Veteran value portfolio manager David Herro, Chief Investment Officer, International Equities at Harris Associates, shares his thoughts heading into the new year.
Value beginning to come back in vogue
In the later months of 2019, we witnessed what appear to be the early stages of a value recovery. For almost the better half of a decade, we saw a huge separation between what are known as growth, momentum, and value stocks. During this time, there were significant valuation differentials. But now, we have seen the curves narrow a little bit. Given where valuation differentials still exist today and past price performance, we believe we are likely in the first or second inning of a value recovery. This means that we expect to see a convergence of valuations in the next few years.
Revaluation of companies
This convergence of valuations doesn’t mean tech will sell off and industrials will outperform – but what I think you could see are companies that have steady cash flow streams, trade at very low valuations, and have good dividend yields, and efficient cash generation will be revalued. On the other hand, those companies that can’t justify the price of their cash stream could come down in stock price. For example, a company like Tesla has zero free cash flow and is significantly overvalued, in our view.
Looking back at the last 5 to 8 years, we saw valuations drift apart between various sectors. Valuations in consumer staples, healthcare, and utilities stocks became extremely high, while stocks in sectors like consumer discretionary and financials had very low valuations. To be clear, I’m not saying they should trade at a premium to the expensive sectors like tech, but the differentials have been too large.
Quality European banks remain undervalued
Some UK banks received a huge Brexit discount in 2019. Even when we analyzed and priced these quality businesses that generate capital above what is required with two scenarios – a No-Deal Brexit or a Jeremy Corbyn government – they were still significantly undervalued by our estimates.
As a whole, European financials is a sector that we think has been misunderstood by the market and is selling at a discount. Lower or negative interest rates in 2019 led the market to believe that earnings for the typical European financial firm would get crushed. However, we did not see earnings impacted dearly. In fact, many of these businesses have been able to grow earnings, albeit at a very slow rate. Now they are at or above their required capital positions and can pay out this surplus of capital generation to their shareholders. These stocks offer attractive yields in a world such as Europe where 10-year government securities are trading at negative interest rates.
2020 Elections. So what?
One thing we’ve learned from Brexit and the British election is that you can’t predict political outcomes.. What I do know is that political events can often cause short-term price movements. But they don’t reflect the underlying changes of a business’s intrinsic value. Therefore, whoever gets elected in the UK, US, France, etc. should not be a concern for long-term investors because there are so many institutions that act as checks and balances. I think the degree at which economic growth is highly impacted over the medium and long term gets overstated and these elections tend to be more bark than bite.
Commodities needed for migration to electric vehicles
Copper, cobalt, and nickel are items needed for the world to move toward alternative sources of energy and electric vehicles (EV) because they are integral to battery storage systems. Companies that mine these commodities should benefit from this growing demand going forward. Even at low commodity prices – which we experienced in 2019, but do not expect to last forever – select quality companies in this sector are generating free cash flow and remain attractive value opportunities to us.
The EV bubble may have been created by the European Union pushing hard for a technology that wasn’t quite ready for the mainstream. I expect EV to play a role and be economical in two to five years. Since governments have needed to subsidize or purchase EVs, that tells me the market isn’t calling for them yet.
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This material is provided for informational purposes only and should not be construed as investment advice. There can be no assurance that developments will transpire as forecasted. Actual results may vary.
Stocks are volatile and can decline significantly in response to broad market and economic conditions. Value investing carries the risk that a security can continue to be undervalued by the market for long periods of time.
Foreign securities may involve heightened risk due to currency fluctuations. Additionally, they may be subject to greater political, economic, environmental, credit, and information risks. Foreign securities may be subject to higher volatility than US securities, due to varying degrees of regulation and limited liquidity.