Markets are going through a period of regime change, with an acceleration in the pace of rotation from growth to value, and an evolution in the nature of the value rally.
Rising interest rate expectations have been one of the main catalysts for this shift. As the global economy has recovered from the shutdowns imposed at the start of the pandemic, inflationary pressures have ramped up, raising expectations of monetary tightening from exceptionally loose levels.
Following the US Federal Reserve’s most recent meeting, the consensus forecast is now for four or five US rate rises in 2022, up from the three expected at the start of the year and as little as one predicted back in September. As a result, bond yields have risen, particularly at the short end of the yield curve: 3-year Treasury yields have risen by over 40 basis points to almost 1.5% so far in 2022.
Bond yields usually have a significant impact on the relative performance of growth stocks versus value stocks. By definition, growth stocks are long duration; their valuation should be sensitive to a rising discount rate on their future assumed high growth. By contrast, value stocks are short duration, and their profits are much more likely to benefit from a pick-up in inflation owing to the beneficial effects of inflation on pricing power.
There’s strong evidence that the rise in yields is now feeding through to the performance of value compared with growth. For global developed markets as a whole (using MSCI World Index), factor returns show that value has already outperformed growth by over 10 percentage points so far this year.
The valuation dislocation in markets currently is very significant, so while growth stocks are very expensive, our investment process is finding cash generative value stocks that are still on depressed share ratings. We think the value investment opportunity has a lot further to run, and Europe is one of the most attractive regions in which to find it.
US equity markets have often been lauded for their high technology constituency, but this is now proving a major headwind as growth stocks come under pressure. These types of companies, which our investment process would classify as ‘high forecast growth’, have done very well during a decade-plus of quantitative easing, cheap money and exceptionally low discount rates. But valuations of these high forecast growth stocks now look extreme while their cash flow characteristics are weak.
European markets have sometimes been unfairly derided for the number of ‘old economy’ stocks when compared to the tech-heavy US indices. But they are currently providing very fertile hunting ground for investors in value stocks.
We began applying a heavy value tilt to all of our European portfolios after the historically brutal sell-off in markets in Q1 2020 precipitated by the Covid-19 crisis, and our portfolios have benefited from this changed exposure emphasising value rather than growth, particularly over the last year. We think there is much more to come as the value rally evolves.
The value rally towards the end of 2020 was a fairly indiscriminate deep contrarian value rally, as a number of stocks had become oversold on Covid-19 concerns. But this has transitioned during 2021. At this stage of the value recovery, in our view it is preferable to invest in cheap stocks where there is clear evidence of recovery – as distinct from 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 refine down our list of Europe’s top cashflow stocks to those with the style factors we are targeting.
Over the course of the last year, we have shifted the emphasis of our stock selection from the contrarian value secondary score towards the other three scores: recovering value, cash return and momentum. We are investing in companies that are showing positive business momentum, generating significant cash flows as the deleterious economic impacts of Covid now wanes and returning that cash to shareholders. We can find a number of stocks fitting this characteristic that look quite cheap.
Additionally, the value rally has now been in position long enough that momentum has migrated from high forecast growth stocks to value stocks – a meaningful signal of regime change. Market commentators are now drawing attention to the fact that value stocks are currently receiving more earnings upgrades than growth stocks – an unusual development that is positive for value but quite negative for expensive growth stocks.
Three European sectors where we are finding lots of value opportunities are financials (largely European banks) consumer discretionary and industrials.
Financials: We own a number of stocks in the financials sector, including a number of banks such as Bank of Ireland, BNP Paribas and Société Générale. This sector is a particularly strong beneficiary of a steeper yield curve. Bank of Ireland is enjoying strong growth in mortgages while BNP Paribas and Société Générale are experiencing a recovery in investment banking and their retail businesses. Bad debts have not been as bad as feared. Balance sheets are reasonably solid. And the stocks have been re-rated from Covid-19 lows but still have upside with price-to-book ratios below 1.
Consumer Discretionary: Pandora, the Danish jewellery company, is enjoying a strong recovery in sales as well as stronger operating margins. We think there is pent up consumer demand and its valuation is not expensive.
In this sector we also hold a few autos companies. For example, Daimler, the owner of Mercedes Benz, and Stellantis, the owner of 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 also have quite significant self-help strategies in place on the cost side – for example, synergies across Peugeot and Fiat Chrysler and a significant fixed cost reduction programme at Daimler.
Industrials: Epiroc is a good example of our industrials sector exposure. It is a Swedish based manufacturer of capital goods equipment that serves industries including mining and construction. Its customers are enjoying a strong pricing environment for metals so their capex levels have been rising in turn, and this helps demand at equipment manufacturers like Epiroc. It has a strong aftermarket business as well. It generates a lot of cash and has a good track record of returning excess cash to shareholders.
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