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(Runtime: 5 min, 20 sec; size: 4.27 MB)
Conor Muldoon, portfolio manager, Causeway Capital.
Value’s underperformed for a significant amount of time, and investors will ask the question, “What role do value stocks play in a diversified portfolio?” We think that value offers significant pent-up alpha given how stretched valuations have become. So the magnitude of this period of value underperformance now matches what we saw back in the [tech] bubble, which stretched from 1995 all the way to 2000. And if we go back and look at the subsequent unwind of that bubble, that was actually one of the best time periods to be a value investor. So value as an investment style outperformed from the peak of that bubble in 2000 all the way through 2007.
The value stocks today have been shunned and are under-owned by investors. Investor attention is really shifted towards growth and momentum stocks. And when we look at these stocks, they’re priced for perfection. Some good indicators that we’ve seen in terms of investor’s focus has been the recent IPO market where we’ve seen lots of companies that have yet to turn any profit, that generates significant negative cashflow, and yet these companies have been priced for perfection in the recent IPOs. To the extent that these companies disappoint, we think investors will look to exit and that exit will happen all at once, which will lead to a significant decline in those kinds of stock prices. And similar to what we saw when the the tech bubble burst back in 2000, value stocks could outperform significantly in such a scenario, given how attractively they’re priced and how under-owned they are by global investors.
So in terms of the potential indicators that the value style may return to favor: in general, finding turning points, it’s actually a hard call to make. And if we go back over the last four to five years, there’s actually been many kind of false starts for the so-called value rally. So specifying exactly what is going to be the catalyst that turn things is actually really hard to do. And when you go back to the last kind of major cycle for value, the turning points was actually in March, 2000 and at that period of time and there was no specific catalyst. It was effectively just some of the recent kind of momentum and excitement around technology stocks. Ultimately as those companies disappointed, investors headed for the exit. So there was no one thing that caused the turn, it was just a refocus by the investor community on fundamentals.
So as value investors, what we focus on is really that kind of bottom-up analysis of what’s happening at the company level. And one of the most important things that we’re focused on is actually capital allocation. And if I could point to one potential catalyst, it would be capital allocation. And ultimately making sure that the management teams of the companies that we own, which are generating good cash flow, that that cashflow is being allocated correctly and for the most part returned to shareholders in the form of both dividends and share buybacks. And when you just think about that equation, if the stock is really cheap, which we claim value stocks are, then the execution risk for buyback is really low. If you get a company trading on half of fair value and the management team can buy back the stock at that very attractive level, then that has a very low execution risk and a very, very high return.
When we look at the market today, U.S. financials are a great example of where this is happening, where you’re having companies such as Citi Group, such as Bank of America, such as Wells Fargo, all return a significant amount of capital back to shareholders. And all three of those offer a payout yield north of 10%. It’s a great opportunity for those companies to be able to buy their stock back at very attractive levels with very little execution risks. So that is potentially one catalyst for a change in sentiment. It is just a capital allocation at that company and bottom up level, and that does matter over time.