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Silicon wafers symbolizing the rapid pace of innovation that has driven the performance of many growth stocks -- Global Equities: Focus on Innovation and Quality in a Higher-Rate World
Insight • March 8, 2024
4 min. Read

Global Equities: Focus on Innovation and Quality in a Higher-Rate World

A closer look at the characteristics of the stocks that may be best positioned for the current environment.

By
Investment Strategist

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The past few years have been a whirlwind for equities: after the blistering post-pandemic rally of 2021, investors had to adjust to higher inflation and a hawkish U.S. Federal Reserve (Fed), leading to a painful sell-off in 2022.

As markets have returned to rally mode over the last six months with inflation and interest rates stabilizing, investors may be tempted to think “2021 is back.” While many equity indexes have reached, or exceeded, 2021 heights, market leadership is markedly different today. In this article, we examine the regime shifts within equities and offer some secular themes that may help investors navigate the volatility. 

Two Crises and Their Impact on Equities

Let’s start by reaching further back in history. The decade following the Global Financial Crisis (GFC) of 2008–09 was defined by largely experimental U.S. monetary policy. It was a period that ushered in zero percent rates in response to the worst global market crisis since the Great Depression. The Fed cut interest rates to stimulate the U.S. economy to allow households and businesses to recover.

Fast forward to 2020 and the onset of the COVID-19 pandemic, which led to a shutdown of the global economy. This time, the Fed implemented its post-GFC playbook in a much bigger way, infusing the economy with monetary and fiscal support that was significantly larger than in 2008. Combining the effects of pandemic-related supply chain disruptions, war in Ukraine, and unprecedented consumer stimulus, we found ourselves in an entirely new economic and monetary policy regime, primarily marked by sticky inflation, higher rates, and higher volatility.

In the decade following the GFC, low rates and subdued inflation resulted in an environment conducive for risk asset performance broadly—“a rising tide lifting all boats.” The period from 2012−2020 provided attractive broad equity market performance, resulting in an average annual return for the S&P 500® Index for the period of 15.3%.

But we think it’s instructive to segment that broad market performance by earnings power—that is, companies that reported positive earnings (“earners”) versus those that reported negative earnings, during that time (“non-earners”). Figure 1 shows that the “rising tide” of 2012–2020 was supportive of both categories, with a modest advantage to the earners. 

Figure 1. How “Earners” and “Non-Earners” Fared in Two Different Interest-Rate Environments

Returns for designated categories within the Russell 3000® Index for the indicated periods 
Figure 1
Source: FactSet, Russell 3000 Index. Historical data as of December 31, 2023, representing periods of low interest rates (2012–2020) and rising rates (2021–2023). Earners represent all companies that reported positive earnings and their forward 12-month performance. Non-Earners represent all companies that reported negative earnings and their forward 12-month performance. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment.
Past performance is not a reliable indicator or guarantee of future results.

Why Innovation and Quality Stocks Can Potentially Thrive in a Higher-Rate World

But the second time frame in Figure 1, one that encompasses the end of the low-rate era, tells a different story. Following a series of interest-rate increases by major central banks, business financing costs are meaningfully higher. Today’s higher-rate environment has punished vulnerable businesses with weaker balance sheets. The differential between companies with positive and negative earnings has widened significantly since the Fed began its rate-raising campaign in 2021.

Not all earners and non-earners are created equal, however. While it may seem like holding a portfolio of earners, and avoiding non-earners, is a winning formula, we believe a more active approach is prudent. Seeking out companies with positive earnings should be complemented by an assessment of relative value, i.e., whether a stock is too expensive versus comparable equities, as well as an assessment of a company’s ability to generate stable or growing free cash flows.

We should look at non-earners with a similar level of scrutiny. Not all non-earning companies are bad from an investment standpoint. In fact, those companies prioritizing investing back in their businesses in the form of research and development (R&D), at the expense of current earnings, historically have outperformed those who spent at lower levels. We have found that the highest R&D intensity companies—those that spend the most on R&D relative to revenues—historically have superior revenue growth, earnings growth, and long-term performance versus the broader market.1

While companies taking advantage of unprecedented technological innovation in areas like biotechnology and artificial intelligence (AI) are growing substantially faster than the broader market and offer the potential for outsized returns, the new higher-rate regime also necessitates a focus on quality, in our view—seeking out companies with higher-return metrics and lower leverage.

Furthermore, an equal blend of innovation (as defined by top decile R&D intensity companies), free cash flow yield, and quality (as defined by top-decile return on equity, return on assets, return on invested capital, and a bottom 50% standing in terms of debt/equity leverage), over a long period of time has been a winning combination, outperforming the MSCI All Country World Index (Figure 2). This combination has historically made for a portfolio well suited to different interest-rate and economic environments.

Figure 2. Innovation, Free Cash Flow Yield, and Quality Have Been an Appealing Combination

Data for the period January 1, 2013–December 31, 2023
Figure 2
Source: FactSet. Data as of December 31, 2023. All categories represent subsets of the MSCI ACWI index; the hypothetical blend represents a one-third weighting of each of the categories. “Innovation” as defined by R&D intensity refers to a company’s total prior year research and development (R&D) spending, as shown on their income statement, divided by the prior year’s total sales. “True Value” as defined by Free Cash Flow Yield, which is the free cash flow per share divided by the market price per share of a company. “High Quality” is an equal-weighted combination of companies with top-decile return on equity (ROE), return on assets (ROA), and return on invested capital (ROIC), and which are also in the bottom 50% of the index in debt-to-equity ratio. See Glossary, below.
The Sharpe ratio was developed by Nobel laureate William F. Sharpe as a measure of risk-adjusted performance. It is calculated by taking an asset class’s (or portfolio’s) excess return above the risk-free rate and dividing it by the standard deviation of its returns. The greater the Sharpe ratio, the better the risk-adjusted performance has been.
For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment.
Past performance is not a reliable indicator or guarantee of future results.

A Final Word

The current backdrop of higher interest rates, persistent inflation, and periodic volatility has seen the re-emergence of equity market dispersion—that is, widely differing performances among sectors. In addition, we believe that disruption—from factors such as major leaps in technology or forward-thinking business models—is here to stay, and investing in equities requires more selectivity than in the past. More displacement is coming from AI and other new technologies, so we believe equity investing needs to focus on identifying the winning disruptors and those well positioned to increase their dominance by leveraging innovation.

In our view, active management is critical to identify companies that can be long-term winners in this environment, while avoiding those with vulnerabilities. An active equity portfolio that can navigate changing regimes, focusing on blending true innovators and quality value stocks, while avoiding vulnerable businesses, can be the key to generating alpha over the long term.   

LGCAX
Class A

Global Equity Fund

The Fund seeks long-term growth of capital by investing in stocks of both U.S. and Non-U.S. companies.

1For example, an historical analysis (2004–2022) of companies in the Russell 1000 Index in the top 10% of the R&D intensity category—those that spent the most on R&D relative to revenues—and the subsequent next three years of investment returns, showed that the highest R&D intensity companies outperformed the rest of the index by an annualized average of 18%. 

Unless otherwise noted, all discussions are based on U.S. markets and U.S. monetary and fiscal policies.

References to fund yields are for informational purposes only and are not meant to represent any specific Lord Abbett bond fund or portfolio.

Asset allocation or diversification does not guarantee a profit or protect against loss in declining markets.

No investing strategy can overcome all market volatility or guarantee future results.

The value of investments and any income from them is not guaranteed and may fall as well as rise, and an investor may not get back the amount originally invested. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance.

Market forecasts and projections are based on current market conditions and are subject to change without notice.

Projections should not be considered a guarantee.

Equity Investing Risks

The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are undervalued, and they may not appreciate as anticipated. Smaller companies tend to be more volatile and less liquid than larger companies. Small cap companies may also have more limited product lines, markets, or financial resources and typically experience a higher risk of failure than large cap companies.

Fixed-Income Investing Risks

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. 

The credit quality of fixed-income securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.

Glossary & Index Definitions

Debt-to-equity ratio represents a company’s total liabilities divided by its equity (its book value, or its assets minus its liabilities). 

Free cash flow (FCF) is a company's available cash repaid to creditors and as dividends and interest to investors. Free cash flow yield is the free cash flow per share divided by the market price per share of a company.

Those with a hawkish view of monetary policy are focused on inflation. They favor raising interest rates to restrict the supply of money. Dovish monetary policy supports economic growth and aims to achieve maximum employment. It seeks to lower interest rates or keep them low, because loose monetary policy increases the money supply.

Return on equity is the measure of a company’s annual return (net income) divided by the value of its total shareholders’ equity, expressed as a percentage.

Return on assets is the measure of a company’s net income divided by (i) its average assets or (ii) its end-of-period assets.

Return on invested capital is calculated by taking into account the cost of the investment and the returns generated. Returns are all the earnings acquired after taxes but before interest is paid. The value of an investment is calculated by subtracting all current long-term liabilities, those due within the year, from the company’s assets.

The Sharpe ratio was developed by Nobel laureate William F. Sharpe as a measure of risk-adjusted performance. It is calculated by taking an asset class’s (or portfolio’s) excess return above the risk-free rate and dividing it by the standard deviation of its returns. The greater the Sharpe ratio, the better the risk-adjusted performance has been.

The MSCI ACWI (All Country World Index)
is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets.

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

This material may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The views and opinions expressed are as of the date of publication, and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions, and Lord Abbett disclaims any responsibility to update such views. Lord Abbett cannot be responsible for any direct or incidental loss incurred by applying any of the information offered.

This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.

Please consult your investment professional for additional information concerning your specific situation.

This material is the copyright © 2024 of Lord, Abbett & Co. LLC. All Rights Reserved. 

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