In this Q&A, Senior Investment Director Chris Chen moderates a discussion between Senior Portfolio Managers Mike Liss and Brent Puff about the often-debated potential advantages of growth- and value-oriented investment styles. Noting the valuation gap between value and growth, Liss makes the case for the continued rotation to value.
Puff counters with the case for growth as global economies recover from the worst of the pandemic and economic activity increases. Surprisingly, the two investment pros also manage to find some common ground in their investment approaches.
- Following strong outperformance by growth, market leadership has rotated to value recently as more cyclical sectors rally. During the darkest days of the pandemic, more growth-oriented, stay-at-home companies benefited, particularly those in technology.
- A valuation gap remains between growth-oriented and value-oriented stocks. This may present opportunities depending on your investment style and approach.
- Both portfolio managers believe higher inflation and interest rates will be a key factor in market performance in the near term. But they differ in how these conditions will affect individual sectors and companies.
It’s been an interesting period for global equity investors, to say the least. In terms of style, style leadership has been a rollercoaster ride. We saw growth having an amazing run post-COVID until the fourth quarter of last year when optimism around vaccines and assumptions of improved economic activity sparked a strong value rally.
At its widest point in May, value had outperformed growth by more than 20% since the fourth quarter of 2020. Since then, growth has made a strong comeback, recovering much of its lost ground.
So, the million-dollar question—what can we expect going forward? And with that, let’s start with Mike on the value side. I understand our approach to value investing is nuanced, which we will get to later, but looking purely at style, what do you make of the big swings we’ve seen so far this year? Has the value rotation run out of steam again?
Mike Liss: I don’t think the rotation has run out of steam. Let’s look at the valuation between growth stocks and value stocks, using the MSCI Value and MSCI Growth indices. Note that the data goes back about 20 years, and the gap has really widened between growth and value. It’s not that value stocks should have a higher P/E multiple or EBITA multiple than growth stocks.
Of course, growth stocks should have higher multiples–they grow faster. The point is that the gap has widened to historic levels we haven’t seen since 1999 and the tech bubble. The gap appears to offer a great opportunity for value investors.
We have a specific definition of growth as well, which we’ll go into later. So, Brent, same question to you, purely looking at style. What do you make of the big swing so far? And do you think the latest rotation back to growth can be sustained?
Brent Puff: If you look at the rotation into value that started in earnest in late third quarter/early fourth quarter of last year and persisted through the first quarter of 2021, it was really driven by two things. The first influence was the market’s belief that a vaccine with high efficacy would pave the way for a strong rebound in global economic activity. Second, I think the other important fact is that interest rates moved from 65 basis points up to about 165 basis points over a short period.
An environment in which global economic activity is recovering strongly and interest rates are rising is going to favor value indices at the expense of growth indices. Value indices relative to growth tend to be more pro-cyclical. The financial, industrial and commodity-oriented sectors, such as energy and materials, are overrepresented in value indices relative to growth indices.
In an environment where the market thinks growth is going to rebound robustly out of a COVID-induced trough, it’s not surprising that the most cyclical sectors within the market began to outperform. The move in interest rates contributed a lot to the rally in the financial sector.
If you deconstruct relative weights value versus growth, the two biggest differences are the weight of the financial sector in value and the growth indices. Basically, the financial sector is about five times larger in value. At the opposite end of the spectrum, the technology space, which tends to be dominated by longer-duration growth stocks, has 3.5 times or so the representation in growth indices than value indices.
Getting back to higher interest rates, what do higher interest rates do for the financial sector? If higher rates continue, that has the potential to materially improve the revenue and earnings backdrop for this sector, which has been under persistent pressure for a long time.
As rates have continued to move lower, basically every loan that comes to you and every bond that matures is reinvested at lower rates. That’s been a very consistent pressure damaging the earnings power of the sector. So, in an environment in which rates spiked, financials, which are a much more significant part of value indices, outperformed.
Long-duration growth stocks are also more sensitive to changes in interest rates. Basically, discounted cash loans in the future are worth less as rates move up. Thus, higher rates both pressured growth stocks and disproportionately benefited the value portion of the market.
What’s happened more recently is the spread of the delta variant having disrupted the recovery to some extent, or at least slowed the trajectory. Interest rates have moderated, and not surprisingly, we’ve seen growth stocks regain some of the ground they lost in the fourth quarter and first quarter.
Brent, you mentioned earnings power. The latest earnings season has come in way over expectations. How has that affected your thinking going forward, and what do you think about the expectations built into the consensus on variants right now?
Brent Puff: You’re 100% right, Chris. The earnings backdrop in the second quarter was very good, both in the U.S. and outside the U.S. Results generally were substantially better than expectations. And we saw a lot of positive full-year earnings revisions.
I think some of the surprises have been the velocity of the recovery in corporate profits. I mean, if you look at the S&P 500, right around 80% of companies reported second-quarter 2021 revenues that were above second-quarter 2019 levels, meaning they fully recovered from the COVID disruption. The other thing that’s just been hard to ignore is earnings expectations have moved up substantially from where they started the year. The year started with S&P 500 earnings expected to be up 20% year over year against an obviously depressed 2020.
Earnings expectations have more or less doubled. Consensus estimates are now assuming a near-40% recovery in profits year over year. So, the backdrop is excellent. I think the outlook continues to be favorable despite some disruption created by the delta variant, supply chain challenges and rising costs.
Some companies are managing through these headwinds better than others. But, in general, companies have been able to offset or pass cost pressures through to their customers. Thus, the forward earnings outlook has not taken a material dent from some of these challenges that companies are wrestling with today
Mike, do you share this optimism in Brent’s assessment of the corporate earnings picture? Does this mean value could have an edge over growth in the current earnings environment?
Mike Liss: I agree, earnings have been good. I’m not terribly surprised at earnings levels given the enormous amount of stimulus poured into the economy. Companies are growing earnings because people have money to spend.
We also know the savings rate is at an unsustainably high rate. People still haven’t spent down their savings because they can’t spend as freely on things they want, such as travel. What is surprising to me, as a value investor looking for the best opportunities, is the misperception in the market that value companies don’t grow. That is factually incorrect.
Let’s consider the Russell 1000 Value® Index as a proxy for value and Russell 1000 Growth® Index as a proxy for growth. If you look at the data going back about 10 years, you’ll see that value stocks do grow earnings. To say otherwise is a false statement.
It’s not that value stocks, in general, are cheap relative to history. They’re generally aligned with history. On the other hand, growth stocks aren’t growing at the rates at which they have historically.
If you look at the earnings estimates over the last 10 years, growth stocks as a group aren’t growing faster than they have in the past. The multiples are just higher.
While multiples are higher for value stocks, too, the multiples for growth stocks are just so much higher than value stocks that it’s not rational. From a value perspective, that gap is where the opportunity lies, of course.
When talking about this growth opportunity within value, how would you describe the way you invest through your value lens? Could that be a bit different than what the public thinks of as value investing?
Mike Liss: Brent is well-versed in the different styles of growth investing. It’s the same with value, there are different styles of value investing. Deep value investing is what Warren Buffet called “cigar butt” investing.
Cigar butt investing involves looking for lower-quality companies trading at dirt-cheap valuations because they deserve to be. We’re not quite fishing from that pond, Chris. We’re looking for high-quality companies that are trading at a discount to their fair value for temporary or transitory reasons.
We’re trying to find leaders in their sectors or industries—companies that have the highest returns on capital within the sectors or industries in which they operate.
We like companies that have good assets, so it might be something as straightforward as Coca-Cola, which has a great brand. Or it might be a low-cost producer of energy or oil and gas in the Permian Basin.
Companies with strong balance sheets are also attractive. They have low levels of absolute debt or no debt. That gives them the flexibility to do other things with the free cash flow they’re generating. In sum, we like companies that have:
- Strong returns on capital.
- Leading market shares.
- Sustainable or defendable business models.
- Solid balance sheets.
- Solid assets.
Mike mentioned the wide valuation gap and growth being expensive as a sort of common criticism of growth investing. Brent, what do you think about this criticism or evaluation concern, and how does that relate to the way you look at investing through your growth lens?
Brent Puff: I think Mike is right. There are certainly parts of the market that are pretty rich today. You can certainly point to some sectors of excess in the technology space that tend to be kind of growthy. That’s true, and I don’t really think debatable.
The question really is in what environment might that multiple expansion compress? I think the answer is tied directly to the direction and durability of interest rates from here. Clearly, one risk in the market involves where we are in the monetary policy and accommodation cycle.
We’ve been in an extremely accommodative environment for a prolonged period. This has led to negative and/or ultra-low interest rates and contributed to the expanded valuations, particularly in longer-duration growth companies. If we are indeed at an inflection point in monetary policy, I think it’s reasonable to believe long-duration growth stocks are more vulnerable to multiple compression than other parts of the market.
For our team, risk/reward, or valuation, is one of the four core tenets of our process. In the recent environment, we’ve been paying more attention to that part of our process. We acknowledge there’s some vulnerability there if monetary policy around the world becomes less accommodative. So, we’re attentive to that risk. We acknowledge that risk exists, and we’re more mindful of it given where we think we are in that cycle.
Shifting gears a little to opportunities. Mike, what opportunities do you see in the market through your value lens? Or are there any stock examples that fit your definition or your value approach, but may not be considered a typical value stock?
Mike Liss: Yes, I’ll discuss some traditional sectors that are attractive on the value side. And I’ll give an example that’s going to surprise you a little bit.
Banks, within the financials sector, and energy are among the traditional value stocks we currently find attractive.
Let’s talk about banks first. Many investors don’t believe banks grow earnings and haven’t grown earnings since the global financial crisis. That’s simply not correct. The earnings growth has been cyclical growth. Earnings growth dipped in 2020, of course, with the pandemic. It’s not surprising because interest rates cratered, and net interest margins were compressed.
We like to point out that we tend to like certain big banks with attractive risks/rewards. These banks, like JPMorgan, U.S. Bank and PNC Bank, grew earnings over the last 12 years. They accomplished this because they have more levers to pull than just net interest margins.
They also have fee businesses and service revenue businesses. Their loan business is also strong because they didn’t engage in the aggressive lending practices that occurred during the global financial crisis. They’ve built their book value and returned cash to shareholders.
This reminds me of 20 years ago when you had the old economy stocks and the new economy stocks. The new economy stocks—tech companies—were just going to kill the old economy stocks. But it turned out the old economy stocks used the new economy technology to improve their operations and their earnings. The old economy companies eventually came out of the tech bubble crisis. They did very well in 2000, 2001 and 2002.
The analogy today is old banks and fintech. Some think the old banks are dinosaurs. However, there’s nothing stopping old banks from using new technology. Many of them are investing billions into their R&D tech budgets.
Examples include JPMorgan, U.S. Bank, Wells Fargo and PNC. Their loan books have started to bottom out and are finally starting to grow. Interest margins are currently squeezed, but eventually the environment will be more positive. I think that change is coming sooner than later.
Now let’s consider the energy sector. It’s true that their earnings plummeted over the last 10 years. I can’t argue that fact. It was very irrational for energy companies to put every dime into the ground to extract oil and gas. That cratered the price of the commodity, and none of the companies made a profit.
Low energy costs due to the shale oil and gas boom benefited the country, but it seriously harmed the companies and their long-term viability. They finally came to their senses and reduced spending on exploration. They stopped concentrating on returns on capital, instead concentrating returns of capital.
ConocoPhillips, Devon Energy, Chevron and Baker Hughes are companies returning substantial cash to shareholders and are committed to continue that practice. We don’t think the market has recognized their more rational behavior yet.
So, banking and energy are a couple of areas where we’re finding good risks/rewards. Let’s look at a stock that might surprise you. Equinix is a REIT, so I might be getting on Brent’s turf a little bit.
Equinix is a global, digital infrastructure company that provides colocation space and related offerings. Customers rent their space and perhaps their equipment. Secular tailwinds like 5G and streaming services, such as Netflix and Disney are driving Equinix’s success.
REITs tend to have more debt, which we usually shy away from as value investors. But Equinix ticks a lot of boxes for us, including:
- High barriers to entry.
- Diverse tenant or customer base.
- Strong balance sheet.
- Solid returns on capital within its industry.
- Strong secular demand.
Brent Puff: You’ll be happy to hear we like Equinix a lot as well, Mike. It’s a company we’ve liked for a long time. It’s a great business.
Brent, the same question for you. What opportunities do you see that are consistent with your process and may not be considered a typical growth stock?
Brent Puff: One thing I would tell you is our team is agnostic to the label. Is this a growth stock or is it a value stock? We don’t think of opportunity across these two spectrums. Rather, we are focused on finding and evaluating companies through this lens:
- A rate of change in earnings and revenue that’s beginning to positively inflect. It could just as easily be a low-growth business as one with high growth rates.
- Inflecting growth rates with the drivers of this improvement sustainable over a multiyear period.
- Underappreciated earning power, meaning we want to believe that using a reasonable set of assumptions, consensus earnings estimates are beatable.
- Risk/reward, or valuation.
One area of opportunity we like is this trend toward outsourcing by all the drug developers. Drug developers are increasingly outsourcing manufacturing operations to third-party providers. Lonza, WuXi Biologics and Catalent are all involved in the service provision there.
Drug developers are also increasingly outsourcing clinical trial development. They are under pressure to get new drugs to market in the shortest possible time and at the lowest possible cost. What they’ve discovered is that using firms that specialize in specific activities can help them achieve these goals. That means more outsourcing over time, and that’s going to continue to be an important driver for companies providing these services.
In the clinical trial development space, leaders include IQVIA and ICON. ICON is in the process of consolidating a major acquisition, which will basically take the company from being the No. 5 player in the industry to a strong No. 2 player in the market. The deal is going to provide a fair amount of revenue and cost synergies over the next couple of years, in our view, as it consolidates that business. We also think its service offerings will improve and help them gain market share. And we think this trend toward outsourcing is going to continue to be a persistent and consistent tailwind for several years.
There’s a lot of positive inflection in these businesses today. We think the drivers of those inflections have staying power, they’re sustainable. And in the case of companies like IQVIA and ICON, we think earnings expectations are beatable and risk/reward is favorable.
Michael Liss: Brent is spot-on here. Value investors also like certain health care stocks, including pharmaceuticals. Pharmas are leveraging contract research organizations (CR0s) to save costs, be more competitive and potentially enjoy good returns on capital.