The Greatest Fortitude
Value managers have had to have the patience of Job over the last two years – but last month saw the first sign that the market’s fixation with commodity plays may be drawing to a close. The popular short financials/long commodities trade suddenly reversed, but was this just a technical adjustment, or the beginning of the end for the metals and mining story?
Markets have always been susceptible to manias, but the commodities strain has proved unexpectedly virulent, persisting far longer than the TMT bubble. “There are aspects to this market that are extraordinary,” says Paul Ehrlichman, CIO, Global Currents, part of Legg Mason. “If you had just bought what was going up the most, and sold what was going down the most – that gap is wider than at any point since 1927. This has been a very challenging and severe period for value managers, with five and sometimes 10-year track records being threatened.”
Mark Donovan, managing director at Robeco Boston Partners, says that there are normally some low-valued stocks that have attractive momentum characteristics, but in this mania, the spread that investors have been willing to pay for high momentum stocks is much higher than the valuation of medium and low momentum stocks.
In 1998-99, when everyone ran to TMT names, the belief was that the unit volumes of internet usage would explode. This time, it is more of a pricing story than a unit volume story. “But it seems to me that it has to fail, as you can only increase commodity prices so much before demand destruction occurs,” he says. “Farmers can only pay so much for fertiliser, and when gasoline went over $4 a gallon in the US, there was a meaningful decline in gasoline consumption. So the notion that the commodity bubble – which is largely price driven – can continue, doesn’t make much sense.”
Style reversal
Indeed, there is now a sense that style performance is about to reverse, with momentum running out of puff. According to Andrew Lapthorne, of SocGen’s Cross Asset Research Group, valuation dispersion measures suggest that the market is starting to differentiate again, with dispersion reaching levels that would typically imply better value returns going forward. Unfortunately, value styles also remain sensitive to the economic cycle, and tend to perform better when the profits cycle is accelerating rather than decelerating. Value investors will just have to keep telling themselves that the more they suffer now, the better it will be when the reversal finally comes.
As a contrarian manager, Donovan says Robeco Boston Partners looks at companies that are experiencing some stresses, where it feels the problems will work out over time and the market is incorrectly viewing those problems as permanent in nature. This time the lagging stocks have been the financial, property, and consumer discretionary companies such as car manufacturers, retailers and restaurants. “Amongst that large group of stocks, some will prove the diamonds in the rough that have been thrown out unnecessarily by investors,” argues Donovan.
Ehrlichman adds that there are two types of value investor, and each will be attracted to different kinds of stock. The defensive value managers are more likely to buy the laggards in sectors like healthcare, food and telecoms, which should pay high dividends. And the deep value managers will look at financials, consumer discretionary stocks, and tech companies – the really beaten up stocks.
But deep value could face further pain, as it only outperforms when profitability is below trend. “The super-boom in profitability is way above trend so the earnings cycle isn’t yet set up for deep value to outperform,” he says. The problem is that value factors – meaning low P/E, low price to book, and low price to cash flow – tend to be pro-cyclical.
Feel the pain
So although the financial leverage part of profitability has been devastated and is unlikely to see further downwards revisions, there is still pain to come courtesy of operating leverage. “That means the scarcity plays will get hit, and you can already see that with the cyclicals because they are going down. We’re trying to be disciplined. Cyclicals can suck you in on a low P/E – that’s a value trap in a stock that’s down because profits are peaking. But value managers are also inherently sceptical of structural changes in profitability and may not be willing to pay up when profits have improved.”
In financials, he says TD Ameritrade and Fidelity National Information Services are interesting stocks, adding: “We are still concerned that earnings won’t be supportive of many of the out-of-favour stocks – we want more visible and durable earnings.” A deeper value, more out-of-favour stock would be Infineon, the semi-conductor manufacturer, or Cisco: “The IT sector has very depressed profitability and expectations and it has been trashed. But it is focused on free cash flow and share buy-backs – compare that to the massive capital spending in metals and mining.”
On the consumer discretionary side he cites Nobel Biocare, which makes dental implants, as a good example. “This is under new management and is essentially an oligopoly, but it has been ripped down to record low levels of valuation. There are some short-term threats to elective procedures like this and laser eye surgery, but we don’t think it’s quite that discretionary.” Ehrlichman also likes Symrise of Germany, which has been hit very hard. Symrise is a global leader in natural and organic fragrances and flavours, but it has been more than cut in half since its IPO and is trading on a low multiple.
Bear warning
Donovan adds that amongst the financials he is looking at insurers and asset managers now, but warns that in a bear market, financial companies can and do go to zero. Bear Stearns lost well over 90 percent of its value, and IndyMac has declared bankruptcy. “Value investors are naturally attracted to financial institutions but you have to be quite careful. The incidence of financial firms failing is probably higher than that of industrials, as small problems on the asset quality side can become big problems for banks with fairly thin capital,” he says.
“The other problem with investing in financial companies is that there is nothing to look at – it’s a leap of faith in management that they have soundly underwritten their loan portfolio. When credit cycles go bad it’s always surprising how far institutions like Countrywide, for example, have gone into the very shaky credits. They didn’t need to – they had by far the leading market share – and yet they strayed into those areas.” He says that Boston Partners prefers to spread the risk with a range of small to medium-sized positions. “So we own about a dozen bank stocks and if eight of them prosper, two of them do okay, and two of them go to zero, our portfolio will be okay.”
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