Morgan Stanley’s Slimmon Sees Value Stocks Coming Back to Life

(Bloomberg) -- Morgan Stanley’s Andrew Slimmon is on a hot streak, with the MSIF U.S. Core Portfolio fund he co-manages up 26% so far in 2021 to beat 94% of its peers. 

He joined the “What Goes Up” podcast this week to discuss what the fund got right, what it’s positioning for next -- and what potential risks keep him up at night. (Oh, and also his pick for best Philly cheesesteak.) Below is a lightly edited transcript of the highlights. Click here to listen to the full podcast, and subscribe on Apple Podcasts, Spotify or wherever you listen. 

Q: In a recent note, you said that bond yields traditionally bottom in August as the markets tend to get some sort of unfounded growth scare in the summer months. Then we’ll see the economy reaccelerating in the fourth quarter. So can you maybe walk us through your thinking and through your strategy?
 
A: I’m amazed at how there’s a consistency to markets. We get a growth scare, usually in the summer, that happens over and over. Rates come down in the middle of the summer, and then they start to lift going into the fourth quarter. And this is exactly what’s happened this time. Rates bottomed on August 3rd, the 10-year bottomed at 1.17% and the 10-year’s back up to a 1.33%. The yield curve flattened all through the spring and now is starting to really steepen. 

What fascinates me is that the financial markets predicted a slowdown starting in the spring. And then we got the economic data that validated it this summer. And now the financial markets are starting to predict an improvement in the fourth quarter, but we haven’t had the economic data to validate it yet. 

Q: That notion about rates creeping up, I wonder, is that sort of playing a large role into the picks in the fund? I notice a pretty decent overweight to banks and diversified financials. Is it that simple macro input, or are there sort of idiosyncratic reasons while you’re in each of these. A couple of regional banks I noticed, First Republic Bank and SVB Financial Group, as well as Ameriprise Financial.

A: So I went to Penn, but I also went to the University of Chicago. So I’ve got a little bit of a quant bent as well. And I know that what defines a stock’s performance is not only their fundamentals, what’s going on at the company level, but also their quantitative factor exposure. And those stocks that you all listed are value stocks and they benefit from rising rates. And one of the reasons why we’re having a very good year in our fund is simply that, going into the spring, we were concerned about a seasonal slowdown in the economy. And so we downshifted some of those value names a little bit, and we increased our exposure to a little bit more of the risk-off defensive-type names. And that worked very well. 

But now we’re at a juncture where you are going the other way. So we’ve increased those positions a little bit because we’re anticipating that we get to the fourth quarter and then the economic data will say, “Oh, wait, it’s not so bad. You know what? The economy is picking up.” You mentioned, Michael, early on, the reopening stocks. They did great last year into the spring. And then we also reduced those in anticipation that maybe in the summer we would have a little bit more of a risk-off scenario. So I would not be selling those stocks right now. But having said that, we’ve actually been more confident in the rising rate environment than the reopening trade. So I think financials, and then secondly energy, will be the two best-performing groups in the fourth quarter. 

Q: Can I ask you to expand a bit on what your thinking is around value stocks. Because I know in one of your recent reports, you had written that when value outperforms growth overall, growth does tend to outperform for a little bit of that cycle -- for just long enough to sort of shake out the nonbelievers. 

A: So look, coming out of recession, value stocks are cyclical. So they all get beaten down in recessions, worse than growth stocks and defensive stocks. And then you get to a juncture somewhere in the middle of recessions where people say, “Oh wait. Not every cyclical stock’s going to fail.” And they have a significant bounce-back rally because they’re so cheap. And we saw it in the recession of ’90, we saw it in 2000, we saw it in 2009, these stocks came back strong. And the average value cycle lasts about 33 months. We’re 12 months in. However, of those 33 months, about 11 of those months on average growth actually outperformed value. So it’s not a straight line back up. There are twists and turns. 

And what I see is that value has made its way back up, but it’s still pretty cheap versus growth. Now I happen to believe that not only will value reprice back to where it normally is, but I think that the change in the tone out of the Fed could lead to a period where value outperforms growth for an extended period of time, the way it did in the ’90s. 

Q: It sounds like you were doing some very tactical type of adjustments there in the middle of the year. Is that sort of a byproduct of the boom-and-bust Covid era that you have to be more tactical than you maybe would otherwise?

A: So look, I’m a long equity manager. So I don’t go to cash because what I’ve learned is, you know, so you raise 5% cash, market goes down a lot, you’re still going to lose money, right? And so the way we adjust is the beta, the risk in the portfolio. And what I’ve learned in this business from being in it a long time is you want to lower the risk in the summer. Summer, it just always seems, we got these growth scares. Yes, the S&P didn’t really go down this summer, but a lot of stocks in the S&P went down a lot. And so I just know that to reduce the risk and the reopening trades and the value trades, they tend to have more risks than the defenses in some of the very megacap tech stocks. So that’s just a seasonal bet that this time was not different and turned out to be the right call. Once we get through this period, the market tends to do well kind of mid-October until mid-December. 

Q: You know, in the press, I think we’re the biggest culprit of building the proverbial wall of worry, so to speak. So let me lay out some of the main bricks of the wall of worry, and let me know if any of them are spooking you. Obviously, there’s the tapering from the Fed that’s coming. And the tailwind from fiscal policy is also sort of wearing off. The enhanced unemployment benefits are going away, so are the eviction moratoriums, all that type of thing. Obviously we have the debt ceiling issue coming up again. And we’ve got Covid flaring up again. Any of these keeping you awake at night or even one I didn’t mention? 

A: Well, first of all, geopolitics are really hard to predict. Could that come out of the blue and be an issue? Yes. And I think oil actually at $72 is no big deal, but you start to get another 10 bucks higher, and higher oil prices can slow an economy very quickly. So that, to me, would be a bigger risk. I happen to think that tapering is going to be so slow and so minor. So they’re going to buy a little less bonds than they were before that, and by the time it actually happens, we’re going to have tapering exhaustion. So I don’t think that would be an issue. If the economy came on too strong and rates went up too quickly, that could cause a jolt. 

So I think there are worries. I’ve learned that political issues that come out of the blue, they tend to happen in the summer, another reason why it’s risk-off. I think we’re not through this period, typically not a great seasonality for the market, so we could have a pullback. I struggle to see a reason for it, but then, you know, that’s what happens. It’s the unknown.

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