Matthew Siddle – Portfolio Manager
Natalie Briggs – Investment Director
The recent explosion of retail trading activity in the US and in Europe has concentrated on specific groups of stocks and is one of the reasons why performance and valuation gaps have widened much more than fundamentals might suggest. While liquidity is driving much of this and indeed the next tranche of US stimulus cheques may provide yet more fuel, this can’t continue indefinitely. There are the first signs of liquidity tightening in China, with the Communist Party chief of the PBOC warning of bubbles, and corporate insiders are exiting the market. At some point the US stimulus party will end and investors may be on surer long-term footing by focussing on stocks that are not on extended valuations and where they are supported by solid underlying fundamentals rather than shifting momentum.
Explosion in retail activity in the US and Europe
The much-publicised explosion of retail activity through platforms such as Robinhood has not been isolated to the US. In Europe, FlatexDegiro, the largest independent brokerage in Northern Europe, saw its January 2021 volumes almost treble year on year, the likes of AJ Bell and Hargreaves Lansdown in the UK reported record volumes in 2020, and Interactive Investor highlighted that their top 10 trading days ever were all in 2020. The announcements in November of breakthroughs in vaccine developments triggered a spike in daily trading, even causing systems issues at brokerages including Hargreaves Lansdown as platforms struggled to cope with demand.
Record levels of retail day trading activity, combined with option purchases and record expansions in margin debt mean that retail is not just involved, but levered up to do so. Even financial institutions report they are taking record levels of risk compared to history.
Retail investors targeting names at the extreme ends of the scale
Empirical Research Partners1, an independent research boutique, used data from Robinhood to model where retail buyers are concentrating their investments. They found that ‘Big Growers’ - the 75 stocks with the best all-round growth credentials - were consistently attracting interest from retail buyers, greater than the 10% ‘random draw’ of the market they represent would suggest. While retail has a longstanding affection for the fastest growing companies, the current level of over 30% of the ‘top retail’ stocks being in ‘Big Growers’ has only briefly been exceeded in the months after Nasdaq peaked on 10 March 2000, when retail buying of high growth names continued for some months beyond the peak.
Figure 1: Retail investors skew to the fastest growing stocks
Big growers: Share of stocks in the highest decile of the retail score
Source: Empirical Research Partners Analysis. Data smoothed on a trailing 63-day basis. 1990 through mid-January 2021.
Another conclusion of Empirical Research Partners’ analysis is that retail investors are seeking out (via Google and chat rooms) and crowding into both the highest momentum stocks and contrarian names, i.e. those companies that have had the five worst 1 day moves as illustrated in Figures 2 and 3.
Figure 2: Retail investors skew to the highest momentum stocks...
Large-capitalization stocks: average daily change in Robinhood users by decile of supernovas1
Figure 3: …and the weakest performing stocks
Large-capitalization stocks: average daily change in Robinhood users by decile of black holes
Source: Robintrack.net, Empirical Research Partners Analysis. 1Supernovas are defined as the average of the five largest one-day returns in the past 63 trading days, June 2018 through August 2020. 2Black holes are defined as the average of the five lowest one-day returns in the past 63 trading days, June 2018 through August 2020.
Retail investors are now demonstrating a clear preference for the most extreme stocks - the fastest growth companies, the fastest rising share prices and those most out-of-favour. These companies generally have the most polarised return profiles, with high trading activity and considerable media attention.
Such retail strategies do not outperform over time
This strategy can work and indeed it has since April 2020 (just as it did in the run up to April 2000), but the approach has not added value over the long term and there is a risk of significant drawdown as we saw straight after the last sustained period this strategy worked ending in April 2000.
Figure 4: Significant drawdown after tech bubble peak
Large-capitalization stocks: relative returns to the highest decile of the retail score
Source: Empirical Research Partners Analysis. Data smoothed on a trailing 63-day basis. Measured over one-month holding periods 1990 through mid-January 2021.
Past performance is not a reliable indicator of future results.
Intriguingly, corporate insiders have been selling stock at a record pace over the last few months. Private equity and venture capital firms are also lining up to launch IPOs, particularly in expensive growth companies, where we have seen retail investors are flocking.
This insider and global Equity Capital Market (ECM) activity has been fuelled by investors deploying record amounts of cash into equity funds. Global ECM activity in the first six weeks of 2021 is already above $200bn compared to $1.3trn in FY2020 and $810bn in FY2019, with the US seeing a record number of IPOs in 2020 (480 vs. 397 in 2000) and another 250 in Jan/Feb 2021 already (annualising at 1500 IPOs if that pace holds for the whole of 2021 vs. last year’s record 480). Year-to-date, EMEA ECM volume is $28bn or +35% ahead of last year. Given the intimate knowledge insiders and institutional private sellers have of their companies, we should not overlook their activity.
Figure 5: The EMEA IPO market is ‘hot’
Source: Dealogic, 28 February 2021.
Figure 6: Insider selling by management is elevated
Source: Washington Service, Bloomberg, January 2021.
Liquidity is driving markets and there are no real signs of this stopping in the US - indeed the next tranche of stimulus cheques due in a few weeks may be another source of liquidity for Robinhood accounts. However, there are potentially the first signs of liquidity tightening in China with credit impulse starting to roll over and the PBOC keeping liquidity unusually tight over Chinese New Year - last seen in 2018, which preceded a slowdown. This signal of a move towards tighter policy was amplified this week when the Communist Party Chief and deputy governor of the PBOC (also head of China’s regulator for the banking and insurance sectors) warned that he’s very worried about risks emerging from bubbles in global financial markets and China’s property sector. At some point the stimulus party will end and it is a risky position to be in for investors left holding stocks that have rerated on the whims of momentum rather than solid underlying fundamentals.
‘Sweet spot’ in good businesses on attractive valuations
With both high growth stocks and cyclicals on record valuations, I believe the more steady businesses that generate good returns on capital, are more cash generative and are on valuations that are not extended (and indeed often cheaper than usual) are the investment ‘sweet spot’.
MSCI World growth versus value
Source: Refinitiv DataStream, December 2020.
Average relative valuations of cyclicals vs. defensives look elevated
Source: MSCI, IBES, Morgan Stanley Research, February 2021.
My focus is on the cheaper, higher quality businesses with less volatile and more recurring earnings. These companies have fundamentally attractive profiles that could deliver decent medium term earnings growth, offer higher cash generation and trade on highly unusual discounts of 15-20% price-to-earnings and 20-30% free-cash-flow yield to the market.
These ‘boring’ companies are an anathema to the retail traders who have increasingly influenced stock movements over the past few months. As an investor, I am focussing on stocks with the potential of better long term returns with lower drawdowns, even if it might be a less exciting journey along the way.
1 R. Cahan and Y. Bai, Empirical Research Partners, Market Structure Research and Results January 2021 ‘Viral Trades: Robinhood and the Retail Rodeo’.
2 Dealogic, February 2021.