10 stocks riding the rotation

The positive news regarding the effectiveness of both Pfizer and Moderna’s vaccines against Covid-19 are exceptionally good news for the world. With many more companies working in parallel we can likely expect more positive developments on these fronts in the coming months and over the course of 2021. While success is unlikely to occur in a straight line, the vaccine is a much needed light at the end of the pandemic tunnel. Equity markets have rallied on the news as you would expect but the real story lies beneath the surface. In this monthly note we take a closer look at the large rotation within equity markets.

Vaccine rally reverses many year to date trends

Since the latest positive vaccine developments were released to the market, we have seen the MSCI World Index rally to 7.43% and the S&P/ASX 300 Index has rallied 9.79%. We have seen a significant jump in some of the most beaten up stocks within the market. Figure 1 below lists the best performing stocks from the top 100 market capitalized stocks within the S&P/ASX 300 Index from Friday the 6th of November to Tuesday the 17th of November. Also noted alongside this performance has been the year to date (YTD) performance of these stocks.

Figure 1. Top ten stock performances post positive vaccine developments as at 17th November 2020

As shown in Figure 1 we have seen a reversal of fortunes for those companies that have been impacted the most. They are now the companies with the most to gain from a vaccine. From a sector perspective you can see that both Energy and REITs are the biggest beneficiaries of a vaccine as illustrated on both Figure 1 and 2.

Figure 2. Some of the worst performing sectors YTD have rallied the most on the positive vaccine news

The 2020 back story

During 2020 investors de-rated the companies that were the most impacted by the pandemic including Travel, Energy, Real Estate and Financials. In contrast investors positively re-rated the few companies expected to do better in the pandemic world. Examples included Information Technology, Health Care and some Consumer companies. Over the course of 2020 the gap between the Covid-19 winners and Covid-19 losers became extreme. The recent price reaction to the positive vaccine news partly reflects the extreme pricing caused by the pandemic.

As shown in Figure 2, Energy, REITS and Transport have outperformed the most on the vaccine news

while some of the best performing sectors like Information Technology, Healthcare, Gold and Consumer Discretionary underperformed the most. Iron ore and some of the Metals and Miners have managed to buck this trend outperforming both during the positive vaccine developments and YTD.

Figure 3 below outlines the returns associated with different groups of stocks during the vaccine rally. We group stocks by different characteristics and look at the return differences between these groups. During the period from the 6th November to the 17th November when the dominant news was the positive developments of the vaccine we observed a number of interesting rotations. The returns to these different stock characteristics are captured in Figure 3 below.

Figure 3. Quintile spread returns to various themes during the vaccine rally and rotation

Most of the relationships observed in the vaccine risk rally are atypical.

• Companies that had performed the best YTD underperformed the most.
• Companies with the great risk as measure by beta outperformed.
  
• Companies with the worst YTD earnings revisions outperformed.
  
• Companies with the lowest levels of profitability outperformed.
  
• The only quality that was more typical was that companies that were cheaper outperformed.
  

The top 20% of stocks that outperformed on the vaccine news were up 22.6% from the 6th to the 17th of November and whilst this is impressive, remember this cohort is still down -12.5% YTD. Other than having positive returns during the positive vaccine news how might we characterise these stocks?

Figure 4: What are the key characteristics of the vaccine winners

The Vaccine beneficiary cohort can be characterised as;

1. Higher risk with an average with beta of 1.5.
2. Greater downgrades to earnings (-35%) in 2020.
   
3. Lower quality in terms of gearing and lower levels of profitability.
   
4. Slightly better value especially in terms of expected free cash flow yields.
   

The vaccine rally has many similarities to a classic junk rally.

In contrast we have stocks that on average have the opposite characteristics. The portfolio has exposure to companies which have had lower volatility, with improving earnings prospects, higher operating margins and which we believe offer better value (see Figure 5 below).

Figure 5: Key characteristics of the State Street Australian Equity Fund

The Bottom Line

The recent outperformance of the lower quality more distressed securities with higher volatility is atypical. Historically we find these bouts of outperformance are often short lived and hence we caution against over extrapolating this recent development. Over the longer term we prefer higher quality businesses with improving earnings prospects, higher operating margins and lower volatility. 

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To view a full list of references and sources for the graphs, please see our full report here