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Paul Roukis, portfolio manager of the large-cap value strategy at Rothschild & Co. Asset Management.
A big question on everyone’s mind is how long can the growth stocks keep outperforming value stocks? Well, from our standpoint the valuation gap is getting wide enough between value and growth stocks to the point where I believe a reversion to the mean is quite possible. Though I acknowledge that the valuation gap could overshoot to the upside, in most market environments value stocks should trade at discounts to growth stocks on traditional metrics like cash flow and earnings. 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 next logical question would be what would be the catalyst for that rotation to value stocks? I would say a greater confidence in the global economic backdrop could be one such catalyst to spark a reversal, though you’d need a definitive trend to inspire confidence. As we’ve seen in recent months, trends are difficult to come by, especially in this era of transparency. The macro picture changes by the day depending on the headlines.
If you think about the attraction of growth stocks, it often boils down to secular growth trends. These companies are often associated with innovation, which in recent years meant social media, smartphones and video on demand. Now it’s themes based on things like artificial intelligence, cloud computing and autonomous driving. Outside of technology, it could be trends like cancer drugs using the body’s own immune system or digitized payments in the financial services sector.
Let’s face it: these trends are a lot sexier than the legacy value industry’s that historically have focused on bricks and mortar retailing and banking, oil and gas production, and electric generation. However, I would highlight that innovation is occurring across all market segments and the legacy value industries have the potential to realize significant benefits in synergies from investments, which in my view are not reflected in valuations. In other words, there are secular growth themes that can fundamentally alter risk-return and growth prospects of the legacy value companies. To me, that is where the opportunity lies in the market: a non-consensus view that is not being priced by investors, at least just not yet.
For instance, let’s take the banking sector. Our portfolio holdings are largely skewed to the money-centre banks, in particular Bank of America and JPMorgan. Why, do you ask? Well, because these stocks traded roughly 11 times forward-looking earnings, which is a 35% discount to the market; generate mid-teens returns on tangible capital and the growing market share across most line items; but mostly they’re gaining market share through heavy investments in technology, like mobile banking and cybersecurity. Because of that, these companies are generating above market trends in loans and deposits. Bank of America has over 37 million digital banking users. These are material trends that really aren’t being reflected in valuations. These banks are likely to generate operating efficiency gains that are beyond historical precedence in my view.
From a competitive standpoint, the smaller regional banks could potentially have a tough time keeping up in this arms race, which is why two of the bigger, more sophisticated regional banks announced a merger of equals earlier in 2019. That’s SunTrust and BB&T. They see a much more competitive landscape that requires scale to succeed.
Now, make no mistake about it. We do recognize the banks are highly cyclical and interest rate and credit trends will continue to be significant influences across market cycles, so we don’t expect material multiple expansion from current valuation levels. But at the margin there should be secular tailwinds driven by new technologies.
There are many examples of misunderstood sectors. For example, the regulated utility industry comes to mind—the same boring old regulated utilities that traditionally have been perceived as staples in retiree accounts seeking income. Our portfolios hold a modest underweight relative to the benchmark in regulated utilities, due largely to high valuations, but they are still part of the portfolio. The stocks trade at roughly 15% premiums to the market, which is largely driven by their defensive characteristics and relatively high yields in a low interest rate environment. Their valuation premium appears to be driven more by technical factors rather than fundamental issues, but the fundamentals are worth taking a look at in our view, and that’s what’s really misunderstood. In fact, the underlying business fundamentals are as good as I’ve seen in a long time.
It’s not atypical to see regulated utilities rate-base and earnings per share growth rates range in the mid-to-high single digits, so above historical averages which were more like GDP-like growers. The utilities are all benefiting from the transition to cleaner burning fuels, so renewables like solar and wind substituting for coal, as well as just pure upgrades to the general transmission infrastructure, so technologies that enable better efficiency and greater reliability. Another example is as battery storage gets more efficient and cheaper to use, this will only further promote the renewable usage.
This investment push should be a multiyear tailwind for the industry. Our portfolio holdings include companies like Xcel Energy, which is one of the more progressive utilities out there, with operations in Colorado and Minnesota among a few other states. The company’s geographic footprint is conducive to renewable energy.
Another stock is DTE Energy, a Detroit-based utility that is a bit more diversified than others, with operations beyond the traditional regulated businesses, which includes energy trading, gas storage, pipelines, et cetera.
Our final utility holding is American Electric Power, a legacy midwestern utility based in Ohio, which is ample opportunity to upgrade its existing infrastructure.
My views expressed today are my current opinion of a company, not an indication of the fund’s intention to trade or hold a position. I would also like to highlight that my opinion may change in the future and it should not be viewed as investment advice.