year-on-year price increases for marketed drugs, modest levels of direct government negotiation for certain drugs, and capping out-of-pocket costs for seniors.
From an ESG perspective, drug pricing is the biggest issue facing the biopharma industry. In our company engagements, we therefore focus our efforts on understanding each firm’s pricing strategy. Our research aims to identify companies who grow revenue through the development of innovative drugs that address previously unmet needs and eschew companies reliant on price increases as their primary source of improving returns. While we do not know the exact details of how drug price reform will be passed into law, we do believe that any sort of resolution will lift the overhang that currently weighs on biopharma valuations, as the market ultimately favors clarity over uncertainty.
Health care reform
We believe wholesale changes to the US health care system are unlikely. We do not foresee a future where a version of Medicare for All becomes reality. Rather, we view improvements to the existing infrastructure first introduced by the Affordable Care Act as our base case. In our engagements with health care services companies, we focus on the importance of embracing their social responsibility to address rising costs and improve health outcomes. We believe it will be critical to showcase specific metrics aimed at measuring the populations served and types of care consumed, as well as indirect metrics aimed at tracking how people feel about the care they receive.
In addition to the societal benefit of lowering costs, we think emphasizing ESG efforts would go a long way to improve health care services’ public perception, which could lead to rerating for the sector.
Bottom line
As we enter 2022, we’re excited by the opportunity set across the entire health care sector. Scientific and product innovation, continued economic recovery, and structural changes to US health care delivery systems should provide a boost for the sector. We believe these tailwinds, coupled with more clarity on US health care reform, will ultimately benefit long-term investors in the sector.
Innovation insights
- Portfolio Manager
- Global Industry Analyst
- Co-Head, Risk & Investment Science
- Sector Co-Lead, Asia
The tech driving disruption (and opportunity) in 2022
The future remains on sale, in our view, as we look to technology and innovation investing in 2022. In 2021, global markets were dominated by macro factors such as rising rates, supply-chain issues, disparate reopenings, and inflation concerns — causing fundamentals to take a back seat.
But critically, amid these macro factors, tech opportunities continue to be fueled by many structural tailwinds, including well-known progress in mobile payment penetration, automation, and essential hardware innovation. In this short outlook, four of our technology-focused global industry analysts and investors share their high-conviction ideas for 2022 within enduring tech themes.
Bruce Glazer on scale payment processors
In 2022, we believe continued reopenings, renewed travel, and the resulting uptick in cross-border payments will all benefit the secular trend of digital payments. Notably, the leading scale payment processors all sold off significantly in 2021 on the back of pandemic-related restrictions, fears of disruption, and factor rotations. In our view, this could be one of the best-performing subindustries within fintech in 2022.
We think the gap between fundamentals and valuations in the group is as wide as it’s ever been. These companies are now growing faster than they were pre-COVID, despite meaningful underperformance during that period, and future expectations remain high, in our view. This has been a unique market environment that is creating some unprecedented opportunities among these names. If the market continues to misprice, we think the companies will begin to make bold moves to unlock shareholder value. These steps could include aggressive share repurchases, potential consolidation, and dividend initiations/increases. Overall, we believe the traditional core payment processors offer significant potential for growth in 2022.
Brian Barbetta and Michael Masdea on COVID winners post 2021 sell-off
Looking to the year ahead, valuations, tough year-over-year comparisons, decelerating growth, and a holiday season with many unknowns make it a hard time to have a lot of short-term conviction. But we believe that uncertainty is actually presenting investment opportunities in the innovative and adaptive companies that we expect to drive durable growth through cycles.
In particular for 2022, the opportunity in COVID winners that have suffered from sell-offs this year looks increasingly compelling. In our view, key areas like the digital economy, health care innovation, and the growth of automation are all starting to look attractive again from a valuation perspective. Digital economy opportunities range from e-commerce to digital advertising to digital finance as widespread companies use innovations like the cloud, AI, and big data to drive growth. In health care, new tools and modalities are enabling scientists to develop innovative treatments for diseases with major unmet needs, powering large growth potential. Finally, the companies enabling automation should be beneficiaries of the continued global automation cycle upgrade in 2022.
In particular for 2022, the opportunity in COVID winners that have suffered from sell-offs this year looks increasingly compelling.
Yash Patodia on Asia tech supply chains
We believe the year ahead looks promising for Asian technology companies as many are in the midst of disrupting long-established supply chains. In fact, Asia tech companies — for example, those in advanced semiconductor manufacturing — are the global supply chain for many massively growing end markets. In addition, localization is creating new opportunities for domestic champions, driving a shift toward an ecosystem of domestic suppliers. Asian software and internet companies are also increasingly displacing global competitors in their home markets — especially in fintech, gaming, and social networking.
In our view, these trends will persist throughout 2022. We are particularly excited about their combination with several structural Asia technology themes, such as the digitization of consumers and enterprises, the electrification of cars, automation, and augmented and virtual reality. This opportunity includes Asia tech hardware infrastructure’s pivotal role in enabling the metaverse. The tech landscape has evolved dramatically over the past few years as digitization has accelerated, revolutionizing traditional industries and economies. Importantly, in the near term, we expect volatility to persist due to geopolitical issues as well as local regulatory tightening, such as China’s oversight of platform and internet-based businesses. However, we believe this revolution will continue driving a multiyear opportunity, fueled by secular tailwinds like favorable demographics and the strong R&D capabilities of Asia tech companies.
Bottom line
The tech landscape for 2022 will continue to be impacted by competing macro headwinds, geopolitical issues, and structural tailwinds. Though rising inflation and rates present risks to tech sectors, we believe the above examples are among the crucial areas within the enduring secular trends that will drive growth in 2022 and over the long term. Importantly, we think these factors, combined with diverging COVID recovery and reopening paths, make active management particularly critical to help differentiate between the potential winners and losers in this volatile environment.
ESG considerations in tech and innovation
Many of the key themes in tech and innovation investing are closely linked to ESG factors. On the positive side, progress in mobile payments, sustainable innovations, and medical technologies are among the advancements having significant impacts — enabling financial inclusion, battling climate change, and increasing access to health care, respectively.
In 2022, we believe these trends will continue. We expect further penetration of mobile banking across leaders like China and Southeast Asia and major markets such as India and Brazil. In our view, we’ll also see progress on EVs, eco-friendly packaging, and renewable energy. Finally, we think health care access will continue to expand through various innovative technologies.
In contrast, there are also key areas where tech innovations are raising ESG issues that will likely need to be addressed more directly in the coming years. For instance, the environmental impact of technology — from energy-intensive blockchain technology and crypto assets to the waste generated by constant hardware upgrades — created significant news flow in 2021 that could continue in 2022. Furthermore, consumers, businesses, and economies alike are increasingly reliant on technology. This could lead to further regulatory action to continue to address issues such as data privacy concerns. Tech and innovation often lead us into uncharted territory, and ESG considerations will no doubt be tied to tech progress in 2022 and beyond.
Key topics and themes
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This is an excerpt from our 2022 Investment Outlook, in which specialists from across our investment platform share insights on the economic and market forces that we expect to influence portfolios in the year to come.