Though growth stocks have outperformed value stocks in recent years, a reversion to the mean is “quite possible,” says Paul Roukis, managing director and portfolio manager at Rothschild Asset Management in New York.
“In most market environments, value stocks should trade at discounts to growth stocks on traditional metrics like cash flow and earnings,” said Roukis, in a May 14 interview.
“However, the roughly 30% current price-to-earnings discount is higher than normal, and one that should at least begin to get the attention of disciplined long-term investors. From a historical perspective, the discount has averaged around 20% to 25% through time.”
The question is what could cause investors to choose value stocks? Roukis said greater confidence in the global economic backdrop could be a catalyst, though investors would need “a definitive trend” to inspire confidence.
The attraction to growth stocks is based on secular growth trends, he said.
“These companies are often associated with innovation, which in recent years meant social media, smartphones and video on demand,” he said, adding it’s now based more on artificial intelligence, cloud computing and autonomous driving.
“Let’s face it: these trends are a lot sexier than the legacy value industries that historically have focused on bricks-and-mortar retailing, banking, oil and gas production, and electric generation,” said Roukis, whose firm manages the Renaissance U.S. Equity Value Fund.
But now, innovation is occurring across legacy value companies as well, he said, and this isn’t being reflected in valuations. “That is where the opportunity lies in the market.”
Take the banking sector, said Roukis, whose portfolio is skewed to money-centre banks like Bank of America and JPMorgan.
“These stocks trade at roughly 11 times forward-looking earnings, which is a 35% discount to the market. [They] generate mid-teens return on tangible capital and [have] growing market share across most line items,” said Roukis.
“They’re gaining market share through heavy investments in technology, like mobile banking and cyber security. And because of that, these companies are generating above-market trends in loans and deposits.”
Bank of America’s loan department has over 37 million digital banking users, he noted. “These banks are likely to generate operating efficiency gains that are beyond historical precedents.”
Meanwhile, smaller regional banks “could have a tough time keeping up in this arms race.” That’s why some are merging, like SunTrust and BB&T earlier this year in a $28-billion stock deal. “They see a much more competitive landscape that requires scale to succeed,” he said.
Roukis added that banks are highly cyclical, with interest rates and credit trends remaining major influences.
“We don’t expect material multiple expansion from current valuation levels,” he said. “But at the margin, there should be secular tailwinds driven by new technologies.”
A look at utilities
Another sector that’s often misunderstood by investors is regulated utilities, Roukis said.
“The underlying business fundamentals are as good as I’ve seen in a long time,” he said. “It’s not atypical to see regulated utilities’ rate base and earnings-per-share growth rates range in the mid-to-high single digits.”
The utilities, he added, are “benefitting from the transition to cleaner burning fuels.” This includes renewables, like solar and wind, instead of using coal.
There have also been upgrades to the general transmission infrastructure with technologies that enable efficiency and reliability. For instance, he said “as battery storage gets more efficient and cheaper to use, this will only further promote renewable usage. This investment push should be a multi-year tailwind for the industry.”
Due to high valuations, his portfolio holds a modest underweight in utilities relative to the benchmark. “But they are still part of the portfolio,” he said.
The stocks, he noted, trade at 15% premiums to the market, “which is largely driven by the defensive characteristics and high yields in a low interest-rate environment.”
One company in his portfolio is Xcel Energy, which has operations in several states including Colorado and Minnesota. “The company’s geographic footprint is conducive to renewable energy,” said Roukis.
Over the last year, Xcel’s stock has climbed higher, with minor dips in June 2018 and during December’s selloff. It’s gone from around US$45 a year ago to above US$59 this month.
Another stock in his portfolio is DTE Energy. This is a Detroit-based utility “that is a bit more diversified than the others, with operations beyond the traditional regulated business, which includes energy trading, gas storage [and] pipelines,” explained Roukis.
DTE’s stock has behaved similarly to Xcel’s, climbing higher over the last year with minor dips in June and December 2018. It’s trading at more than US$128 this month, compared to US$102 a year ago.
Roukis’s final utility holding is American Electric Power. It’s “a legacy midwestern utility based in Ohio, which has ample opportunity to upgrade its existing infrastructure,” he said.
AEP has also been on a steady incline over the last year, from around US$66 a year ago to more than US$89 this month.
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