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Finding value in the current cycle

By Steve Woolley (pictured) and Alessandro Dicorrado, portfolio managers in Ninety One’s Value team

 

Global markets have recognised that an economic recovery is underway, and whether that is a Covid related recovery or a general cyclical recovery, stocks are being repriced higher. To the extent some sectors still have room to run after the recent market rally, the opportunity in the value segment is attractive, which still trades cheaply in absolute terms, relative to its history, and especially versus the rest of the market and other investing styles, with growth and quality factors still very expensive on a long term view.

Value tends to correlate with pro-cyclical macro variables, for example GDP growth, inflation or rising interest rate expectations – all of which we have seen of late to varying degrees. And value is one of the few styles that can outperform in this kind of pro-growth environment, particularly when compared to where the market and certain sectors and styles are trading today.

When considering the recent rally, it is also worth remembering just how long value has been in the doldrums. Whilst there has been a recovery in value names of late, on a historical view it is barely a blip on the screen in terms of the kind of underperformance that value had suffered, whether it’s looked at on a 1, 3, 5, or 10-year view. This leaves a lot of runway for value to go in terms of potential future performance. Of course, selectivity is key and there is a case for looking at value in a more dynamic way than it has been traditionally – including with a recognition that it can coexist with growth.

 

UK value

The UK has had a specific set of challenges in recent years on top of dealing with the global pandemic, which from a vaccine perspective it has handled relatively well. It is therefore worth shining a specific light on this market in terms of seeking value. UK stocks were already looking cheap due to the uncertainty surrounding Brexit, both in the lead up to the country leaving the single market and some lingering political uncertainties which followed. This made the UK one of the cheapest countries amongst developed markets.

Covid concerns then moved in and had a further impact on UK stocks. However, the country’s quick vaccination strategy and the ongoing rollout is supportive, much to the benefit of UK value stocks; initially to cyclical industrial sectors such as housebuilders and builders’ merchants, and still providing plenty of latent upside to sectors such as financials and travel and leisure. Particularly given how hard-hit UK stocks were, the recent recovery here looks especially minute when compared to the longer term and the country remains attractive on a global comparison basis.

 

The runway ahead for value

Despite some calls to the contrary, there is no reason to suggest that we are nearing the end of a value recovery given the supportive macro indicators of late and when considering the longer-term picture. In addition, for all the concerns inflation has caused market participants, it tends to correlate with value outperformance and could provide an additional tailwind.

It is therefore worth looking at those sectors and businesses that tend do well in a pro-inflationary environment – for example the money-centre banks, both in the US and the UK, select energy stocks and some of the more cyclical sectors such as housing, construction, and other industrials. These businesses tend do a better job of passing on inflation through pricing, or through higher profit margins, than some other sectors of the market.

However, value does not necessarily have to just correlate to cyclical businesses and industries. There will be instances where the more staple-like businesses, healthcare or consumer staples themselves, should rightfully fall onto a value investor’s radar. We always attempt to move nimbly between value styles as they present opportunities in the market.

 At the moment, the market is telling more of an idiosyncratic story so deep value – the most traditional value style – will not necessarily achieve the desired outcomes. Whereas looking for fallen angels, for example staple companies that are growing steadily at 4-5% per year and trade on low teens multiples, may be more attractive in the current environment.

Lastly, for those seeking value: remember that value and growth can in fact coexist. Think in terms of

‘hybrid companies’, those which display both growth and value characteristics. We believe that the combination of low valuation with growth is one of the highest predictors of high future returns and therefore a worthy addition to those seeking value in the current market environment.

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