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Picking the unloved gems

Picking the unloved gems

20-10-2022 | Vision

Value investing may offer safe havens in a recession as the Fed raises rates, says veteran fund manager Chris Hart.

  • Christopher Hart, CFA
    Christopher
    Hart, CFA
    Portfolio manager

Speed read

  • Value stocks tend to do better when rates rise or recessions hit
  • Europe is the favored market as valuations are inexpensive
  • Headwinds include inflation, dollar strength and Ukraine

He says rising interest rates as central banks led by the US Federal Reserve try to combat spiraling inflation will promote value investing while keeping the rival style of growth investing subdued for several years.

Value investing is the practice of picking stocks whose market values do not reflect the underlying potential of the company. The style tends to perform far better in a normalized interest rate environment where the cost of capital is adequately factored into multiples.

Growth investing conversely tends to outperform in a low-interest rate environment and was the dominant form of market returns during the boom years that ended during the Covid pandemic.

“Over the next several years, I do not think that growth investing will come back with the strength it exhibited in 2018-2020, which was heavily due to multiple expansion and not significantly accelerating earnings growth, relative to history,” says Hart, Portfolio Manager of the Boston Partners Global Premium Equities fund.

“There will be periods of growth outperforming that will be heavily driven by the Fed’s playbook, the ‘Fed put’, once interest rates peak and start coming down again. A perfect example would be when the Fed stops cutting rates, and then we’ll probably have a spurt of high multiple stocks outperforming as ZIRP (zero interest rate policy) becomes the new theme not to miss.”

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Unsustainable rate policy

“That's the way the market's been conditioned. The zero interest rate policy that supported growth for so many years, particularly in 2018 and 2019, was not sustainable and is not coming back. I expect Fed rates to rise to maybe 4.5% to 5%, and then normalize at about 2.5%. That really ruins the argument for indiscriminate investment into long-term growth stocks.”

Hart says the bull market that fueled the outperformance of growth stocks was largely based on rising share price multiples rather than underlying earnings. “There was massive multiple expansion of high-multiple stocks and multiple compression for low-multiple stocks that was not supported by material changes in relative operating income growth,” he says.

How multiple changes accounted for the majority of returns in growth from 2017-2021.
Source: Boston Partners
“Growth will have a hard time trying to replicate this kind of performance which saw a wide deviation in the price of high-multiple stocks compared to their earnings relative to low-multiple stocks. Interest rates won't get to the point where that is supported again.”

Mispriced quality and momentum

Value stocks could also act as insulation during the volatility that any future recession would cause, Hart says. “If we define value as low-multiple stocks with better-than-average quality and momentum characteristics, then they could be safe havens,” he says.

‘These stocks fall right into our style where we look for companies where quality and momentum is mispriced. Their multiples are already reflecting the belief that we’ll be in a recession over the next year, or year and a half. Those companies already reflect the reflationary environment based upon their prices.”

“Recessionary volatility is already being experienced across lower-multiple stocks which have outperformed higher-multiple stocks for the last two and a half years.”

“So, you could say they’re a safe haven because you have the support from their fundamentals and underlying quality. And if their momentum is not as bad as the markets often perceive low-multiple stocks to be, supported through bottom-up analysis, then you have the underlying multiple support to look forward to as well.”

Inflation as a headwind

Inflation may though start to eat into the earnings of value stocks as input costs rise, as profit margins of lower-multiple companies are by definition lower.

“We have to be careful about inflation from a stock-picking perspective,” Hart says. “We have to find the companies that are better able to navigate an inflationary environment than the companies that can't, again supported by bottom-up analysis.”

“We screen nearly 12,000 stocks, so there's got to be several hundred out there that are not going to be dramatically affected by inflation as much as perception dictates. Through security selection, we can avoid lower-quality businesses that have a higher level of sensitivity to inflation.”

Don’t underplay Russia-Ukraine

Another potential headwind is the ongoing Russian invasion of Ukraine that has already rocked markets and fueled inflation, particularly in energy and food.

“I'm actually surprised that the markets haven't reacted more violently to the blowing up of the Nord Stream pipelines, the attack on the bridge to Crimea, or the bombing in Kiev,” Hart says. “It doesn’t bode well.”

“The market is acting as if the Ukrainian situation is like Syria; it’s seen as being an inconsequential backwater. Yet it's actually very serious because it’s basically a dangerous proxy war between Russia and the West.”

Europe the favored market

Regionally, Hart says Europe offers better opportunities in value, while the US continues to face uncertainty over the outcome of the mid-term Congressional elections, and emerging markets are unfavorable due to the strength of the US dollar.

“Valuations are extremely supportive in Europe and the UK on both a relative and an absolute basis,” he says. “We're able to find businesses that are very inexpensive, with similar quality and fundamental characteristics to US companies, but trading at a much lower valuations.”

“Within the context of industrials and consumer discretionary, multiples have compressed in Europe and the UK to levels that are very compelling. The fundamentals are stable to improving, but we need to have that near-term momentum piece to start to turn positive, which I suspect is still up to three quarters out.”

America’s EU Commission

Americans go to the polls to elect all of the House of Representatives and one-third of the Senate in November. “If the Republicans don’t perform extremely well, I think the US market will be in a lot of trouble, because it would give President Biden more power to wield the heavy hand of regulation.”

“The regulatory branch underneath Obama and now underneath Biden has been very similar to what the European Commission is to the EU. A lot of policy is being made by unelected officials who hide behind the executive branch. A mixed government as a result of the mid-term elections will be helpful to the markets in the sense that less intervention will emanate from Washington DC.”

Avoiding emerging markets

Emerging markets led by China that were once seen as high-return opportunities are at the mercy of the mighty dollar on which many rely for income, Hart says.

“I'm very skeptical about emerging markets, especially with deglobalization, and with the strength of the dollar today,” he says. Energy costs are going to remain higher for longer, and energy is somewhat a reflection of dollar strength.”

“Arguably, you could say certain countries will benefit from higher commodity prices, and they’ll be able to weather the storm a little better. But I don't think the opportunities that were present in emerging markets over the last 20 years are going to present themselves that quickly going forward.”

Health care looks healthy

For sectors, health care stocks that benefitted greatly from the pandemic continue to shine. “When you look at the multiple expansion and contraction of health care stocks over the last 20 years, it's actually probably a more cyclical sector than one would think,” Hart says. “I think we're at a cyclical upturn today.

“Our pharmaceutical holdings have better drug pipelines relative to existing drugs and generics, and they’re trading at very favorable valuations. You want to buy these companies when there are a lot of questions surrounding generic migration and new pipelines replacing the revenue streams of a previous blockbuster.”

“From a health care services perspective, I think there's a pretty decent runway going forward, due to more consolidation within the industry. There will be more vertical leverage from an operational perspective and more efficient utilization of the health care system.”

Picking the unloved gems

Meanwhile, the value investing style still means picking the unloved businesses that others ignore. “The trick is to find that cohort of names that defy what the market is saying,” Hart says.

“The value cohort or the lower half of stock market distribution is going to have lower-quality businesses in it, but that doesn't mean that all companies are lower quality. There are some real gems out there.”

“There is a significant value play in Europe that is still developing, and it will be interesting to see how quickly any acceleration downwards emerges in the US from an earnings perspective, because we've already seen that in Europe.”

“We’ll continue to take the same approach no matter the market environment, and I believe our clients have appreciated that consistency over the long term.”

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