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Equity markets around the world suffered a steep drawdown in the first quarter as the coronavirus drove an unprecedented shutdown in economic activity. Leading the way down was the value style, with traditional value sectors, such as energy and financials, underperforming. As equity markets began to recover in the second quarter, the value style continued to lag, just as it has for the better part of the last 12 years.
As contrarian value investors focused on non-US markets, we’ll admit that arguing for value has become a little tiring. While it is typical for value to be in favor or out of favor for multi-year periods, this has been a particularly long stretch. Interestingly, the first nine years or so of underperformance were driven by better earnings from other styles, such as growth and quality. But for the three years prior to the pandemic, the underperformance, particularly outside the US, was driven primarily by valuation expansion (Figure 1), with little difference in earnings growth among the styles. This appeared to suggest a turning point, as the relative valuation gap approached the levels of the technology, media, and telecom (TMT) bubble and the global financial crisis (GFC). But COVID-19 showed how misplaced that optimism was, and now valuation spreads are the most extreme we have seen in several decades, with investors paying handsomely for safety during an incredibly uncertain time.
What could reverse this trend?
With valuations so extreme (Figure 2), we believe there will be a cyclical bounce-back in value stocks as the world’s economies emerge from a deep recession. But to get a multi-year move, we believe the earnings of value stocks need to be better than growth or quality stocks for more than a brief cyclical period. Said differently, can value industries, such as banks and energy, grow earnings faster than expected and sustain that growth?
Looking at banks first, should the enormous fiscal and monetary expansion create a bit of inflation, it could benefit deposit margins and credit costs, and lead to higher ROEs and earnings. Also, compared with the post-GFC period, when banks were considered a culprit in the crisis, they now seem to be viewed by central banks and regulators as safer hands to deal with when it comes to everything from the transmission of monetary policy to cybercrime to digital currencies, reducing what had been a headwind for the industry.
Turning to energy, it’s an overstatement to say that fossil fuels are obsolete. They will play an enormous role for years to come, and while secular demand may peak, money can still be made in shrinking industries as supply and prices adjust. Also, while some companies are ahead of others in preparing for a future of reduced demand, this crisis is likely a wake-up call to the laggards that cash flow, rather than production growth, is the better way forward. Short term, as we like to say, “the cure for a low oil price is a low oil price.”
Don’t bet against human behavior
While value has been out of favor, we don’t believe human behavior has changed, including the tendency to extrapolate current news flow into the future, which can create mispricing opportunities in stocks. We see many such opportunities in companies outside the US trading at extreme lows in price, valuation, and sentiment, not only in banking and energy, but also in many other pro-cyclical areas of the market. We believe price matters, as price ultimately follows earnings and relative price follows relative earnings.
Of course, price is only part of the story. We also believe fundamental challenges need to be offset by strong balance sheets, which can give companies time to get back to more normal operating margins and correspondingly higher valuations. We also think that investments at extreme lows (in price, valuation, sentiment) should be accompanied by significant upside potential, to reward the patience that will be required. So, while this market environment has undoubtedly been painful for value investors, we continue to lean into these extremes and think that the current valuation gap provides a historically attractive entry point.