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David Cohen (David): I love stock picking. I love finding ideas that have been misperceived by the market or that have been left for dead by investors and being able to see something others don't see. I think that gives me a creative outlet to really express sort of my passion for investing. And so, you know, that's really what I love about it.
Male voice: Welcome to a new episode of the Robeco podcast.
Erika van der Merwe (Erika): Value stocks are in revival. This after what seemed like an endless run of underperformance relative to growth stocks. But is this the long-awaited value rotation and how big is the opportunity from here onwards? David Cohen is portfolio manager for the Boston Partners Large Cap Value Strategy. Welcome, David. Good to have you on the Robeco podcast.
David: Thanks, Erika. It's great to be here.
Erika: David, let's start with a quick introduction. So as a house, value investing is your business, right?
David: It is, we’re value investors through and through
Erika: and your own focus area is large cap value. Right. So how is your universe defined then?
David: So we can invest in any company that is two billion or larger market cap. And in the US we can also own ADR’s of companies trading abroad up to 15 percent of the portfolio. And so there's over 10,000 stocks in our universe that we can review. And we're looking for, you know, as always with Boston Partners, three circle stocks, companies with attractive fundamentals, attractive valuation and positive business momentum, meaning they're getting better, not worse.
Erika: So, David, undoubtedly the value rally since November has brought great relief to you and your colleagues and all fellow value investors. We spoke to Jay Feeney last year, your CIO. He told us that the decade of growth beating value had been by far the most stressful time of value underperformance in his 35-year career. But, David, is this it? Do you see this as the rotation that had been expected or could it still be a bumpy road ahead for value?
David: Well, you know, if you think back a year ago, the world was literally shutting down. Right? Fear was at its peak and the environment was as extreme as anyone could have imagined. Growth to value spreads where three standard deviations wide. The consensus believed in the inevitability of low interest rates forever, the possibility of negative rates and the impossibility of inflation. So, if you fast forward to today, the 10-year US government bond is 151 basis points, or 90 basis points higher than it was a year ago. The yield curve is steeper and investors are rightly worried about inflation. The macro backdrop of low rates and slow growth with disinflation has been totally supplanted by a normal business cycle outlook that holds we’re in the early stages of an economic recovery. So, for the majority of my career, we rarely talked about growth versus value. There were periods of growth outperformance and there were periods of value outperformance and it would temporarily become a discussion point. But it only became such a dominant narrative over the last few years when investors became complacent in the idea of scarce growth, disinflation and low rates. That's over. The low growth environment that we were in, favored those bond proxy stocks like real estate investment trusts, utilities and staples at unprofitable growth companies. And the market had rewarded both of those with unprecedented multiples while simultaneously putting trough on trough multiples for cyclicals in the midst of the pandemic. So, we're still in the early days of that trade unwinding. The extremity of the previous growth cycle is now being sort of narrowed and valuation spreads have come in some but are still very wide. So we're seeing characteristics like free cash flow, returns on capital and equity, capital discipline, that are the driving forces to our investment process starting to be rewarded. And we've been positioned for this and we're benefiting. But this is the normal environment now while we were in for the last three to five years. So, I think what you're likely to see going forward is not just a temporary factor, rotation away from growth towards value, but more the emergence of a normalized environment for stock picking where you're going to see growth outperform at times, value outperform at other times, inflation expectations rise and decline. And so our process is tailored to be able to navigate that environment. Where we struggle is when you see these periods of just growth running away and taking over, outperforming value by 20 percent because of sort of the settling in of this one mindset that we're just never going to have sort of normal economic cycles. So I think the question of growth versus value is really not the right one. It's just a matter of what we've transitioned into. And to emphasize the point, I think we've gone from an extreme growth environment to a more normal business environment that should prevail for the next several decades.
Erika: Perhaps go a little deeper into some of the points you made, and those points are on policy making, stimulus, at first, the thinking that we'll never see inflation again. Now there's talk about inflation and a possible tapering of policy making, but we still have extreme policy stimulus in place. And in the US, it's overlaid with extreme fiscal stimulus. So what would all of this mean for value stocks? So let's just say if inflation were to return more permanently, what does that mean for a value investor?
David: Yeah, I think you hit on the key point, which is that, you know, out of covid, we moved from an environment of extreme monetary policy, loose monetary policy, which has been in place since the great financial crisis to ultra loose financial or monetary policy, plus fiscal stimulus. So stimulus checks, extended unemployment benefits, all of that is leading to sort of this this fiscal stimulus, which has put money directly in the hands of consumers versus just being on bank balance sheets and financial institutions last cycle. So the combination of those two sets gives you sort of the raw ammunition, or maybe the sort of fuel to lead to inflationary cycles going forward. So if you think about what drives inflation, it's really, you know, velocity of money plus quantity of money. The quantity of money has been increased dramatically over the last 12 to 18 months. And now the question is what happens with velocity? And so that's really, you know, if you think about where the consumer's been, they've been locked up in their house. Nobody's doing anything except buying stuff on Amazon and other e-commerce sites. And now we're in an environment where we can travel again. Where the vaccinations are rising, where we can go back to work, where we can pop into the corner store, where we can, you know, buy these big-ticket items that aren't just related to our homes. And so that sort of velocity and the savings rates that have built up over the last year because people haven't been consuming are going likely to drive higher velocity of money. So, again, price level equals velocity times quantity, quantities up. If velocity accelerates, you could see a meaningful pickup in inflation as we go forward. Now, some of this is being exacerbated by cyclical factors due to supply chain issues which have emerged due to covid. And those will start to taper as we get into 2022. We expect some of the semiconductor shortages will be debottlenecked in autos and in other parts of the supply chain. But we do think that there are some secular driving forces behind this.
Erika: And if we were to see high inflation, then what would it mean for your stock selection process and for the value stocks in your portfolio?
David: Well, certainly it opens up, you know, more cyclical investing opportunities. So sectors like energy, which had been left for dead by the market and materials and other such sectors have been sort of left behind as the market focused solely on sort of secular growth areas. And, you know, just seeing sort of inflation go through normal cycles. And the need for investment in those areas due to higher prices will lead to better performance out of that. So it just broadens out the market is a better way to put it.
Erika: Again, your point about things being more normal, the way things used to be in terms of economic cycles.
Erika: You also refer to this spread, the significant spread between the cheaper stocks and the more expensive stocks. I had a look, Robeco’s quant equity researchers researched this and they agreed with you, they conclude that the value comeback still has a long way to go based on this differential in valuations. And they’ve a paper out on that spring has sprung for value investing. But of course, one can't be absolute about these things. Just because there's a huge valuation differential doesn't mean value will keep on rallying. If you were to do a scenario analysis, what would you say could flip us back to a value underperformance in the coming months?
David: Well, I think you would have to see some sort of shock to the system, you know, maybe a recurrence or a spread of some other variant of Covid. You know, people are talking about the delta variant or some mutation that led to sort of a lockdown again. And just people lost faith in the ability to stimulate the economy on the back side of that. I think, you know, there's a huge amount of savings in consumers’ hands today, their corporate balance sheets are in a very strong place, very low levels of debt. And so really there is a fair amount and there's pent up demand. So there's a pretty good setup for this inflationary environment to take hold. But if for some reason people just decided not to consume and the aggregate level of demand was lower going forward, then you could see sort of a return to sort of very narrow secular growth themes.
Erika: The term secular, I think there might be different interpretations of what secular drivers are. Also, what if we were to look at more longer term, much more fundamental secular factors and the implications for the performance of value? So just to illustrate the point, here's a teaser. It's a clip from Meb Fabers’s The Best Ideas Show. Tobias Carlyle from the Acquirer's Funds made this point. This was just before the November rally started.
Male voice: They stitched these three datasets together to track from 1825 five to the present day. And they find that there are basically three big periods of value underperformance and they seem to congregate around these periods of technological advancement, these booms in a state. So there's one right at the very beginning of the data set in 1841. And the significance of that date is that it’s the invention of the telegraph. And so until that time, information had travelled around the world on sailboats and information got to as fast as a sailboat was being blown across the ocean, which is not very fast. And when the subsea cable came in, they got it almost instantaneously. So that triggered a value bust relative to the tech boom. There was another one that ended in 1904 was down 59%, value had trailed and then there was another one. Most recently, there's the 2000 bust was not as bad as this one. The 2000 bust was significant, but didn't kind of approach this one. We're now at 60 per cent, so this is the worst bust for value in the data. It's lagging behind the growth names by an incredibly wide margin.
Erika: They're referring to a long-term study over 200 years. But to me, what I hear there, David, is often the challenge that you have for value investors, that things have just fundamentally changed. And that other the way we look at value stocks, or just value stocks in general, are being challenged in a fundamental way because of technological advancements. How do you react to that?
David: I think he's spot on with the point that we're in a technological revolution, a renaissance in the global economy today. And honestly, that's what gives me the most excitement about the far reach of it is what gives me the most excitement about investing and value today. So what we're seeing is that every sector of the economy is now being touched by digitization and electrification. Semiconductors are the enabling technology that are creating that in the economy. And what we're starting to see is that spread into areas where tech was sort of limited or didn't have as far reach. So autos, industrial applications, other sorts of consumer products. And so now what we're seeing is that all these sectors of the economy are being transformed by technology and there are going to be winners and losers on the value side that allow us to sort of pick stocks within that. So to give you an example, the whole logistics space, which is largely, you know, considered a value investing space, is now being transformed by technology. And there are value names that are actually applying technology to gain market share, to expand their markets, to become more efficient, which should drive operating margin improvement and better returns over time. So technology is making old world businesses, so to speak, better. And that's allowing, you know, that's basically leading to emerging investment opportunities for us in the value side. So the breadth and scope of this technological renaissance is really opening up opportunities within value, whereas in the past it was only emerging new companies. And that's why I think both growth and value can work, because, you know, certainly new companies will come out of this renaissance, but old companies are being transformed and they can win as well.
Erika: So you've totally flipped the argument then on technology and the implications for value. That's fascinating. Let's go a little deeper then. What are the opportunities that you are seeing in the large cap space for value?
David: Yeah, so I certainly mentioned semiconductors. That's been an area of focus for us over the last several years. Semi cap equipment, this is a global oligopoly that basically enables all semiconductor production around the world. When we were buying these businesses, they traded at double digit free cash flow yields, low double-digit earnings multiples at the trough of their cycle. Now, they've certainly performed well. Momentum's picked up and the valuations are less inexpensive than they were, aren't as inexpensive as they were, but they're still attractive to us with compounding characteristics. You know, if you broaden out, we're starting to see, you know, certainly off the bottom, we've seen tremendous opportunities in consumer discretionary in industrial applications. So industrial machinery companies where, you know, farm/agricultural equipment that's being transformed by technology as well, where you're putting sensors on tractors and being able to sort of be more specific in how you sort of manage crops through a cycle. So it's really a broad reach between sort of traditional cyclical opportunities. You know, energy is another sector where we've really spent a lot of time recently, the market, because of concerns. And, you know, this focus on growth tech had left that sector for dead. Oil prices went negative last year. I covered the energy sector for 15 years. I never thought I'd see negative oil prices, but they went negative. And, you know, that was an opportunity for us to sort of start to enter the market, the energy space again and go overweight energy. And now we think because of neglect of the supply side of the equation for the last several years, we're seeing higher prices, which should last for a while.
Erika: What are you avoiding in stocks that or sectors that typically might be considered value? What are you avoiding within that?
David: Yeah, so within our benchmark real estate investment trusts, utilities and consumer staples are around 16% of the benchmark. They've gotten as high as 20% in the past. Now, we don't have anything against these sectors. We're not dogmatic about it, but they tend to trade at higher multiples and have less attractive fundamental and momentum characteristics. So they don't really fit our process, at the current moment. We have a significant underweight to those areas.
Erika: Then, I refer to the extreme fiscal stimulus that you're seeing in the US. What are the implications of Biden's policies in these giant stimulus packages for your stocks and your sector choices? Infrastructure is so much more of a theme these days. Sustainability, so much more of a theme in the US compared to previously.
David: Yes. So it does have a reach, but it's more limited than you would think. Right, because policies have to be approved, which we've seen. You know, they've been talking about infrastructure now for six to nine months and nothing's happened yet. It seems like we're close and then it takes time to enact those policies. Now, this is if this infrastructure bill passes, it'll be of a scale that that is sufficient to impact the revenues of a number of companies. And we have exposure. We own construction machinery companies. We own rental companies that benefit from that. We own some material companies that will benefit from infrastructure. Tax policy is certainly something that's going to impact companies within our within our universe. We've done a screen to sort of determine who's paying the lowest tax rates, where they're domiciled. And we're fully aware of, you know, who will be negatively impacted by changes in tax policy.
Erika: So on sustainability then, and you referred to the energy sector and ESG. How do you factor these concerns around ESG, whether it's the environment or just broader, S and G as well. How do you factor that into your stock selection process, your investment thinking?
David: Well, we have a dedicated team at Boston Partners that looks at ESG as it relates to every company that we own and a broader universe of companies. And so we have dedicated analysts and a team that is focused on that. It's integrated into our research process. We take the view that we don't want to exclude any sector or company for ESG reasons. What we want to do is focus on how you do what you do. So if you're an energy company, I was talking to an energy company recently, actually, that is working on ways to reduce flaring, that's working on ways to improve their water usage. And so we would rather support and engage with companies who are at the leading edge of, you know, reducing and improving their environmental impact and putting in best practices for, you know, for their workers and for other aspects of sustainability, rather than just excluding because they're involved in an industry that might be deemed, you know, sort of unsustainable over the long term.
Erika: Does that satisfy your critics, those who feel you should perhaps not be investing in fossil fuel technology?
David: Probably not all of them, but I think there is an increasing market. You know, what stands out to me in talking to clients and consultants about this issue over the last year is that everybody's trying to understand how to think about it. And so, you know, it's a spectrum. I think on one end you're going to find people who only want to invest in emerging technologies that are going to eliminate hydrocarbons and that's fine. I think that's you know, there's going to be a certain number of consultants and clients that go in that direction. And then you're going to find people who just realize it's going to be a transition and a journey over many decades and want to take a more measured approach and improve things step by step. So I think we can fill a need and match that consumers sort of desire to improve ESG issues.
Erika: David, just going back to November, when you saw the market rallying, it sustained in the weeks and now even the months thereafter with major opportunities for investors like you. How big are these opportunities? Because I believe in terms of holdings, your fund is now experiencing its biggest turnover since inception.
David: Yeah, I mentioned earlier just the excitement you feel as an investor when you see one of these markets sell off. So, you know, going back in February and March, we were reviewing literally hundreds of stocks and trying to find very specific things that we could do to improve the portfolio. So we turned over about 20% of the portfolio at the end of Q1 and early Q2. And what we're looking for was high-quality names that were on sale. And then we were looking for value dislocations, companies that had sold off more than 50%, that were being left for dead, where we thought, OK, you know, we may not have near-term visibility on this company getting back to the revenue and cash flow generating levels that they were at in 2019. But we think over a couple of years, two to three years, they ought to be able to do that. And the stock is trading at very low valuations relative to that earnings potential. We tried to avoid companies that had, you know, that had any balance sheet issues or liquidity issues in the near term. We really didn't want to get involved in anything that would pose sort of financial risk with the uncertainty around the virus and what was happening in the economy. And so, you know, we use that filter. And I'm proud of the work that the organization did during that time, both our team and our broader research department, you know, as I said, going through hundreds of names and narrowing down to the best opportunities, and it paid almost immediate dividends for us. So, you know, drove significant outperformance from sort of middle of March on last year. And that's continued into 2021 for us. So I would say the opportunities were huge initially. And then the market, you know, as we got incremental data on vaccines and reopening, those opportunities closed and the alpha was realized, we've captured some of that. And from here, you know, it's going to be more stock specific or more industry group specific.
Erika: David, I want to close by asking you some rapid-fire questions just for fun. Quick shop answer. So what's the best part of being a value investor?
David: I love stock picking. I love finding ideas that have been misperceived by the market or that have been left for dead by investors and being able to see something others don't see. I think that gives me a creative outlet to really express sort of my passion for investing. And so, you know, that's that's really what I love about it.
Erika: What are your views on the emergence or one could say the re-emergence of the retail investor?
David: Well, I would say I'm all for it. I mean, I think, you know, retail investors, practically speaking, have to be careful. You know, we're trained professionals in the industry. But if they can find ways to make money, they ought to be able to participate. I just think they should do it with eyes open and do it in a risk managed way. You know, there are plenty of I know highly sophisticated retail investors that don't do this professionally. And I know sort of reckless retail investors. And so I think, again, that's a spectrum. And I think, you know, from a professional's perspective, I think it introduces volatility into the market that we can, you know, take advantage of and exploit when stocks get overbought or oversold. And we've done some of that this year, as we've seen, you know, certain stocks get caught up in either direction on the sort of the retail trade that we've seen out of in the wake of Wall Street bets.
Erika: How do you deal with these long and painful periods of underperformance? And even I would imagine short periods must be tough. Even a month must be tough.
David: Yeah. I mean, I think, you know, for me personally, I try and keep it all in perspective. Our CEO and CIO, Jeff Feeney, talks about signal versus noise. And so, you know, I have ways that I try to find the difference to differentiate between signal and noise. Meditation is something that I've used for more than half my life at this point. That's really helped me sort of settle down my own emotions when they sort of get activated and really try and focus on what's important. And that's been a great tool for me.
Erika: What about your personal investments? Does your personal investment portfolio contain any stocks that could be considered growth-like, David? Are you consistent?
David: Well, sure. I mean, so I don't think growth is mutually exclusive from value. So I think you can have high-growth companies that are attractively valued. Right, because the value of a business is relative to its cash generating capabilities over time. So the best investment in the world would be the highest-growth company trading at a at a reasonable or low multiple. And so, yes, I am consistent with the three-circle process that we employ, but sure, I own high-growth businesses that that I think are value investments and attractively valued.
Erika: David, thank you so much for your insights and for chatting to us on the Robeco podcast.
David: Thanks, Erika, appreciate it.
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