When investment managers combine the inside view with the outside view, they make better decisions when it comes to choosing equities, according to Peter Stournaras, head of the integrated equity group at T. Rowe Price Group Inc., during the Canadian Investment Review’s 2024 Investment Innovation Conference.
“The combination of the two is better than either individually,” he said, noting he takes both these perspectives into consideration when making investment decisions. “When you drive to work in the morning, . . . you’re combining what you know about the situation with what you know about how traffic normally is. . . . [If] the outside view says the left lane is fastest, but you see an accident up in the front of you in the left lane, move over to the middle lane.”
The same strategy can be used when making investment decisions. For instance, the outside view may say the U.S. is expensive, while the inside view may show opportunities ahead when potential headwinds, such as hyper-scalers and mega cap companies, are factored.
The inside view shows the pace of innovation in the digital era is changing society, said Stournaras, noting the pace of adoption is also much higher because it lacks a physical element. “You don’t have to build a big plant, you write software . . . and that’s what the product becomes. It becomes a knowledge-based society.”
The impact of network effects at companies like Google is vast due to its superb business model, he added. “The users are creating the value for the company every time they do a search and then they’re continuing to expand their dominance in their moat and, therefore, their profitability.”
The inside view focuses on how current examples differ from past examples, he said, and understanding that inside view is understanding those drivers for change. Since 2015, the dominance of hyper-scale companies has expanded significantly, noted Stournaras, pointing out it becomes a winners-take-all scenario — the local coffee shop that has the best reviews on Yelp Inc. gets more customers more quickly. “It’s changing the dynamics of competition and it’s creating bigger moats for those companies.”
On the other hand, he said the inside view shows the market is expensive, driven heavily by mega caps that make up a large part of the S&P 500, the Russell 3000 and even the world index. However, he added, the rest of the market, particularly within emerging markets, is at a dramatic, historic earnings yield discount relative to the rest of the market.
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Indeed, the Russell 2000 small-cap market index looks extraordinarily cheap relative to the S&P 500. Within that group, noted Stournaras, there are good companies with higher returns on equity, wider distribution, a bigger cross-section of volatility in terms of return on equity and valuations and earnings growth.
“The inside view tells us there’s enough different here that, all of a sudden, the outside view, when things are cheap and there’s a potential catalyst, means we should potentially diversify our portfolio . . . towards small caps.”
Read more coverage of the 2024 Investment Innovation Conference.