3 varieties of value stocks offer opportunities.
We recently laid out reasons we think now may be a good time to consider value stocks. But what exactly do we mean when we say, “Value?” We essentially are talking about three flavors of stocks:
- Cyclical value companies have earnings and cash flows that are likely to improve as the economy improves, and conversely suffer as the economy slows. They tend to outperform during the early stages of a recovery, as appears to be the current case, with manufacturing and economic indicators stabilizing at a low base and inflecting higher. Stocks in the Industrials, Materials and Consumer Discretionary sectors fall under this category.
- Relative value companies typically represent high-quality franchises with strong balance sheets that are gaining market share or have a competitive advantage within their category. These franchises dominate their industries and, although their valuations relative to history may be on the higher end, future cash flow, profit margins and growth rates have shifted to a higher trajectory than their historical norms. These stocks trade at a discount to their intrinsic value as they execute their business strategies. Relative value opportunities can emerge from any sector and are identified using a fundamental research process to uncover these often-hidden gems.
- More traditional deep value stocks represent companies that trade at low absolute levels of valuation based on traditional metrics such as price/earnings or price-to-book ratios. There are many reasons for their depressed valuations. They may be specific to an individual company; for example, a company experiencing high debt levels or a change in top management. Depressed valuations also can be broader in nature, affecting entire industries due to the timing of the economic cycle (think pandemic-driven demand destruction earlier this year that slashed demand for products and services in the Energy sector) or more acute, longer-term challenges such as those confronting the brick-and-mortar retail industry. There are big winners in this Consumer Discretionary category—and big losers. In a retail landscape in which online shopping has been booming, further accelerated by Covid-19 restrictions and stay-at-home orders, retailers that haven’t been able to adapt are at a distinct disadvantage and may not survive.
Similar dynamics are occurring in Energy. As consumers become more aware of environmental issues and their carbon footprint, traditional fossil fuel producers must quickly address and adjust to these concerns or risk becoming fossils themselves. Finally, we place the Financials sector in its own category. Valuations are low, but they have been that way for a while as the Federal Reserve’s persistent lower-for-longer monetary stance has squeezed financial company margins, weighing on profitability. The Fed’s commitment to keeping rates low, along with the potential for stricter regulations in a Biden administration, means investors will need to be more selective within the sector.
Where to find value today
There’s likely no end in sight for the value versus growth debate. While value may currently be the cheapest asset class to own, a variety of virus-related political and societal issues could remain headwinds. We believe the current landscape warrants a balanced approach to quality, growth and cyclicals. Attractive structural growth profiles and secular forces in such sectors as Technology can’t be ignored; but after a long period of outperformance, these high-flying stocks could pause, while beaten-down cyclicals could outperform, closing some of the valuation gap. Over the longer term, we prefer to allocate capital and drive alpha by leaning into higher-quality companies with strong management teams, balance sheets and cash flows while also considering fundamental change factors that offer opportunities.