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Peter Hardy, senior client portfolio manager, global value equities for American Century Investments.
The way we have always found returns is by identifying the best values within our universe of quality businesses and then layering in non-common securities to further open up our opportunity set and then also utilizing income as a way to further diversify our return sources for our clients. All of these things have enabled us to provide a return that does well during up markets or keeps up during the up markets and then protects on the downside.
The last five years have presented an environment that we really haven’t previously seen. Since the financial crisis growth has outperformed value virtually every year. So the links in the magnitude of the outperformance of growth as a style versus value as a style is historically significant. The magnitude is back towards the ’99 tech bubble and the length of the out-performance we haven’t seen historically really ever. That growth versus value dynamic, however, is something that we’ve seen at most market peaks going back historically.
What is unique over the last five-year period is that while growth has been outperforming value, low-volatility defensive names and higher-yielding names have also outperformed. So we’re now using a new term called DARK: used to be growth at a reasonable price and we’re monikering the term DARK, defensive at a reasonable price, to describe our current portfolio positioning. Identifying those names that are high-quality, low-volatility, dividend producers and also cheap from a valuation perspective is the nuance in the current environment and the way we are positioning the portfolio to find value currently.
So where are we seeing that in specific examples? One area is banks. Going into the financial crisis, banks were over-earning. Part of that over-earning was due to the fact that they had increased their leverage, making them more risky, and they were over-valued in that period. In 2008 we were very underweight banks by virtue of this. Banks have since recapitalized over the last 10 years. Their capital levels are the best they’ve ever been historically and they’re under-earning due to the low interest rate environment. We think there are ways for them to cut costs to revert from an earnings perspective, but basically the backdrop is they are under-earning and under-valued.
Some of our exposures in banks are in the large money center banks such as Wells Fargo, JP Morgan and PNC Financial. In addition to under-earning on their spread revenues, so the deposit base, they have fee-related lines of a business to diversify their returns. They’re well capitalized and are attractive in our valuation methodology. A more nuanced situation from a bank standpoint is a small thrift bank Cap Fed located here in Kansas City. It’s one of the best capitalized banks in the country. It is a small one, very conservatively managed and with its special dividends pays a 7.2% dividend yield.
Another area where the portfolio is overweight currently is in healthcare. Broad concerns about “Medicare for all” in the U.S. have caused these stocks to be pressured and we think the concerns are overstated for a variety of reasons—mainly that the chances of strong-form “Medicare for all” making it through Congress are very, very little. J and J would be an example of a company that is a low-volatility defensive name that is cheap. It’s really one of the highest quality businesses that there is—highest quality in pharma, they have a great med tech business—and then they spend the most out of any pharma company to maintain their market leadership by investing billions of dollars in R&D. They have new and exciting products coming in in immunology and oncology. And the risk to the stock has been concerns about liability over talc and opioids. We believe this risk is overstated and even in its worst case scenario, the hit to the company from a liability perspective would be a speed bump. They’ve had about 30 to 45 talc cases and 35 have been dismissed. And J and J has never really had a big settlement at pharma. So this stock is cheap for a variety of reasons, and is one we own in the current market environment.