6 February 2020
In their third article exploring the themes which inform their investment strategy in 2020 and beyond, GAM Investments’ Niall Gallagher and Christopher Sellers take a close fundamental look at three ‘value’ sectors which have underperformed in the last decade and ask whether there is room to be more optimistic for the future. They also assess the sustainability and continued attractiveness of the structural growth trends behind some of the best performing stocks of the last decade.
In our previous article ‘Why we need to talk about value versus growth (again)’, we discussed the yawning valuation gap that has apparently opened up between growth and value stocks. And in our subsequent article ‘Value, volatility and the prevalence of factor investing’, we argued that the market’s preference for low volatility goes at least some of the way to explaining this.
Here, we discuss some of the fundamental reasons behind the de-rating of three major European value sectors – banks, energy, and autos – and examine the extent to which there might be room for their re-assessment. We also discuss whether the dramatic re-rating of certain growth stocks is justified by the sustainability of the fundamental trends underpinning them.
Can value withstand new technologies and decarbonisation?
Many value stocks exist in areas of the economy being profoundly challenged by technological advancement and the need to combat climate change. There is nothing new about technological change. Ever since the advent of the industrial revolution, new technologies and new ways of doing ‘things’ have been upending business models, wreaking creative destruction throughout economies and societies. The urgent need to combat climate change, however, is new and will have profound implications for how we live our lives and how business operates within our economies. We also expect to see it exerting significant influence on the valuation of equities.
From an investment perspective, we should ask: do certain stocks and sectors have lower, or even negative, terminal growth rates than the market as a whole? And is that what the market is telling us in the way it values certain stocks relative to others?
As the largest of the value sectors, banks are often seen as the poster child for value. Figure 1 demonstrates that the sector certainly looks cheap versus history on an absolute basis. Indeed, the sector looks ‘record cheap’ when we examine its price / earnings valuation relative to the MSCI Europe index.
There are reasons to be cautious on the longer-term prospects for banks, given the growth of ‘fintech’ and the challenge that new entrants pose to traditional bank revenue streams. Many banks have legacy IT systems that make it difficult to react as quickly as needed to structural change and new entrant attack. However, it is easy to ignore the fact that many banks control their own destiny. Customers rarely switch current accounts and most banks are taking the task of digital transformation seriously, so we struggle structurally to write off the entire sector.
Figure 1: Bank sector P / E ratios
The key difficulty for almost all banks over the short and medium term is how to operate in an environment of negative interest rates and very low bond yields. Many sovereign yields are negative all the way out to seven years, typically as far out as many banks’ balance sheets are invested. A lack of profit opportunity on un-remunerated sight deposits, traditionally a robust source of bank profits, and challenges with reinvesting maturing bond portfolios, are seriously pressurising net interest margins, with negative earnings consequences.
Our view is that the sector is ‘conditionally cheap’ – that is to say, the sector is cheap on the condition that interest rates and yields rise at some stage. But this is related to monetary policies, such as interest rate setting, asset purchases (QE) and many of the same phenomena we think have driven the high valuations of many low price volatility stocks, and the low valuations of many high volatility / cyclical stocks. It is difficult to make a fundamental case for the sector as a whole without believing that interest rates and yields will rise, although certain banks are interesting, principally those with strong growth in non-interest income sources and markets with a consolidated industry structure.
The energy sector is another large component of the value index that also looks cheap versus history and provides very generous dividend yields to income investors.
Figure 2: Energy sector P / E ratios
However, the energy sector faces serious environmental risks. The obvious – and long-term – risk is that the need for decarbonisation will leave oil companies with ‘stranded assets’ that ultimately have low terminal values. A much more immediate risk is the growing importance of ESG and sustainable investing for many asset owners and the influence this will exert on stock selection. The risk for publicly listed energy companies is that a growing pool of investors simply will not buy their equity – irrespective of valuation – and that a reduced pool of investment capital may increase their cost of equity capital. It is plausible that energy stocks may perpetually screen ‘cheap’ – the true definition of a value trap. Therefore, does the apparently cheap valuation of the energy sector have more to do with ESG and sustainable investing than membership of a value factor?
The autos sector is very cheap versus history, which could reflect cyclical worries. We think it also reflects structural environmental factors. A key part of the global decarbonisation challenge will fall on to the autos sector, which will need to reduce vehicle carbon emissions and ultimately find a way to replace the internal combustion engine with non-carbon emitting power trains. The costs of this transition are vast and the equity market is right to question whether such costs will ultimately – or at least for a period – significantly reduce autos sector profitability. The rise of ride-hailing (through Uber, etc) in major cities also raises questions over long-term vehicle ownership trends.
Figure 3: Auto sector P / E ratios
We believe there are reasons to be selectively more optimistic. We do not see demand for mobility falling. The growth in the global car fleet is driven by the growth in the emerging market middle class and a number of auto manufacturers have convincing strategies for electrification. In addition, we are not convinced that low / no profitability ride-hailing services have a viable future outside large, dense cities. Nonetheless, the level of structural uncertainty hanging over the sector partly explains its low valuations. Again, it is hard to attribute such valuations purely to membership of a value factor. The greater cyclicality of the autos sector does, however, mean that it is a higher volatility sector. So the extensive re-rating of low volatility has arguably been associated with a derating of higher volatility sectors.
Growth and new structural trends
The flipside to questions about whether many value stocks are, in fact, value traps is to ask whether many growth stocks have re-rated based on higher structural growth rates and higher returns. Themes such as the growth of the Asian middle class and many of the technological innovations evident in the ‘digital economy’ such as e-commerce, the internet of things / industry 4.0, cloud computing and medical advancements, could be deemed to justify some of the sector and factor re-ratings we have witnessed in recent years. But we think such thinking can be dangerous. Many stock market eras have witnessed ‘wonder’ stocks driven by technological innovation where excessive valuation and over-exuberance ultimately led these stocks to crash back to earth. While each example will be stock specific – and there may well be great single stock exceptions – we think scepticism is required when extrapolating forward high growth rates and high returns into perpetuity. We think caution is required with some of those areas of the market that have done particularly well since 2015, including the software and services sector, medtech, many consumer staples and pharmaceuticals, where valuations have expanded without a corresponding increase in revenue growth.
A structural trend in which we do have some confidence, and which we see persisting for some time, is the growth in the emerging market (mainly Asian) middle class, largely because demographics wield far more predictive power than many other trends. The attainment of middle-income status – approximately USD 1,000 of after-tax income a month –will propel a historically large number of people into the global middle class in Asia over the next decade. Some estimates suggest that as many as 800 million people will join the global middle class from Asia in the next decade. This will have significant implications for spending power and for those companies well positioned with such consumers. The growth will certainly not be linear and cycles will intercede along the way. But we have some sympathy with the idea that the structural growth rate for luxury and premium consumer companies has inflected higher in recent years and this is evident in the reported results of certain consumer discretionary and consumer staples stocks.
In summary, we find interesting valuation anomalies across value sectors of the market. But selectivity is required and we believe that such anomalies are likely the result of specific stocks’ volatility as well as their value characteristics. Conversely, not all stocks in the growth sectors of the market that have re-rated in the last few years should be considered overvalued based on observable trends, although we think many have re-rated purely based on their defensiveness / low volatility characteristics as we cannot find evidence of acceleration in their underlying business.
The catalyst for a shift in current valuation anomalies is hard to identify, but it is likely to be a change in monetary policy and / or a change in the mix between monetary and fiscal policy.
Sometimes, however, valuation anomalies just run their course and self-correct so investors need to remain vigilant to this change and identify in advance where they believe the best opportunities may lie.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development. Reference to a security is not a recommendation to buy or sell that security.