Are we at an inflection point for equity markets? Could value stocks, which have underperformed growth stocks for some time now, be ready for a rotation? Harris Associates’ David Herro, CIO-International Equities, and Bill Nygren, CIO-US Equities, have witnessed numerous growth and value rotations during the past thirty-plus years, as well as global crises. Below, they share insight on signs of a shift back to value, how volatility can create opportunity, and why being a patient, long-term value investor has its advantages.
With rates so low, there have been some factors that have meant that companies with nice cash flow streams were almost at a handicap versus companies that don’t generate cash. If you believed rates would stay low forever, then you were happy to own growth-oriented companies that don’t generate free cashflow in the short or medium term because the discount rate is so low. Now, in an environment with rising inflation, rising interest rates, it becomes much less attractive to invest in businesses with low or little cash flow streams.
Central banks around the world have been bailed out by a low velocity of money over the last decade, which was caused by the recapitalization of the global financial system post the Financial Crisis. All these banks had to build reserves, from 3 or 4 or 5 percent of capital to 12-13-14%. And now, there is too much money in the system, especially when you have velocity picking up. So that's the structural aspect that has to be dealt with – with monetary policy. So, I believe the solution to inflation is you have to tighten monetary policy and you're going to have to advocate supply-side policies.
By the way, now that these financial institutions are at or above their required capital requirement, we think the next decade is going to be good for their owners. Every dollar they generate they can now use to grow their business or give it to the owners. Whereas in the past 10 years, every dollar they generated, some of it had to go into reserves.
Some commercial real estate firms could be a kind of back-to-the-office play. They make a lot of their money on maintenance for office buildings, and maintenance has been cut way back. We expect profitability for them to increase as more people get back to the office. So I think the evidence of the actual reopening occurring keeps getting stronger and stronger, and the value case for the names that will benefit from reopening, for the most part, continues to exist.
So, when companies' prices drop 20, 30, 40 percent in a couple of weeks, and you are convinced the underlying intrinsic value has not, then opportunity awaits – whether it's adding to existing positions, which we believe have been unfairly hit, such as areas like the European financials sector, or even adding a few other businesses. Volatility provides opportunity if you have the nerves and conviction for it.
Clearly, stock selection is the strength we bring to the table. We are not market timers in any way and, in order to maximize the impact our stock selection has on the portfolios, we run focused portfolios, generally between 20 and 70 names. Compare that to a typical mutual fund today that owns somewhere between 100 and 150 names. Each stock that we decide to own has a much bigger impact on our performance than it does for our peers.
We invest for a very long-term time horizon. If you have something that is undervalued and the value’s growing at least as fast as other companies – and management is aligned with outside shareholders – it gives us the luxury to think really long-term.
Many private equity firms typically buy poorly managed companies where they have to change out the management teams. We differ from them by trying to identify well-managed companies where we want to partner with the existing management teams. This helps us avoid getting into a situation where there could be somewhat of a race against time of the team destroying value while we try to change out management.
Disciplined Value Approach
Value isn’t just a style of investing at Harris Associates – it’s the only way of investing. Since its founding in 1976, Harris Associates has had an unwavering focus on value investing. Their consistent, research-driven approach to finding quality companies around the globe that can be purchased at a significant discount to their true business value has been effective through the years. Every member of the investment team at Harris Associates follows the same three investment tenets when considering companies to add to focused portfolios:
- Price: businesses trading at a significant discount to the estimate of their intrinsic value
- Growth: companies expected to grow per-share value over the long term
- Management: executive teams that think and act like owners
We seek to invest in businesses that are priced at substantial discounts to our estimate of intrinsic value. We think this approach provides us with a ‘margin of safety,’ which reduces risk and allows for above-average returns over time.”
~ David Herro
CIO-International Equities, Harris Associates
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Investing in value stocks presents the risk that value stocks may fall out of favor with investors and underperform growth stocks during given periods.
The S&P 500 Total Return Index is a float-adjusted, capitalization-weighted index of 500 US large-capitalization stocks representing all major industries. It is a widely recognized index of broad US equity market performance. Returns reflect the reinvestment of dividends. This index is unmanaged and investors cannot invest directly in this index.
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Inflation is the steady increase in the price of goods and services over time. It devalues units of currency resulting in consequences like higher cost of living. Structural inflation is inflation that results from changes in the structure of demand and supply.
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