Over the past decade and a half, growth-oriented investors benefitted from the one-way movement of interest rates to zero—first in response to the 2008 financial crisis, then a sluggish recovery and finally the pandemic. Now that both inflation and interest rates have reset higher, managers have scrambled to reposition portfolios.
Our view is, we’re in a new prevailing environment. The pre-pandemic winners, and those through the COVID-19 euphoria, won’t be the stocks that lead over the next five years. There will, and should, be a heightened awareness of what investors are paying for earnings, the quality of those earnings, and the impact interest rates will have on a company’s bottom line, which for years investors could almost disregard.
No more. Refinancing risks are mounting, creating the need to take a more discerning approach to identifying stocks with solid balance sheets and sustainable earnings growth. In short, a focus on quality and value.
Pinch point arriving
Sustainable dividend yields, return-on-equity and low leverage are characteristics that should be rewarded in this high-rate era. Value-focused portfolios that compound steady earnings year after year, built on quality equities acquired at attractive levels, should generate a positive absolute return over the long term, with a better risk reward trade-off over a comparable index.
Before the pandemic, markets were generally trading around 17 times price-to-earnings (PE). The central-bank fuelled flourishes of 2020 and 2021 saw multiples climb to around 30x PE at the aggregate index level. Rate hikes and the subsequent correction of last year have again brought PE ratios back to where they were before COVID-19. But the question now is, what will earnings look like going forward, and how much should investors pay for them?
The historically sharp rate hikes over the last year are approaching an inflection point. The delay from monetary policy is fading and we should begin to fully grasp the impact those hikes will have on companies and the real economy—in other words, the pinch point is beginning now.
For leveraged firms, this poses problems. Many corporates managed to refinance through the pandemic at ultra-low rates, but over the next few years those rates will reset. When new debt is raised, it will be in a very different environment, and we expect to see ample pressure across the marketplace for companies that have less sustainable leverage profiles. To be sure, markets are less expensive than they were 12 months ago, but we would argue they are still pricey. There is going to be increasing pressure on earnings, in which case, investors will still be overpaying even at 15x PE.
There are of course compelling pockets both at the country and individual stock levels, respectively. Asia, excluding Japan, contains markets priced at attractive valuations. At the company level, there are world-class names throughout Europe and in Emerging Markets, but managers need to look past the aggregate picture to individual opportunities.
2022 case study
Our response: Pyrford International-managed funds are the allocation that when markets turn volatile, clients can be assured that their capital resides with a responsive, defense-oriented manager. When the BMO International Value Fund is paired with a growth equity allocation, our strategy can provide downside protection while strengthening the asset mix at the overall portfolio level.
Our approach takes a five-year view, and starts with a country-level assessment before looking at individual stocks. The geographic backdrop must demonstrate supportive economic growth and markets that are undervalued compared to peers. At the stock level, we look for companies that have almost oligopolistic structures—entrenched industry positions that allow for price and wage pass-throughs to customers.
We also place a specific lens on low leverage, dividend yield and ROE, targeting not necessarily high yields, which can be a red flag in terms of payout sustainability, but rather affordable yields. Ideally, ones that are growing incrementally each year.
Growth, still overvalued
Growth has always been more expensive than value because investors are paying for the promise of greater future cash flows. Historically that premium has been in the 40-50% range, a gulf that climbed to 100-110% above value stock PEs during the pandemic, or twice as expensive (see chart). Yet despite last year’s correction, growth still trades at a significant overvaluation, in our view.
Going forward, with a growing awareness of the impact higher rates will have on earnings and cash flow, value should close the gap. Typically, growth stocks trade about 1.4x relative PE to value stocks, or as mentioned, about a 40% premium. Since 2020 that multiple has hit 2.0x or higher while value stocks have seen in many cases price-to-earnings multiples fall. Proportionately, that means value has actually gotten cheaper as a percentage relative to growth, which we see as a catalyst for downward pressure on growth stocks.
MSCI World Growth versus Value – PE
Source: Refinitiv Datastream/Pyrford International, January 2013–March 2023.
The discussion now is, to what extent can central banks successfully quell inflation without inducing a recession? If central banks overtighten and trigger recessions, that will provide us with opportunities to buy stocks that over the subsequent five years will drive our returns, providing that compounding rate that we look for. Our primary task is to apply our stock-screening methodologies up front, identifying opportunities that may be overvalued at this juncture but could, through a downturn, reach entry-level valuations.
We of course don’t know when or how deep a slowdown will be, but the market is indicating there will be one. Inflation pressures aren’t falling away as quickly as the market had hoped, and higher terminal rates will exert pressure on markets. When that happens, there can be opportunities to identify and pick up some high-quality companies to add to the BMO International Value Fund—which is exactly what we will look to do. We believe there will be many value plays for investors like us as we move through 2023 and into 2024.
Please contact your BMO Institutional Sales Partner to learn more about the Pyrford International team, and the BMO International Value Fund.
1 Annualized performance:
Value Fund – Series I
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