Searching for Value When Growth Is King
It’s been a tough road for value investors during the past decade, even causing some pundits to declare the investing style is dead.
While a growth-driven US market rally in the first quarter presented a challenge, however, we have still uncovered some unloved stocks and sectors around the world — with reasonable valuations and solid company prospects.
A POLICYMAKER-DRIVEN GLOBAL EQUITY RALLY
In the first quarter of 2019, equities across the globe saw a big recovery from the sell-off at the end of 2018. The MSCI All Country World Index was up 12.3 per cent in USD in Q1 2019.
What drove the rally? In one word, ‘policymakers’ who switched to a dovish tone. Earlier fears that US interest rates would continue to rise, were transformed as the Federal Reserve adopted a more patient approach to policy normalisation and communicated a pause in its multi-year tightening cycle. Markets have gone even further, now expecting the next move to be a rate cut.
Similarly, the European Central Bank acknowledged economic risks had moved to the downside and delayed potential interest-rate hikes from sometime in the fall of this year to early 2020.
And lastly, China also signalled monetary easing and numerous stimulus measures including tax cuts, lower bank reserve requirements and increased spending.
The rally favoured high-growth sectors like technology and media and entertainment, which partly explained the strength of the tech-heavy US market and China. On the other hand, traditionally defensive sectors with perceived low-growth characteristics like consumer staples, telecoms and health care were the weakest sectors, as were banks, which didn’t fare as well amid a combination of low growth and lower yields.
That being the case, growth as an investment style outperformed value.
However, as value investors, we think that as we move into the second half of this year, we’ve got a tailwind coming. We expect more signs that the global growth slump is ending. Already, China’s economy appears to be rebounding, the eurozone economy is starting to accelerate and the US Fed has turned from hawkish to neutral.
FINDING VALUE WORLDWIDE
From an investment standpoint, we believe the best opportunities globally are in Europe.
Europe
Regional valuations in Europe reflect excessive pessimism. While investors are overwhelmingly bearish on Europe, we believe the region is cheap and well-positioned to benefit from a weaker euro, looser financial conditions, renewed fiscal stimulus, a more accommodative central bank and a potential pickup in both domestic and external (i.e. Chinese) economic activity.
Banks in the region now deliver a RoE 20 per cent below the broader European market, however, the shares trade at a discount on Price to Book Value of almost 60 per cent. While we would not expect these two measures to line-up for a leveraged sector like banking, the shares would have to go up, on average, by 100 per cent for banks to trade on a multiple comparable to their returns. European banks in the portfolio have continued to boost their book values and with capital levels rebuilt and profitability on a strong recovery path, are boosting their dividends significantly.
Asia
Secondly, we believe there are great opportunities in Asia given the longer-term wealth accumulation and demand potential of Asian consumers. We are finding opportunities among telecom providers and consumer staples in the region. Some banks in the region are also generating solid returns, but trading at significant discounts to book value.
United States
The US market across various metrics has hit new highs for this cycle, trailing only the extremes found during the technology bubble of the late 1990s. As US corporate earnings come under pressure, we may finally see the beginning of sustained US market underperformance.
That doesn’t mean we’re not investing in the US. It’s a deep and liquid market with selective opportunities. We’re just not finding enough value relative to the rest of the world to justify the global benchmark’s (MSCI All Country World Index) ~55 per cent weighting to this single market.
WHICH SECTORS ARE MOST APPEALING?
Looking at specific sectors, we remain committed to healthcare despite concerns about regulation and pricing.
Healthcare
Healthcare has offered above-average growth in profits and earnings and yet has been trading at lower-than-average valuations both historically, and against some of the other more expensive sectors. Healthcare is capable of innovating through its challenges and producing products and earnings growth that we think the market isn’t yet recognising.
Technology
The technology sector is generally looking expensive. We have avoided the expensive momentum-driven stocks. Instead, we have been finding opportunities in the more mature, cash-generative software firms as well as some hardware companies with restructuring potential. We have also found value in semiconductor manufacturers where supply concerns have created excessive pressure.
Consumer staples
In consumer staples, investors have generally gravitated towards the perceived winners that are delivering above-average growth, further pushing up already high valuations for these stocks. Over the past few years, the staples companies have countered gross margin pressure with lower overheads and marketing spend. However, as we have seen from the recent loss of market share announced by a number of companies in both Europe and the United States, it suggests that some companies have cut a bit too deeply.
At the same time, we have seen the grocery channel evolving with retailers investing in e-commerce and private labels in order to fend off the rise of alternative platforms such as Amazon and the discount retailers. This is having a negative impact on a lot of manufacturers, particularly in the US.
Energy
Finally, energy stocks were pretty beaten up in the second half of 2018, as the price of Brent crude oil fell to US$50 a barrel after the Iranian boycott that was supposed to come into effect didn’t. The sector was arguably oversold and due for a potential rebound, which we saw in the first quarter as the price of oil rose some 35 per cent to US$70 a barrel.
When oil starts to recover like it has, it looks less attractive to us, but we continue to see value within the larger integrated oil companies. They’ve had strong dividends, growing free cash flow, and increasing returns.
One company we like in this space is BP. Growth projects are coming online after a decade of investment; production has grown 2.4 per cent y/y in the latest quarter. Capex has declined and has found a stable level, and management intend to keep it constant with an increasing oil price. Operating costs have fallen rapidly and have now stabilised.
Dividends are well covered with the breakeven oil price for the dividend to be covered expected to fall to between $35-40 over the next few years. We believe the shares are attractive in today’s market with a dividend yield of ~ six per cent and a 2021 Free Cash Flow yield of 10+ per cent at $65 oil.
Peter Wilmshurst is a portfolio manager at Templeton Global Growth Fund.
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