Value stocks come from larger and more well-established companies which are undervalued, due to the size of the companies and reputation, they are, at least theoretically, considered to have a lower level of risk and volatility associated with them. After almost a decade of growth investing, the increasing inflation, and the decision of central banks to also raise interest rates, have created the perfect opportunity for value investing.
With all the above in mind we have asked some questions on the topic to Ben Inker, Co-Head of Asset Allocation at GMO and Léon Kirch, Managing Partner, CIO European Capital Partners, who have been focused on value investing for years, so we can understand better what type of companies within value investing could be more interesting at the moment, what sectors as well as what geographical areas.
On this first note, Ben Inker, Co-Head of Asset Allocation at GMO, says that while a weakening global economy is often claimed to be a negative for value relative to growth stocks, at GMO they think the fundamental impact of a recession would be pretty similar on both groups, so even if a recession looms that would not scare them off from value today.
He states that from an absolute perspective, the weak equity markets of the first half of 2022 has left the absolute valuations of value stocks looking much better than they did at the start of the year.
“We would warmly recommend value investors today to focus more attention on the valuations within sectors rather than focusing primarily on trying to pick the perfect value sector.”
Ben Inker, Co-Head of Asset Allocation at GMO
Léon Kirch, Managing Partner, CIO European Capital Partners, mentions that the current spike in inflation numbers is proving to be far from temporary as the rising commodity prices are gradually feeding through the value chains and ultimately leading to higher consumer prices for many goods & services. And points out that the end of “free money” has had profound implications for financial markets.
As the Luxembourgish expert says, in a world where the cost of capital increases, valuations matter again and some of the market excesses of valuation and financial engineering are being whipped out. Some of prominent examples are the SPACS, the MEME stocks and ARK Innovation, he says.
He continues saying that, on the other side of the spectrum, value investing, focussing on the price being paid for an asset and the earning power of the underlying businesses, can shine again. Secondly, the success of passive investing has led to a situation where all market participants own the same stocks and their share price moves are guided by the inflows/outflows in these ETF’s and not the fundamentals of the underlying businesses.
“We are focussing on so-called quality value, and avoiding deep cyclicals that could prove to become value traps as they are not able to pass on at least part of the higher input prices to their customers.”
Léon Kirch, Managing Partner, CIO European Capital Partners
Mr. Kirch mentions that for value investors, the fair value of business is the present value of the discounted cash flows, and as the price finding mechanism in the stock market is disturbed by the emergence of passive, the awakening should be brutal for some investors once they discover their investments are not supported by fundamentals.
Thinking of the type of companies that could be more interesting at the moment, Mr. Inker says that they try to cast a broad net when looking for attractively valued companies and so they do not restrict themselves to a particular type. He says that 18 months ago it was largely ‘reopening’ plays that looked most attractively priced, but today on the contrary they find attractive stocks are more evenly spread across industries and size bands. He remarks that they are trying to maintain strong standards on the quality of companies they are buying today given the potential of corporate cash flow to weaken from here, but they have no trouble finding attractively priced companies within the ranks of higher quality companies.
Léon Kirch, from his side says that they are focussing on so-called quality value, and avoiding deep cyclicals that could prove to become value traps as they are not able to pass on at least part of the higher input prices to their customers.
On this note, he says, they look for companies that have so-called “moats”, like a strong brand name, a franchise, intellectual property, economies of scale or a market leading position, that gives them pricing power, and he says that they remain convinced the companies that will outperform are presenting 3 characteristics, they show solid earning power due to their strong moats protecting them against inflation, they are trading at substantial discounts to their fair value, and finally they have strong balance sheets and generate positive cash-flows protecting them in a more difficult operating environment.
Talking about what sectors could be more relevant at the moment Mr. Kirch says financials, industrials and consumer discretionary are the top ones, on his side Mr. Inker agrees with the financial and industrial sector, and also adds some less ‘value-y’ sectors like health care and technology hardware. An he says that they would warmly recommend value investors today focus more attention on the valuations within sectors rather than focusing primarily on trying to pick the perfect value sector.
Thinking about what geographical areas are more interesting for them, Léon Kirch says that regardless they do not focus on specific geographical areas and rather in companies, at the moment they like Spanish banks ( Caixabank ) due to the exposure to mortgage loans when interest rates increase, and on the other hand they are trying to shy away from energy-hungry German chemicals that depend on Russian gas.
Ben Inker, on the other hand says that from his perspective their current favorite regions are the emerging markets and Japan from an absolute valuation perspective. He says this is largely driven by the fact that these regions are the cheapest in absolute terms and the value spreads in those markets are similar to the rest of the world, which leaves the value stocks looking overall cheapest.
Talking about Japan, Mr Inker says that while companies in the US, Europe, and China have spent the last decade borrowing ever more and leveraging up their balance sheets, Japanese companies have continued to pay down debt. Given that interest rates are close to zero in Japan, that use of cash has not been hugely productive from a shareholder standpoint. But large numbers of Japanese companies now have little or even negative net debt, which frees up their cash flow for more productive uses. Regarding the emerging markets, he continues, currencies are undervalued on average across emerging world, which provides the potential for future appreciation and helps their current competitiveness in a global economy.
