Value has proven over the past two years that it’s not dead, after all. The rotation away from growth stocks towards value that started in November 2020 continues. But will it be smooth sailing for value strategies from here onwards?
Jay Feeney, CEO and CIO of Boston Partners, the US-based value investment house, argues in this podcast that we’re gradually returning to a more normalized pricing of risk. Listen to the full conversation.
We do not guarantee the accuracy of this transcript.
Jay Feeney (JF): So what I think people, what they confuse, they talk about visibility. And it's a very often-used word in our industry and people talk about, I'm going to wait for things to become clearer and more visible. What they really mean is I want to develop more confidence.
Male voice: Welcome to a new episode of the Robeco podcast.
Erika van der Merwe (EM): Over the past two years, value has proven that it's not dead after all. The rotation away from growth stocks towards value started in November 2020 and still continues. But the move has been in fits and starts. And let's face it, the market mood now is tense, fickle and unsure. So will it be smooth sailing for value strategies from here onwards? Jay Feeney is CEO and CIO of Boston Partners, the US-based investment house focused on fundamentally driven value investing. Welcome, Jay.
JF: Thanks for having me. It's great to be back.
EM:When we last spoke to you, Jay, it was, ironically, just weeks ahead of the beginning of this rotation. You gave us insight into what it means to be a value investor, the grit it takes to survive extended seasons of underperformance. And I distinctly remember you saying something like it had been the most stressful time in your career. What would you say has created the context for where we are today for value having come back into favor?
JF: Well, I'm glad my crystal ball was working back then. I'm not sure if it's become a little bit cloudy over the past 12 months. But you know, how many times in my career has value been declared dead? It's many times. Yesterday, it was interesting that David Einhorn, a famous US hedge fund manager, was on Bloomberg saying that he thought value was dead, which is shocking given that he's a value investor. But I think in times of uncertainty, you stick with the fundamentals and you stick with the facts. And it's very clear that the, you know, I don't think that value, quote unquote, turned around. I think what's simply happening is we're getting into a more rational pricing for risk in a more rational allocation of capital, because in the wake of the global financial crisis and, you know, ten or twelve years of quantitative easing and zero interest rate policy, we had just a massive misallocation of capital created by low interest rates and a negative and low cost of capital. And what's happening now is a regime change again, precipitated by a new trend in inflation and a new resolve by global central banks to remove monetary accommodation, and that regime change is simply restoring, I think, a more rational balance. We're nowhere near equilibrium yet between, let's call it, growth and value. But I think we're really on the threshold of watching an unfolding of a restoration of a more normal investing environment. So I'm quite positive on the outlook for so-called value investing for at least the foreseeable future.
EM: So you refer to an unfolding sort of in the early stages of that. So, by implication, are you expecting value to do much more still?
JF: Yeah, by my, well, let's step back. So from 2010 to, let's say 2016, obviously we were engaged in quantitative easing and zero interest rate policy and massive accommodation by global central banks. And then you had Covid and the amount of accommodation went parabolic. I mean, in between 2010 and 2016, by my numbers, in the United States, the Federal Reserve's balance sheet was about 5 -- pre-global financial crisis, the Federal Reserve central bank balance sheet was 5% of gross national product during the financial crisis. That expanded to 10 to 25%. And then during Covid, we went to 37% of GDP, the Federal Reserve's balance sheet. So just think about that. A third of the nominal economy, the Fed's balance sheet was that size just gives you an idea of the size of monetary accommodation. During that period from 2010 to 2016, both value and growth compounded about the same rate of return; about 13% a year. From 2017 to 2020, value compounded at a positive rate of return of around 4%. Growth compounded at 22% per year. That's unsustainable. So when people are looking at discrepancies and if value’s in favor, value’s out of favor; value didn't do poorly. It's just growth, broadly defined, went parabolic and that's what became mispriced. So value valuations never really became extended in the so-called value investment universe, but growth really became distorted.
EM: So things have changed. Now, you spoke about a regime shift. We were told at first, of course, that inflation, the rise in inflation is only temporary. Markets believed that, but it didn't turn out that way. Inflation kept rising and central banks started hiking rates in major steps. And we know from history that high inflation and high interest rates are good for value stocks. Why is that, Jay?
JF: Well, looking at the source of growth's outperformance, which again went parabolic during Covid, I mentioned a misallocation of capital, basically the cost of capital for many equities and the so-called innovation disruptive cohort, the Cathie Wood's target companies, so to speak. She manages the Ark Fund, as many people know. The cost of capital for these companies was driven to zero. And the real cost of capital was zero or negative in many instances. And by definition, when money is free or has a negative cost, you're going to get a distortion in terms of the valuations. And basically risk was mispriced. And, you know, think about the amount of money being thrown at such thematic concepts as flying cars and driverless cars and, you know, very, very long duration investments, which had very tenuous and uncertain payouts over many, many long decades. And in an environment of zero interest rate policy, quantitative easing, zero cost of capital, negative real interest rates, that's completely understandable.
Now, you clearly, on a global basis, with the exception of the Bank of Japan, you have a concerted effort to fight inflation. I mean, after a period of such massive balance sheet expansion, the monetary aggregates globally during Covid were expanding at 25, 30% per year, something like that. In the wake of that, you know, Milton Friedman said everything depends on inflation, and inflation is always and everywhere a monetary phenomenon; you know it's going to be – it’s clear we finally have the inflation genie out of the bottle. Right? It shouldn't be a surprise to anyone. Think about this. When the housing market broke back in 2008, everybody knew housing was overvalued. Cab drivers were flipping houses. And, you know, everybody's aunt and uncle was talking about investing in real estate. And the crash hat housing market was, I like to say, the most widely anticipated surprise in generations. And here we are, back with the size of the monetary accommodation that happened for the last 12+ years globally has led to tremendous inflationary pressures globally. And it’s just again, the most widely anticipated surprise, second most widely anticipated surprise that you're seeing a regime change with dramatic global tightening, a repricing of risk, a return to positive real Fed funds rates, or at least a trajectory to achieve that. And you're going to get less craziness in an allocation of capital and people are going to be less inclined to throw money at flying cars and just simply super long duration investments that are going to take decades. What are they going to want to invest in? They're going to want to invest in short duration product. Right? Obviously, Treasury bills and cash right now are probably the most popular. But by definition, value equity securities are in and of themselves relatively shorter duration instruments than these hypergrowth innovation disruptor stocks that are out there. So, sorry, for the stream of consciousness, but…
EM: I’m loving it. So we’re in this new regime, as you say. So is this a permanent shift? And even just starting at the very element of high interest rates and higher rates; so just looking at the central bank policymaking regime, how long do you expect this to last? And as for color on this, let me bring in the very same Cathie Wood that you referred to from Ark Invest. This is from her latest podcast, where she's very clear that the Fed could and in fact, should soon pivot. Here she is.
Cathie Woods: Markets are selling off across the board, and that's very unusual. It's associated with crises and more convincing evidence to us that the Fed is too tight and that it will pivot. And when it does, it will do so, we think, significantly. Now, if you take equities and bonds and look at what's happened since the peak, you will see that the loss to investors is more than twice what we saw in ’08, ‘09. That's how bad this is, because bonds are selling off with stocks this time.
EM: So it was extreme. It's still extreme. How much longer could this transition, painful period last?
JF: The short answer is, I don't know. But, you know, listening to that audio snip, you know, I'm reminded of Warren Buffett and Charlie Munger's Partners’ famous comment that, you know, the standard human condition is ignorance and stupidity. And when I hear that and I look at somebody talking their own book, it's just shocking. I mean, Cathie Wood's fund has continued to collect net inflows. It's one of the few funds out there that's been collecting net inflows during this period of instability. And, you know, I think she fancies herself as some type of Pied Piper. And she's the poster child right now that we have not experienced and broken this buy-the-dip mentality. There's this buy-the-dip mentality that's persistent in the investment, in the community of particularly retail investors out there. We haven't seen panicked forced selling at this point, which I think we're probably going to see at some point in the next, you know, in the next couple of quarters. I mean, just as an aside, the inflation statistics came out this morning in the United States and they were, you know, a negative surprise. You see a fairly negative reaction in the market. And I think, you know, she's a classic example and I think she's going to be representative in this generation. Just like back in the Internet bubble, there was a group of investors that are basically, you know, time will tell, we'll go back and look at and say, you know, what were we thinking by investing in that stuff? So I can't answer your question in terms of how long the so-called regime will last. But look, we've broken a 40-year trend in, just looking at the ten-year yield. And, you know, trends tend to continue. So I don't think, in the early stages of the recognition of inflation, you know, ‘transitory’ was thrown about quite readily by both investors and central bankers alike that, clearly, that term has been retired. It certainly doesn't feel, if you look at the underlying trends in inflation rate now, that the Fed is prepared or poised to pivot any time soon.
EM: And then if you say the Fed isn't about to pivot and he's got this powerful policy tool, he said he's not afraid to use it, the policymakers are clear that we, you know, we could head for a recession. What if we were to extend that further? If we were to hit a deep recession, what would that mean for value investors? Is there a threshold of economic growth below which value stocks will end up struggling?
JF: Well, right now we've seen in the last two or three months or maybe even in the last couple of weeks, we went from having probably equities were not fully reflecting a so-called peak Fed funds rate. And basically, as we speak, higher Fed funds rates, higher rates are finally being reflected in equity pricing. But I don't think equity prices fully reflect the potential impact of a recession on earnings. I think this is going to be a very important reporting quarter to get some insight as to where companies are guiding in terms of downward guidance anyway, in terms of their outlook. Sure, in a big market downdraft, are equities potentially going to drop across the board, of course. But on a relative basis, I think the degree of safety offered by lower, multiple, more appropriately valued stocks than we're seeing and holding in our portfolios, particularly with a quality overlay, I think, you know, remain quite attractive.
EM: So [that] prevents you from going for those stocks that are cheap for a reason. So very much focused on picking stocks that can survive heavy downturn with that margin of safety.
JF: Yeah, well, you know, our approach is pretty straightforward. You know, we're looking for three characteristics. You know, obviously the first and most important is we’re looking for attractive valuation in relation to its profitability; cash generation and obviously its growth profile. But we're also looking for signs of positive underlying business momentum and catalysts for change. And we're obviously looking for fundamental quality and stability of earnings, stability of revenues, consistency as well as favorable capital allocation. So you mix those three kind of attributes and then you generally have a better momentum, higher quality portfolio which is done compounded at decent rates of return over the last several years. It's just that in an environment where the Fed has created a zero or negative cost of capital for certain companies, you know, we were lagging in that period. And I think you're going to just see a fairly significant correction of the high multiple cohort, which there are a lot of stocks still trading at very high multiples of earnings and sales out there. And I think they're going to be most at risk. And I think a lot of investors out there have not got the memo yet that they hold a lot more risk in their portfolios than they think.
EM: So is that particularly on the growth side? So my question would be, what do you see happening on the growth side of the markets? So it's clear that you expect more unwinding in that area. The last time you spoke about the extreme valuations that growth stocks had reached.
JF: And yeah, beyond that, Sorry to interrupt! You know I think the Russell 1000 growth, you know, which is not a necessarily a low-quality portfolio but it's clearly a growth benchmark. I think it's somewhere around 40% overvalued relative to value. So, you know, some people think value's outperformed over the last year. It's probably, has, it run out of steam? You know, if I pencil it out, it looks to me like growth remains 40 plus percent overvalued relative to value. So I think this cycle has quite a bit of runway left in it. EM: But that brings me back to you quoting David Einhorn right at the beginning, because my reading and understanding of the quote, Bloomberg's quote of him was that he sees himself as a value investor and says that because of what we've been through with the performance of growth stocks and given the macro environment, that people have simply lost the ability to do proper value investing. And that's exactly what you're describing.
JF: Well, he said, you know, a lot of a lot of value investors and, you know, a lot of value investors who ran hedge funds, just shut down. And they've exited the business because, you know, they just couldn't take it anymore, which is understandable. You know, it's difficult to wake up every day and have people snickering at you like, well, wow, I can throw money at a passive index fund and basically compound, a growth fund, and compound at 22% a year. And you know, you value people can only deliver us 3, 4% per year and it's hard. And so I think he's talking about the fact that, you know, a lot of a number of high profile value investors have called it quits. Yeah, they've just given up.
But more, I think the other aspect of it, that he may not have addressed directly, is that a large amount of trading nowadays is computer driven, algorithmically driven, rules based, factor driven. And so there's just on the margin, there's been a degradation in the amount of fundamental bottom-up analysis that's taking place on the margin. There's the balance of investment flow is being driven by quantitative algorithmic and non truly non fundamental, certainly not value investors. And so, you know, I detected a lot of frustration and he's a very talented value investor and it's kind of a bummer to hear that when he says you know maybe it is dead but I don't think he really believes that. I think he's actually looking at the environment right now and he sees what's unfolding is probably one of the better opportunity sets of that's materialized in many, many years. And we believe that too.
EM: Jay, you mentioned passive investing. Do you see any merit in this very strong drive towards passive investing solutions in the industry, whether philosophically or even from the perspective of the current composition of indices?
JF: Well, you know, it's a tool. I mean, you know, Warren Buffett pointed out many years ago that if you're not willing to invest any time in doing any type of research whatsoever, you're probably better suited in just simply buying a passive index, you know, an S&P 500 and just sitting on it over time. And you'll probably do fine. You know, the problem is, as I mentioned, that I may or may not have mentioned, is that, you know, the indices have become incredibly top heavy and concentrated in a fairly small number of high multiple stocks. And you know who the names are. We all know who they are. And I'm not saying those are low quality companies by any stretch, but, you know, they're trading at 20, 28, 29 times earnings. And that certainly doesn't set the stage for favorable returns.
So passive investing, it's certainly an effective and useful tool for a whole range of applications. And I certainly think it has an important place in many, many, many investors’ portfolios. But after a massive misallocation of capital that's been driven by global central bank easing for such a long period of time, I've mentioned the distortions in pricing are clear and I do believe that active investing; thoughtful, active investing based on bottom-up fundamental analysis is able to differentiate and outperform. I know, I know. Our track record certainly demonstrates that.
EM: Jay, where are you creating advantage for your clients? Where do you see most opportunity right now without getting too specific on stock names, but sector-wise, theme-wise?
JF: Well, I mean, the health-care sector has suffered for many years just with a political overhang in the United States, particularly, you know, pharmaceuticals and things like that. But across that whole space, there's an enormous amount, I think, of mispriced names relative to the underlying fundamentals and pipelines of the company. So we generally maintain a pretty healthy allocation there. Financials recently have done a little bit better, but overall during much of this cycle, they've lagged technology names quite considerably. And I think and we certainly have a decent representation in the financial sector, as does energy. Energy certainly has a lot of positive momentum right now and it's benefiting, frankly, from the underinvestment which is materialized for a lot of different political and non-political reasons and the geopolitical as well. But energy is an area where we do invest and we have some exposure and it's been a contributor year to date. And I think if you simply look at the fundamentals in that space. There's opportunity there as well.
EM: Great. Thanks, Jay. So drawing it all to a close, are you convinced that a focus on value will get us through the hard times, which undoubtedly are ahead for all of us? Now, for background to this question, Robeco recently published its five-year outlook, which it entitled ‘The Age of Confusion’, of course, referencing the fact that there's limited visibility right now on important macro variables, the fact that uncertainty reigns. And perhaps even gloomier than that title is a comment by Robeco’s Pim van Vliet. He says stock markets are going through a regime shift, moving from a growth mindset to what he calls a survival mindset. And he says that means investors will need to think which companies will still be around in ten years’ time. So all pretty dramatic, quite gloomy. What do you see in the time ahead?
JF: That's a pretty open-ended question. The one word that jumped out to me was, you were quoting, but the term ‘visibility’ and I don't believe there's ever any visibility in investing, you know, simply because your return is predicated on the future. And the future by definition is unknowable. So what I think people, when they confuse; they talk about visibility. And it's a very often-used word in our industry. And people talk about, I'm going to wait for things to become clearer and more visible. What they really mean is I want to develop more confidence. You know, our confidence, my confidence as an investor just simply stems from adhering to certain, immutable, inexorable facts. You know, we call them laws of physics, and I'll go back to it. And the price that you pay is the most important decision that an investor can make. And, you know, the price that you pay is the most important single decision you can make. And prices are getting cheaper right now. And so basically, that to me, I'm becoming more confident and more emboldened now, simply because as we return to a more normalized pricing of risk and shelving the TINA, there's no alternative and zero interest rate policy in quantitative easing. And getting back to simply a more normalized cost of capital, fundamentals will matter, valuation will matter. And like I said, normalcy will return. And the balance, the imbalance between the innovation disruptor stocks and the whole growth complex versus the so-called value old economy will become to be more normalized. So, confusing time. Yes. A lack of confidence. There's never going to be visibility, but I certainly have a great deal of confidence that any investor that basically pays a reasonable price in a high quality company that pursues favorable capital, shareholder-friendly capital allocation is going to do well.
EM: Jay, you certainly are a man who sticks to his principles. Thanks for making the time for us; the wonderful insights and reflections and wisdom.
JF: Sure. Thanks for having me.
EM: And to listeners, thanks for being part of our conversation. We'd love to hear from you. Please do send us your comments, your feedback and suggestions to email@example.com. And you'll find all of our podcasts on your favorite podcast platform as well as at Robeco.com.
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