Sector Repositioning Favoring The ‘Value’ Style
AT A GLANCE
· Since the 2008-2009 crisis, the ‘Growth’ component has dramatically crushed the ‘Value’ segment in terms of relative performance. There are a number of reasons for this, the main one being the marked decline in interest rates owing to slower growth, sluggish inflation and persistent monetary easing.
· The Value segment contains more cyclical companies that, on a relative basis, underperform when the economy slows down and indicators such as the purchasing managers' confidence (‘PMI’ or ‘ISM’ indices) decline. On top of this, most value sectors suffer from disruptions
· A structural recovery in growth, a sustained rise in interest rates, a pickup of inflation and a steepening yield curve: these are the elements that would be needed to reverse the trend, which goes back many years. It may still be slightly too early to conclude that this is the right time, at least in a structural way, but value stocks have rarely been so cheap from a relative point of view.
· Given improving sentiment but ongoing uncertainties, it is better to be selective. We find value in American Financials and Insurance globally, as well as in European Technology and Construction Materials. On the other hand, we remain careful on Consumer Staples and Industrials as these are not cheap.
If we consider the stock market as a pie, we can imagine different ways to carve it up. A widely-used method is to divide the pie into a ‘Value’ piece (relatively cheap stocks, often paying high dividends) and a ‘Growth’ (growth stocks) piece. Since the 2008-2009 crisis, the ‘Growth’ component has dramatically crushed the ‘Value’ segment in terms of relative performance.
There are a number of reasons for this, the main one being the marked decline in interest rates owing to slower growth, sluggish inflation and persistent monetary easing. This is particularly true in Europe, where financial stocks account for a substantial part of the indices. Low interest rates are not good for the Financial sector…
In addition, growth stocks, by definition, expect a large share of their cashflow and earnings in the future. Financial models discount the future at a present value. However, a lower discount rate (the discount rate is linked to interest rates) increases the present value of this future, which is another reason why growth stocks are more attractive than value stocks when interest rates are low and declining.
On the other hand, the Value segment contains more cyclical companies that, on a relative basis, underperform when the economy slows down and indicators such as the purchasing managers' confidence (‘PMI’ or ‘ISM’ indices) decline.
Finally, investors are often willing to pay more for growth when it is scarce. This mechanism can be compared to fashion, to a certain extent.
Cautious rise in Value stocks
Since mid-August, Value stocks have started to catch up. The recent rise in bond yields - following their abrupt fall at the beginning of the Summer – and the now very accommodative monetary policies to boost the economy are certainly in large part responsible for this.
A structural recovery in growth, a sustained rise in interest rates, a pickup of inflation and a steepening yield curve: these are the elements that would be needed to reverse the trend, which goes back many years. It may still be slightly too early to conclude that this is the right time, at least in a structural way, but Value stocks have rarely been so cheap from a relative point of view. Looking at the MSCI global indices, the growth index has an expected price-to-earnings ratio for 2019 of 21.12 and that of value stocks: 12.84. The premium is around 65% and it even exceeded 80% during the Summer! Price-to-book ratios show an even bigger gap: 4.56 for the growth style and 1.67 for the value style. It was only at the peak of the internet bubble that there was a higher premium in the price-to-earnings ratio: 92% at the time. And it was just before the value segment posted a spectacular outperformance…
Cheap for some good reasons
However, apart from top-down catalysts, there are also a number of sector-specific reasons from a bottom-up perspective that have given value stocks a difficult time recently. Cyclical stocks are suffering from a slowdown in growth. Meanwhile financials are struggling in an environment of low (or negative) interest rates, especially when the yield curve is (too) flat. Increasingly stringent standards, requirements and controls have also structurally increased bank costs.
On top of this, most value sectors suffer from disruptions: digitalisation and other financial technologies in the financial sector; online advertising and e-commerce in the media and retail sectors; and in the automotive and energy sectors: a tightening of emissions standards and the uncertainty surrounding the revolution in electric and self-drive vehicles.
The watchword is selectivity
Given ongoing uncertainties, it is better to be selective. At the outset, however, globally the cheapest and most obvious cyclical sector is the Financials (our recommendation has increased from neutral to positive). The sector's 2019 price-to-earnings ratio is overall 11.3 (as a reminder: 12.84 for the MSCI Global Value Index). The 3Q19 results and the health of major US banks and other US Financials are quite encouraging, hence our positive recommendation. The same applies to the Insurance sector (a positive recommendation too) in the United States and Europe. Although some selectivity is preferable, in general, insurers' shares are cheap, last published results were good, especially in Europe, and the dividends remain attractive.
We are, however, keeping our recommendation on European Banks at neutral because, i) growth and inflation in Europe remain weak; ii) numerous banks in Europe are still fragile, iii) negative (refinancing) interest rates will continue to hurt the sector for a long time, iv) the new regulations are relatively burdensome and restrictive, v) there is a trend of losing market shares, particularly in investment banking to American banks, vi) uncertainty over Brexit (a strong headwind above all for UK banks, which are expected to lose market share to eurozone banks), vii) digital costs, viii) in Northern Europe, scandals of banks involved in money laundering, damaging the reputation of the financial industry. However, some banks are likely to do well, especially the strongest (well-capitalised) banks that operate in an already well-consolidated market. These are mainly large banks in core eurozone countries (France, the Netherlands, Belgium).
We would return to positive more generally on European Financials if the economic recovery were to accelerate, for example in the event of major stimulus packages, particularly in Germany.
We also recommend awaiting on the Real Estate sector after its good performance so far in 2019 (we have downgraded our recommendation from positive to neutral).
As discussed above, some technological disruption is affecting the financial sector. Why not then benefit from the relatively low valuations of European Technology stocks (positive recommendation) relative to their US peers and even, in absolute terms, given the cyclical improvement but also the growing share of this sector? In addition, most of these companies have reported good 3Q19 results and bright outlooks.
In any case, one industry that remains attractive and less affected by disruption is Building Materials. These are usually local companies; we don’t think people will be able to purchase a bag of cement or a pallet of bricks on Amazon soon! Moreover, this sector will undoubtedly benefit from growing government investment in infrastructure. After the underinvestment situation that has persisted for many years in this segment, a catch-up movement is likely to begin. And if the authorities in question pull the plug on investments to counter a further slowdown in the economy, this movement would only be more marked. Didn't Mario Draghi himself say that it is now up to the governments to stimulate the economy? Mrs Lagarde also seems to support this view. We therefore favour Building Materials in Europe (positive recommendation), which have in general reported good results for 3Q19 and which trade at reasonable valuations, compared with other industrial stocks in Europe but also in the United States (more expensive). It can also be seen that costs are rather well controlled in the sector, with some pricing power over customers.
We remain a little more doubtful about the fossil Energy sector (neutral) although it is cheap. The energy transition will continue to squeeze demand and force the Oil Majors to restructure, which will consequently keep pressure on their suppliers (oil services). Investment in the environment is booming, which could benefit some of the leading industrial/utility companies, especially in Europe.
In the Industrial and Consumer Cyclical sectors, on can certainly find some discounted stock opportunities. But in general, these sectors are not cheap and/ or still face many disruptions, making them moderately attractive. We are, however, interested in some companies that are active in the transport, automotive and travel business.
Finally, remember that the sector that is the most inversely correlated to the economic recovery is Consumer Staples, still very expensive today; hence our negative recommendation on this sector.
These are all investment ideas to be considered before the great wave of Value pours onto the market and sets in motion all the boats of value, even those that now seem to be quite bogged down…