Quality value in Europe – a change in direction for the new investment cycle
- An era of ultra-low interest rates and accommodative monetary policy have made money cheap, allowing investors to buy trendy growth stocks at inflated prices.
- The macro backdrop, along with investor mood, has now changed dramatically and investors now seem more conscious of the price they are willing to pay for a company.
- We are focused on better quality value companies with a high return on equity and average dividend yield, in the view that these types of companies should be able to grow quicker than the market.
The macroeconomic backdrop for much of the past decade has been far from ideal for value equity managers, many of whom have left the industry, either fired or fed up with seeing value suffer year after year. But as inflation rises, global trade reduces and hence competition falls, so many traditional industries may see pricing power increase. Against this background, value equity managers might finally get their long-awaited time to shine.
Hey, big spender
As a value manager, it is important to remain focused on the fundamental principles of investing. When someone purchases a stock, they are essentially buying the true value of a company and its products and operations. Any extra purchase price in addition to this cost is simply sentiment that other people have towards that company. Prior to the last 18 months, ultra-low interest rates and accommodative monetary policy made money cheap, allowing investors to buy trendy growth stocks that appeared exciting with little regard for how large the added ‘sentiment’ was.
As a result, money moved towards companies with high price-to-earnings (P/E) ratios which market participants believed would offer big payoffs in the future. These types of companies typically made very little cash flow and were dependent on outside investors to fund the business. Akin to the end of the dot-com bubble, many investors have treated the market more as a lottery than an investment opportunity – a strategy that has performed extremely well for investors during an era of easy money, but which cannot do well forever.
Over recent months/weeks the macro backdrop, along with investor mood, has changed dramatically. The past 18 months has seen growth and value vie for dominance (Exhibit 1). But with inflation moving higher, supply shortages, global trade coming under pressure and ultimately interest rates likely to rise investors are now a lot more conscious of the price they are willing to pay for a company. We saw a fairly dramatic shift in money allocation at the start of 2022, with the MSCI Europe Value Index up 2.6% in January, compared with a 5% decline in the MSCI World Index, and an 8.8% fall for the MSCI Europe Growth Index.
Is the value play here to stay?
Value has had a short-term period of relatively good performance, but how long can that last? Growth investors may argue that the structural drivers that bolster growth stocks have not gone away; deflationary forces could reassert themselves once short-term supply chain issues and political tensions resolve themselves. However, we believe that inflation is here to stay, at least for the next few years.
Political tensions continue to escalate, with the Ukraine-Russia situation impacting supply fluidity further. As supply chains suffer, we see companies re-shore their businesses, moving operations closer to home to avoid further disruption. Doing so would create higher paying manufacturing jobs, and some businesses will pass these costs onto customers via price hikes, creating inflation.
Elsewhere in the investment sphere, we believe environmental, social and governance (ESG) considerations are hugely inflationary too. The cost of getting ESG ‘right’ is high. You can see this in the investment industry alone, with asset managers hiring more analysts to dissect companies’ ESG claims and those firms in return recruiting more staff to respond to this scrutiny. This pressure is also reflected in the oil price. It has been impossible to ignore the shift in capital away from ‘dirty’ energy companies in favour of new ‘clean’ technologies. While this pivot has been well intentioned, these are juvenile businesses and often not effective substitutes for tried-and-tested energy sources. Poor substitution means that demand for oil increases, pushing up prices – a consequence that has been felt by many of late. Again, this situation can lead to inflationary pressures in the economy.
We would argue that these inflationary pressures will not go away quickly. Rather than reverting to the deflationary environment of the past decade, we believe we are at the beginning of a new cycle, one that is very different from the last.
Seeking quality value in Europe
At the other end of the spectrum from highly rated growth companies are deep value stocks, ie. companies that appear extremely cheap, sometimes for good reason. In Europe, one area of deep value (generally financially challenged companies) comes in the form of banks. Despite this uninspiring depiction, the banking sector has been ‘flavour of the month’ for many investors who are keen to jump into value. Much of the value play we saw in the first few weeks of 2022 began here, given that higher interest rates should lead through to higher profits for the banking sector. Once the deep value areas have been bought up, we believe that the value play will broaden into wider areas of the value market.
We prefer to focus our attention on better quality companies that we consider to be undervalued by the market, but which have a high return on equity. Given the retention of cash flows into businesses, we believe that these types of companies should be able to grow quicker than the market. Against a backdrop of higher interest rates and inflation, we believe that quality value stands in good stead for the new cycle.