Markets are going through a period of regime change, with the pace of rotation from growth to value accelerating, and the nature of the rally in value changing.
Rising interest rate expectations were one of the main catalysts for this change. As the global economy has recovered from the shutdowns imposed at the start of the pandemic, inflationary pressures have intensified, raising expectations of monetary tightening from unusually easy levels.
Following the last meeting of the US Federal Reserve, the consensus now calls for four or five US rate hikes in 2022, down from three forecast at the start of the year and as few as one forecast in September. As a result, bond yields rose, especially at the short end of the yield curve: 3-year Treasury yields rose more than 40 basis points to almost 1.5% until now in 2022.
Bond yields generally have a significant impact on the relative performance of growth stocks versus value stocks. By definition, growth stocks are long-lived; their valuation should be sensitive to an increase in the discount rate on their future strong growth assumption. In contrast, value stocks have a short duration and their earnings are much more likely to benefit from an acceleration in inflation due to the beneficial effects of inflation on pricing power.
There is strong evidence that rising yields are now trickling down to value performance relative to growth. For global developed markets as a whole (using the MSCI World Index), factor returns show that value has already outpaced growth by more than 10 percentage points so far this year.
The dislocation of valuations in the markets is very large right now, while growth stocks are very expensive, our investment process finds cash-generating value stocks that are still on depressed stock quotes. We believe the value investment opportunity still has a long way to go, and Europe is one of the most attractive regions to find it.
US stock markets have often been hailed for their high-tech clientele, but that is now proving to be a major headwind as growth stocks come under pressure. These types of companies, which our investment process would label as “high expected growth,” have done very well through more than a decade of quantitative easing, cheap money, and exceptionally low discount rates. But the valuations of these expected high growth stocks now look extreme while their cash flow characteristics are weak.
European markets have sometimes been unfairly ridiculed for the sheer number of “old economy” stocks relative to tech-heavy U.S. indices. But they are currently a very fertile hunting ground for value-equity investors.
We started applying a strong value tilt to all of our European portfolios following the historically sharp market sell-off in the first quarter of 2020 precipitated by the Covid-19 crisis, and our portfolios benefited from this shift in exposure putting emphasis on value rather than growth, particularly over the past year. We believe there is much more to come as the rally in value evolves.
The rally in value towards the end of 2020 was a fairly indiscriminate contrarian rally in value as a number of stocks became oversold due to Covid-19 concerns. But that has evolved in 2021. At this point in the value recovery, in our view, it is better to invest in cheap stocks where there is clear evidence of recovery – as opposed to a deep value stock where there is no evidence of recovery. To target cheap stocks with evidence of recovery, our investment process deploys what we call secondary scores. These allow us to narrow down our list of Europe’s best treasury stocks to those that exhibit the style factors we are targeting.
Over the past year, we have shifted the focus of our stock selection from the contrarian value sub-score to the other three scores: value recovery, cash yield and momentum. We invest in companies that are showing positive business momentum, generating strong cash flow as the deleterious economic impacts of Covid fade and returning that cash to shareholders. We can find a number of stocks matching this characteristic that look pretty cheap.
Moreover, the rally in value has now been in place long enough that momentum has migrated from expected high growth stocks to value stocks – a significant signal of regime change. Market commentators are now drawing attention to the fact that value stocks are currently receiving more earnings increases than growth stocks – an unusual development that is positive for value but quite negative for expensive growth stocks.
The three European sectors where we find many value opportunities are financials (mainly European banks), consumer discretionary and industrials.
finance: We hold a number of stocks in the financial sector, including a number of banks such as Bank of Ireland, BNP Paribas and Societe Generale. This sector particularly benefits from a steeper yield curve. Bank of Ireland is benefiting from strong growth in mortgage lending while BNP Paribus and Societe Generale are experiencing a recovery in investment banking and their retail businesses. Bad debts were not as severe as feared. Balance sheets are reasonably strong. And stocks have been repriced from Covid-19 lows, but still have an edge with price-to-book ratios below 1.
Consumer Discretionary: pandora, the Danish jewelry company, is enjoying a strong recovery in sales as well as improved operating margins. We believe that consumer demand is pent up and its valuation is not expensive.
In this sector, we also own a few automotive companies. For example, Daimlerthe owner of Mercedes Benz, and Stellantide, owner of the Peugeot and Fiat Chrysler brands. These companies are benefiting from pent-up consumer demand, which is helping volumes, and pricing is strong, which is boosting margins. Both companies have also implemented some pretty significant self-help strategies on the cost side – for example, synergies between Peugeot and Fiat Chrysler and a major fixed cost reduction program at Daimler.
Industrial: Epiroc is a good example of our exposure to the industrial sector. It is a Swedish manufacturer of capital goods equipment that serves industries such as mining and construction. Its customers are benefiting from a high price environment for metals, so their investment levels have increased in turn, contributing to demand from equipment manufacturers like Epiroc. It also has strong secondary market activity. It generates a lot of cash and has a good track record of returning excess cash to shareholders.
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Friday, January 28, 2022, 11:38 AM