With macroeconomic data telling two different stories—one of low unemployment and robust earnings, another of high inflation and rising interest rates—Luke Casey of Pyrford International provides an inside look at the investing factor that’s making a surprise comeback: Value.
A resurgence in value strategies
Supply chain disruptions, geopolitical conflicts and central bank policies devised in response to COVID-19 – all of these factors have helped create a volatile market in recent years, which in turn has seen institutional investors flock towards pockets of growth in the face of market fragility. We’ve seen impressive runs made by ‘lockdown winners’ and more speculative pockets of growth. And while a flight to growth can be natural, this unique run for growth-oriented equities has led to many investors missing out on a key investing trend: the return of value.
As the world settles into a begrudging acceptance of living with COVID-19, economies are more or less reopening. Current forecasts are realigning with pre-pandemic predictions for economic growth, and fundamentals are coming back into focus. This creates a very favourable environment for value portfolios, which are designed to compound steady earnings year after year and capitalize on equities that were acquired at an undervalued market position.
Consider how this contrasts with growth portfolios. While they continue to attract headlines and at times demonstrate eye-popping surges in share price and revenue, you’ll notice that the cost for these assets is reaching exorbitant levels. In other words, you’re paying a large premium for projected earnings at a time when interest rates are on the rise—a trend which disproportionately impacts growth assets.
What’s more, these strategies are known to sport a high degree of risk and volatility. Couple that with an unpredictable market still beset by uncertain inflationary effects—and an ongoing war in Ukraine—and it’s no wonder risk-conscious investors are seeking out assets better designed to withstand the present volatility. It’s our view that value investing offers the ideal solution to the ongoing challenges, as well as upside participation in a fully restored, post-pandemic economy.
Avoiding P/E traps
In general, price-to-earnings ratios (P/E) have perhaps diminished in terms of how much influence they hold on investors, with a long-term trend towards higher P/E ratios generally on the S&P 500.
It is now more or less common for investors to feel as if they need to stomach high P/E ratios in order to obtain decent earnings growth. As value investors, we disagree—we simply don’t believe in growth at any price, preferring instead to look for quality companies that have pulled back far enough for their stock price to be attractive.
Real S&P 500 10-Year P/E Ratio
With economies reopening and the market re-settling (at least in terms of lockdowns and restrictions common of the pandemic era) you are more able to buy reasonably valued stocks – which is to say stocks that trade at reasonable P/E multiples and dividend yields – because economic growth is, broadly speaking, healthier.
This healthier economic growth will naturally be a boon to a greater variety of sectors, leading to higher potential for improved earnings growth across a wider range of assets. Looking back, this contrasts with the pandemic mindset where some investors felt you had to search out speculative assets operating in niche industries or subsectors, and that these assets had to dominate their niche in order to ensure sufficient earnings growth.
While all holdings must adhere to strict quality criteria, not all high-quality assets in the world will meet our tough valuations standards.
But the most recent quarter has demonstrated that more seasoned industries (and assets within those industries) have been able to compound their earnings because of economic growth that’s more evenly distributed. Which isn’t to say that no remaining issues exist with respect to supply chains or continued inflation. But compared to the past couple years – which were marked by total economic shutdowns – the “rising tide” of broader growth is a marked improvement.
Under the hood: BMO value strategies
With the BMO International Value Fund, we favour quality stocks that display compounding value and stable returns through dividends and share price growth. While all our holdings must adhere to strict quality criteria, not all high-quality assets in the world will meet our tough valuations standards. Take quality technology names in Europe: some became more attractive to us throughout the past several months, but they remained too overpriced to be included in our portfolio. Instead, we’ve opted for patience—rebalancing according to the changes in the European market, but ultimately leaving our portfolio largely untouched in regards to new positions. Our most recent new country allocation being Indonesian assets due to the currency retrenching to a more reasonably valued level through 2020.
Other assets did become more attractive, growing cheaper over the past several years, especially among several European banks. But their cheapness was offset by the quality of their earnings. These banks needed steeper yield curves to increase profitability. Short-term rates are increasing at a much faster pace than the long-end rates, which effectively means the yield-curve is going against them.
Our preference tends towards true quality investments, ones that are positioned to benefit long-term amid economic recovery and restored health. What’s more, our bias towards quality assets with strong industry positions, has our portfolio positioned to be better protected in the event of prolonged inflation with many names having previously exhibited the ability to pass on cost increases.
While some investors are looking for compelling turnaround stories, it’s important to remember one critical fact: there’s a reason they were down in the first place.
While many assumed inflation to be transitory, the reality is that inflation continues to be top-of-mind for many economists and investors. Furthermore, continued pressure from the war in Ukraine could accelerate price growth in the next several quarters, perhaps longer.
As market leaders, many of the companies in our portfolio have the pricing power to offset inflation pressures, making them more durable through a tough economic climate. While there may be margin pressure in the near term, over the longer term these durable, high-quality names will be better positioned to adapt to an inflationary environment. It’s also worth noting that larger sectors, such as telecom, have been generally less impacted by inflation, which makes them good areas to overweight in our portfolio.
Why compounding matters
The market has seen some tech, freight and healthcare companies fluctuate from “highly overvalued” to simply “overvalued” during recent months. However, we’re still cautious. While some investors are looking for compelling turnaround stories, it’s important to remember one critical fact: there’s a reason they were down in the first place. Our value and quality biases ensure that we avoid these potentially volatile picks in favour of more sustainable growers.
Another area of interest to deep value hunters has been the market for initial public offerings (IPOs), which experienced a boom in recent years due to the introduction of Special Purpose Acquisition Corporations (SPACs). These highly speculative vehicles allow companies to go public without the regulatory reporting standards required in a traditional IPO, and in our experience, they are not very indicative of long-term value, nor quality for that matter.
We’ve witnessed these types of speculative assets slam into a roof and collapse. Sometimes they bounce back, sometimes they stay down, and other times the cycle repeats. But with a focus on value, quality and fundamentals, we’re able to leverage the “Low Volatility Anomaly” to produce compounding gains year over year—no matter the market. Time and again, research has shown that it’s nearly impossible to time markets exactly right. So, if you have capital that needs protection but you also want to grow, then low volatility offers a powerful core holding, especially at a time when the macro backdrop features significantly higher geopolitical risk and inflation.
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