Comparative valuations, as measured by their price-earnings ratios, have diverged significantly across global sectors and geographic regions over the past couple of years: strongly up for some sectors and regions, and down for others. Such anomalies present opportunities for the value investor. History teaches us that we will likely see a normalization of these tendencies. History also teaches us, though, that discipline and a long-term view are required to capitalize on this trend.
Nowhere is the gap in comparative valuations more evident than between traditionally defensive global sectors and economically sensitive industries. A likely reason for this is the institutional market’s willingness to pay an increasingly high premium for bellwether stocks that can better absorb the impact of economic uncertainties and generate dividend income. Indeed, P/E ratios for sectors historically associated with value, such as utilities and consumer staples, outpaced their ten-year averages throughout 2013. In 2014 and the first half of 2015, valuations in those fields have zoomed even higher.
Some traditional growth sectors have also seen valuations spike since 2014. Last July, Federal Reserve chair Janet Yellen pointed out that “valuation metrics in some sectors do appear substantially stretched” and specifically mentioned smaller firms in social media and biotech.
At the opposite end of the spectrum, we are finding pockets of value in economically sensitive names. With geopolitical and macroeconomic risks looming across the globe, investors have neglected certain regions and sectors amid hard-set pessimism. Many Russian natural-resources companies and Chinese banks saw their price-to-book-value (P/B) ratios pushed to multiyear lows in 2014. These types of stocks, in our view, give rise to opportunities for equity investors.
Of course, looking for stocks that trade below intrinsic value — at the right price — is nothing new. In our view at State Street Global Advisors, investors should not simply pile into stocks that are at the bottom of P/E rankings. After all, some stocks are cheap for good reason.
At State Street we look for stocks where sustainable economic profits are underappreciated in market valuation and where we believe negative outcomes are already largely priced in. This might include stocks with cyclically depressed earnings or stocks where there is a perception that earnings power has been impaired. With a sufficient discount to intrinsic value, we feel we can look through the uncertainty of near-term earnings outcomes.
Take the 2011–’12 crisis in the euro zone, for example. We surmised that pricing on European bank stocks was too pessimistic. Buying good franchises when uncertainty was high ultimately paid off. Indeed, the P/B ratio of European banks has almost doubled over the past five years despite a continued decline in return on equity. In early 2014 we highlighted an opportunity in Chinese banks. We thought valuations implied a material decline in returns and nonperforming loan ratios of about 8 to 10 percent, compared with the 1 percent reported, and therefore the extent to which the negatives were already priced in seemed compelling. In addition, we saw the Chinese banking sector as being well capitalized, with strong preprovision profitability. Although there were concerns around liquidity, we concluded that the system was protected by a low loan-to-deposit ratio and a semiclosed capital account. In the past 12 months, Chinese banks have rerated strongly as investors have become less concerned about the near-term outlook for nonperforming loans and more focused on the cheap valuations.
We also find value in the Russian oil sector, where we believe we are being paid to wait for earnings to turn around. As with other companies in the broader global oil sector, Russian names have been prone to falling production, increasing capital intensity — and, until recently, no obvious path back to growth. Combined with geopolitical concerns, it is easy to see why investors might deem this area too risky. Despite the market fluctuations, however, earnings power has actually been stable over a decade, and we believe that, fundamentally, several companies in the sector have turned a corner in terms of cash flow per barrel and production growth. In essence our philosophy often brings to light certain stocks that may not seem attractive based on economic risks but are actually priced at a point where they make sense. (It must be said that in recent times this call has been quite painful for us, as we have felt the brunt of a currency crisis and falling oil prices.)
The implementation of our philosophy requires something of a contrarian mind-set. We regularly find ourselves researching stocks that are in the teeth of bad news. Our value approach has taken us underweight to more highly rated defensive sectors such as consumer staples — a call that has cost us in terms of our short-term performance. Importantly, our value investment strategy is long-term. To paraphrase the pioneering value investor Benjamin Graham, the market over the short term is like a voting machine or a popularity contest. Over the long run, however, it’s a scale reflecting true fundamental value. Rarely has this been more the case than now. Investors who emphasize fortitude over the long run can potentially reap the benefits as neglected stocks come back into favor or realize their unappreciated earnings power.
Please refer to State Street Global Advisors’ longer version of this piece for additional details on the firm’s value strategies.
Rick Lacaille is global chief investment officer of State Street Global Advisors in London.
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