MASTERCLASS: Value Investing
- 55 mins 50 secs
Global economic growth seems to be slowing and there is concern that the increases in interest rates by many central banks will lead to a recession. Three experts discuss this macroeconomic environment, value's outperformance compared to growth, and where they are seeing the greatest opportunities.Channel: MASTERCLASS
- Alessandro Valentini, Fundamental Portfolio Manager, Causeway Capital Management
- Kari Montanus, Senior Portfolio Manager. Columbia Threadneedle
- Kenneth Little, CFA® Managing Director, Investments Group, Brandes Investment Partners
Visit our website www.brandes.com
Masterclass: Value Investing Transcript
Jenna Dagenhart: Hello, and welcome to this Asset TV value investing masterclass. We'll cover the macroeconomic backdrop, values resurgence, and the sustainability of this out performance compared to growth. Joining us now to share where they're seeing the greatest areas of opportunity, we have Alessandro Valentini, Fundamental Portfolio Manager at Causeway Capital Management, Kari Montanus, Senior Portfolio Manager at Columbia Threadneedle Investments, and Ken Little, Managing Director, Investments Group at Brandes.
Jenna Dagenhart: Ken, kicking us off, global economic growth seems to be slowing and there's concern that the increases in interest rates by many central banks will lead to a recession. How does this macro environment tend to impact value?
Ken Little: Yeah. The macro environment certainly looks very different today than it did a couple years ago. When we first started coming out of COVID, the focus was really on the economic recovery and what that would look like for many of these cyclical areas. Shift that to today and the focus is on, are we going into recession? How can the Fed control inflation? So very different macroeconomic environments. All else being equal, some of the challenging economic environments of a recessionary environment tend to be headwinds for value. So if you think about where value tends to have meaningful exposure, it tends to be in industrial areas, materials, energy, some of these more cyclical areas tend to not do as well in slowing and declining economic environments. But contrast that with other areas that also have good representation and value, like healthcare, are trading very attractive today, and really shouldn't be impacted as much by the economy.
Ken Little: They're much more defensive industries, much more non-cyclical industries. So still good opportunities in some of these areas within value, even in a slowing economic environment. But that's only part of the story. I think the other part of how value does in this economic environment is not so much driven by what the economy does, but the starting point of evaluations. And when we take a look at it from that lens, value as a style and a universe of value companies are very attractive today from a valuation perspective, both relative to the market and importantly relative to the growth part of the market. So that setup bodes well for the future of value performance. And in some ways it reminds us a lot of the early 2000 period. We had a recessionary economic environment coming out of the '99, 2000 tech bubble, but value tended to do very well for the next three, four and five years, partly because it was so discounted from a valuation perspective. We think we have that same setup today.
Jenna Dagenhart: Kari, turning to you, is it typical for value to outperform when the Fed is raising interest rates like it is right now?
Kari Montanus: Yeah. Value does typically do better and outperform when the Fed is raising interest rates, really for a few reasons. A rising rate environment typically reflects solid and improving economic growth and many value stocks are companies whose earnings are directly tied to economic growth or GDP, particularly in industrial and consumer cyclical areas as well as commodities companies. These companies will see a nice uplift in their earnings as a result of the better improving economics growth background. Banks and financial stocks in particular, very traditional value sector, are some of the most sensitive companies to interest rates going higher. They benefit from higher rates and a steepening curve, which drives higher earnings for them. But at the same time, growth stocks, especially the higher growth stocks with limited or no earnings today, they will see PE multiple or sales multiple compression as interest rates rise. Growth companies get a lot of their earnings from the future so if you discount these future earnings at a higher interest rate, that of course lowers the value of these companies, whereas value stocks tend to be cheaper so they see less of a multiple impact.
Kari Montanus: We've seen this being played out in the market. During the pandemic, when we went into recession initially, albeit a quick one, growth stocks outperformed at the beginning, especially technology companies, other companies that benefited from the stay at home environment. But as soon as the vaccine was announced in November 2020, there was a big reversal and value stocks rallied really, really hard. They had sold off the most and rebounded the most as the market anticipated that with a vaccine the economy and therefore earnings would recover. But since the vaccine announcement value had a very, very strong run, just driven by this reflation trade and recovery of the economy.
Kari Montanus: But so far in 2022, as Ken was alluding to, the nature of the value trade has shifted. We had expected coming into this year, economic growth and corporate earnings growth was going to slow, especially compared to last year off the bottom. But when Russia invaded the Ukraine and energy prices shot up even higher, this has exacerbated the inflation situation and raised fears, not just of slowing growth, but really recession, especially in Europe. And COVID still, unfortunately is not over. China's zero COVID policy and lockdowns together with the war in Ukraine has just further exacerbated supply chain bottlenecks and inflation. So the Fed as a result has almost been forced to become more hawkish and acknowledge that inflation's not transitory, it's rather running much hotter. CPI, almost 9% the latest reading. Some of the highest readings we've seen in decades. So the Fed is poised to raise rates in a less measured way than was anticipated earlier on, but faster and farther to contain inflation. And then that of course has prompted fears of recession. So even though value stocks have done better than growth even so far this year in the market, it's been much more of a defensive value of stocks that have outperformed the market as the recession fears have been growing.
Jenna Dagenhart: And Alessandro, value investing as a style has seen a resurgence lately. What's the driving force here? Do you think that it's just because of increasing interest rates or are there other factors at play as well?
Alessandro Valentini: Sure. As Kari mentioned earlier, interest rates is a big part of it. We're coming out of a period where we see massive amount of liquidity being injected in the market in excess of over $30 trillion over the last few years. And this has basically driven the cost of money basically to zero. So in that case, you see long data cash flow payments being valued the same as cash today. And that has really helped the speculative growth stocks to flourish. Now we are seeing this headwind actually turning into a tailwind and inflation is forcing the hands of several central banks. And this also drives a return towards fundamental analysis of cash flows. So the market now is focusing on companies that have more tangible, shorter term cash flow, rather than putting a lot of faith in companies that promise cash flow coming in the future. And this is driving more price discovery. And this is very positive for value. The expensive speculative growth investments where fundamental analysis are to perform, it's in a difficult point right now while companies that have more short term, more tangible cashflow are really seeing the advantage here and they're really been valued more thoughtfully by the market.
Jenna Dagenhart: And Kari, I know you touched on this, but would you mind elaborating on which sectors are the biggest drivers of performance here?
Kari Montanus: Yes. As I mentioned, rising rates usually are a sign of strong economic growth, but this pandemic has really distorted the economic cycle. We had a COVID recession, had a quick recovery, and with all of the stimulus money that Alessandro was referring to, it's created an overheating of the economy. Demand has more than exceeded our capacity to supply. If you want to buy a car, it's very difficult. If you want to take a flight, it's more expensive than ever. This combined with the Ukraine invasion and the China lockdowns, it's further exacerbated the inflation situation. Really inflation's running at some of the highest levels we've seen in decades. So many believe that the only way that the Fed can control and stamp out inflation is to raise rates so high as to cause a recession. So in recent months, recession fears have been very elevated in the market. Year to date, value stocks have outperformed growth in aggregate.
Kari Montanus: The value indices have outperformed the S&P and the growth benchmarks, but it has been mainly a defensive trade that's been working. That is to say that large cap stocks have outperformed mid-caps and small caps. And in terms of sectors, it's been utilities and staples, traditionally the most defensive sectors, that have been the best performers of so far this year in the market. Discretionary areas like industrials, consumer and technology are down quite sharply. The other sector that has really outperformed so far this year, and it's been massive, is energy. In fact, energy is the only sector that's in the green for the S&P year to date. It's up over 30%. And this comes on top of a very big year in 2021 as well. Energy stocks have done very well, as you would imagine, because oil prices and gas prices have surpassed record levels in the last few months. There's a supply shortage of both gas and oil. Russian oil's coming out of the market.
Kari Montanus: So energy has actually given back some of its gains more recently because fears of recession have been growing, but still it's up pretty nicely so far in the year. We still like a lot of energy stocks, especially on this pullback, because we think that some of the supply shortages that we're seeing are more structural in nature. And due to under investment in fossil fuels for the past decade for various reasons, should keep energy prices higher for longer. On the flip side, utilities and staples as sectors have outperformed for different reasons. Their earnings are viewed as more predictable and more stable. They're less sensitive to economic growth. So they hold up better during a recession. Packaged food companies, beverage companies, traditionally they're stable earners. People have to buy food. It's not discretionary purchase. But what is interesting and challenging in this current environment, we may go into recession, but even these companies are facing inflationary pressures on their businesses with higher raw materials costs and logistics costs.
Kari Montanus:Some of them may or may not be able to pass on these higher costs to their consumers. Utilities are also viewed as stable earners, but higher costs, energy in particular, people are starting to question whether the utilities companies are going to be able to pass on these higher costs to consumers who are so strapped due to inflation. But net-net, what I'm trying to say is that the current macro backdrop of slowing growth, heading into recession possibly, the Fed hiking, inflation's still high, this combination is a challenge for many, many companies and for investors to navigate. So even the traditionally defensive type of companies are challenged. So it's why some people are saying there's just no place to hide.
Jenna Dagenhart: Yeah. Quite a challenge, indeed. And to Kari's point, within the US, inflation has recently touched fresh 40 year highs. Now, Ken, how is value as a style historically during times of above average or rising inflation?
Ken Little: Yeah. The rate of inflation we're seeing today is one that most of us have never seen in our investing careers or lifetimes. But historically, if you look back over very long periods of time, value as a style tends to do pretty well in inflationary environments, whether that's higher than average inflation or increasing inflation. And so why is that the case? Part of it relates to the sectors that tend to be heavily represented in value indices. So if you think about commodity companies, the energy companies, those tend to do better in higher inflationary environments. So that's certainly part of it from an absolute standpoint. The other important part is from a relative standpoint, if you think about value stocks as compared to growth stocks, as Alessandro mentioned, the cash flows in valuing a growth stock tend to be much further out in the future.
Ken Little: So mechanically, as inflation increases and interest rates rise to try to combat that inflation, the discounting mechanism of bringing those cash flows back today tends to impact growth stocks much more than it does value stocks. The value stocks tend to have more of their value coming from near term cash flows over the next few years. So while they're negatively impacted, certainly not nearly as much as growth stocks are. And that's definitely the dynamic we're seeing today. If you look at how markets have changed, particularly in the last six to nine months, as inflation has really spiked up and the Fed has tried to get a handle on that by raising interest rates, you've seen a dramatic shift in performance differential between value and growth, and we think that's likely to continue.
Jenna Dagenhart: Alessandro, how sustainable is the performance that we've seen in value as a style and this out performance compared to growth?
Alessandro Valentini: Sure. And we think that we are at the beginning of this new phase of out performance for value. And the main reason is when you look at the out performance of value versus growth so far, it's really been driven by growth outperforming and the growth premium coming down massively versus value. In absolute term, value itself hasn't done tremendously well for some of the reasons that both Kari and Ken mentioned. Big parts of value, it's more cyclical, and that hasn't done great in an absolute context. What we've seen is growth really underperform. So if this condition of price discovery and focus on fundamental analysis that I mentioned earlier persists, we should start seeing value outperform as well. And especially as concerns around a slow down in the economy start to both come through and eventually the market gets over them. So when we look at the recent value out performing period, and we compare it with previous periods of out performance for value, going back to the '70s, we can see that this has been one of the shortest ones. So even if you look historically, we have significant way to go in terms of value continuing to out perform.
Jenna Dagenhart: Alessandro, you're pretty optimistic there. Ken, turning to you, given the strong relative performance of the value index this year, the widest out performance compared to the growth index in over 20 years, do you think that this run in value is close to being over or would you side more with Alessandro?
Ken Little: Yeah, I think Alessandro touched on it. I mean, this has been a relatively short lived so far rally in value. If we look back historically, it's not unusual for value out performances over cycles to be at least three, four and five years. And we're basically 18 months into this value rally. So we certainly think just from a duration standpoint, there's more to go in terms of a value rally. So why is that the case? If we break that down fundamentally, really, there's a couple reasons why we think there's more room to go in terms of value performance. One, it's the starting point of valuations. We're still at historically very wide gaps between value stocks and growth stocks. Even with the strong out performance over the last 18 months, that's barely been a blip on the radar in terms of closing that gap in terms of value and growth. So that's part of it.
Ken Little: You're also starting to see sentiment change, and we're starting to see assets flow back into value mandates, back into value funds. Still fairly early days of that. But I think people are warming up to the idea of investing back in value again, partly because of the interest rate environment, partly because of the inflationary environment and what we spoke about earlier, that value tends to do better in those environments.
Ken Little: And then lastly, and maybe most importantly from our perspective, why we think it's still sustainable, the value rally. If we look at the fundamentals of many of the companies in the value index and in the value universe, the fundamentals are actually doing very well. Now, certainly many of those companies will have challenges in an inflationary environment, whether they can pass on that higher cost to consumers. But we still think they're very well positioned. The earnings growth rates and expectations are still very good. Many cases, even better than the market as a whole for value stocks, even holding aside the energy sector, which certainly is doing better in a higher energy price environment. But we think fundamentals in general and cashflow generation and returns to shareholders are very well supported right now by the fundamentals of the companies in the value universe. So when we put all those things together, the wide differential in valuations, the sentiment starting to change and the strong fundamentals of these companies, we still think there's plenty of room to go in terms of the value rally.
Jenna Dagenhart: Kari, what's your value investing philosophy and how does your approach differ?
Kari Montanus: Yes. We manage a high conviction, low turnover strategy in our select midcap value fund. We own 45 to 50 stocks. We're value investors so we look for stocks that are cheap, that are out of favor with investors or sentiment is negative for new ideas. Our philosophy and process revolve really around earnings. Stock prices tend to track corporate earnings over time. So we're always looking to buy cheap stocks in companies where earnings are depressed, but where we can see a catalyst for them to accelerate and recover and drive a change in investor perceptions. It's this combination that we look for upside to earnings estimates and multiple expansion that can drive big upsides in stocks. A key differentiator of our strategy is our long holding period. Core to our philosophy, really to capture the entire investment life cycle of a stock from beginning to end.
Kari Montanus: It's this idea of getting in early, anticipating change early, holding on to the stock as the company undergoes a transformation, looking past the daily noise, sticking with our stocks as the companies are becoming better companies over time, and then letting our winners run even once this transformation is complete. Our portfolio is concentrated so our good stock picks account, but we still think it is sufficiently diversified. And even against an ever changing macro backdrop and the current environment is highly unpredictable, I would say we stick with our discipline and our process, and it's generated attractive out performance for our investors over the years.
Jenna Dagenhart: And Ken, many people have different impressions and understandings of what value investing is. What is value investing from your perspective at Brandes?
Ken Little: From our perspective, value really boils down to a few key concepts. One is that price matters. So price matters. The price you pay for an investment has a large impact on eventual returns of that investment. So being price disciplined is paramount to the process and the value philosophy for us. Secondly, the other important concept is to take a business owner's view of companies. So not trying to predict necessarily where stock prices are going in the near term, but trying to value a business as a business owner would. So how does that play into it? We think about competitive positioning of companies, cash generations of companies, balance sheets, shareholder returns. Those are all things that are fundamental to owning a business if you own the entire company. That's what we try to put into our perspective of how we think about those businesses.
Ken Little: And then putting those two concepts together, we're looking to buy those businesses at attractive discounts. That's what we think creates a margin of safety in building portfolios. And then finally, as Kari mentioned, a key part of the process is having patience. We think over long periods of time, fundamentals and prices eventually converge, but as we've seen over the last decade, sometimes that takes longer than average. But ultimately we think if you're building portfolios that are trading at significant discounts to that underlying business like owner's net worth, we think that creates attractive valuations and attractive long term rates of return.
Jenna Dagenhart: Alessandro, how important are management actions in terms of delivering on the fair value that you assign a business?
Alessandro Valentini: Absolutely. We are fundamentally long term investors that really focus on similar to what Ken and Kari said about the fair value of a business versus what the business is trading at right now. We find that most opportunities really end in two buckets. One is a cyclical recovery bucket, and one is a restructuring bucket. In both cases, management interaction is extraordinarily important. When you think about a cyclical company, if you're going through a cyclical downturn, you want to have the business in the hands of a good management that has been able to show the ability to come out of this cycle stronger and better. And these are the companies we focus on. When you've seen previous cycles, we want to focus on companies where the market has just given up. The cycle will continue forever. The economic downturn will continue forever. And these great cash flow generators will never earn that cashflow again. That usually doesn't turn to be true.
Alessandro Valentini: Usually good companies and good management, they go back and they earn returns that are probably higher if they do the right thing than the previous cycle. And then you have restructuring stories and these are different. These are companies that have done something wrong, where usually you get new management that changes the nature of the company, changes the DNA. Importantly, changes the capital returns and the allocation of capital by these companies. So knowing what managements are doing, understanding what management goals are and understanding how they are putting that into practice in the day to day, it's extraordinarily important. So when you think about both buckets, what management does and the fact that management does what they say they're going to do, it's so important for us and it's something we pay a lot of attention. Whether you're getting into an economic downturn or not, that really matters for the performance of the stocks in the portfolio.
Jenna Dagenhart: Mm-hmm. And there's been a lot of emphasis lately on the concept of ESG and a great deal of capital has flowed into ESG focused funds. Ken, has this trend been a headwind for value investors? And is the concept of value investing inconsistent with ESG or can the two be compatible?
Ken Little: I certainly think over the last decade or so it's been a bit of a headwind for value. But I don't think it's solely responsible for it. I think more of that relates to the issues that were raised earlier in terms of growth expectations and interest rates. But if you think about some of the areas that are heavily represented in value indexes, they tend to be ones that aren't necessarily favorably viewed from an ESG perspective, particularly on a carbon footprinting perspective. So the energy sector, materials and utilities, until the last 18 months or so all have had a pretty big headwind, part of that relating to the flow of funds into ESG sectors and exclusion of those sectors from those portfolios. But back to your question about whether these are compatible or not, I certainly think they can be. It doesn't have to be the case that ESG funds don't have any exposure to these sectors at all.
Ken Little: And you're starting to see some change in that area. As opposed to completely excluding those sectors, there's more of a focus on owning the better companies in those sectors or engaging with companies within those sectors to try to drive positive performance. But ultimately, we think about ESG factors as fundamental factors that all companies have to deal with. So back to the concept of thinking like a business owner, these are concepts that you have to take into consideration in valuing a business and thinking about the risk reward trade off of owning those companies. And that doesn't just come about from the risk factors that get much of the focus from an ESG perspective, but it also creates opportunities for many companies. And we've seen this in a number of areas where ESG actually acts as a tailwind. And so we're starting to see the tide turn a little bit and I think the relative under performance of ESG funds over the last year or so has changed some people's perspectives about whether they are compatible with value and how these things can still mesh and be consistent with having an ESG portfolio.
Jenna Dagenhart: I'm turning now to the recent rebalancing of the Russell value and growth indices. Ken, this rebalancing has resulted in companies such as Netflix, PayPal, Zoom video, and Meta, formerly Facebook, becoming constituents of the value index. Are companies like these really value stocks?
Ken Little:They certainly can be. Many of these companies or companies like these are terrific businesses that have built up incredibly strong customer bases, technologies and moats around their businesses. So there's no reason value investors couldn't own these companies. But if you think about why they might not have been in most value portfolios over the last few years, it primarily comes down to the price you were paying for those businesses and the price you were paying for expectations of future growth and the duration of that growth. But in many ways, that's starting to change. As we talked about with rates moving up and growth stocks being discounted back, the earnings of growth stocks being discounted back, we've seen many companies and the names that you mentioned starting to move into the value index. You've seen many of these companies come down by 50, 60, 70% within the last 52 weeks. So they're starting to look much more attractive from a valuation perspective. And like I said, the underlying businesses are very good. So we tend to think of it, not as a value stock or a growth stock. It all comes down to what price do you pay for these businesses? And with these companies coming down, it's certainly starting to change the universe and the opportunity set for value investors today.
Jenna Dagenhart: Kari, how does the Russell benchmark reconstitution affect your process?
Kari Montanus: Well, we're bottom up fundamental stock pickers. Most of our alpha in our portfolio comes from stock selection, as opposed to big sector bets or factor bets. We are not beholden to the benchmark. We don't own something just because it's big in our benchmark, but of course we are aware of the benchmark and our sector exposures. I would say typically we don't make big changes around the annual June Russell rebalancing. I mean, sometimes companies go out one year and then the next year they're right back in and vice versa. But this past year in June, one of the bigger changes to the Russell midcap value benchmark was in energy. The sector energy stocks have run so hard for the last year and a half, doubles and triples many of them. So the energy sector in terms of the bench had gotten to almost 9% or 10%.
Kari Montanus: And a lot of these companies became too big to be in the small and midcap benchmarks. So energy actually came out of the mid and small cap value benchmarks. We did trim back our energy exposure, our holdings a little bit just to realign it a little bit, because the change was so significant. These companies, these stocks had had such great runs anyway, and it is probably prudent to trim them back over time just given the volatility. But our value benchmarks did lose a lot of energy, but as Ken just alluded to, we got some really interesting high growth stocks ironically, as some of these companies, software, technology, even consumer, some of these stocks have come down just so hard. 60, 70%. In some cases. Our process captures them. We have a screen that we use to find stocks where valuation is cheap and earnings are depressed. And some of these growthier names are actually starting to look pretty interesting to us at these levels so we are doing some work.
Jenna Dagenhart: Alessandro, I want to get your take as well. Are you starting to see opportunities in areas that were previously too richly priced, areas that some might say are now on sale for 60, 70% off?
Alessandro Valentini: Yeah, I've been, again, echoing what Kari and Ken said. We are starting to do some work on some of these companies because valuations have been impacted so tremendously. We're not quite at the level where the valuations will fit with our process yet. The market is optimistic, especially in areas of technology, in terms of fast recovery potential and some of the longer term cashflows being unimpacted by some of the recent events. So we are ready to act when we see the market completely throw out the towel. We don't think we're quite there yet, but clearly the valuations are more interesting. One area where we are finding more opportunities, we're starting to find more opportunities consistent to what I mentioned earlier about the cyclical bucket. It's actually some industrial companies in Europe. Especially the darlings that had great management, great market position, leading market share in global markets. And some of these companies are starting to see the valuation compress significantly because of concerns around a recession in Europe are starting to mount. And usually these companies, they trade a very cheap multiples when the market is just focusing on the next six months in terms of our recession. Again, we're not quite there in terms of the valuation, but some of these great businesses and very high quality businesses within Europe are starting to look more interesting to us.
Jenna Dagenhart: Yeah. Building off of that, Alessandro, European companies look particularly cheap on valuations, but there are several concerns around the economic outlook. How do you balance the risk and the opportunity?
Alessandro Valentini: Well, that's exactly what we do at Causeway. Our process is really a blend of fundamental focus in terms of figuring out what the fair value of the business is and what is the marginal safety. But then we marry that with a sophisticated quant approach that tells us what is the risk for each company that we might consider including in the portfolio. And clearly what's going on in Europe is giving us a very good idea what the risk adjusted return is, which is really as we focus. The opportunities that we find interesting in we have in our concentrated portfolio right now in Europe is companies that are already discounting these valuation. They're basically already discounting a full and deep recession in Europe, which is probably now going to be the ultimate outcome. We're going to have a slowdown, but it's not going to be a deep recession like we've seen in the past.
Alessandro Valentini: And one area of interest, you can take the banks, for example, in Europe. And one example is UniCredit, which is an Italian bank. This is a bank that has repaired their balance sheet. They have significant excess capital that a regulator have recently allowed them to return to shareholders, even in the current difficult environment. They have improved the ROE, they have new management and you are basically getting an opportunity to buy a company like this that is restructuring, that is doing better with new management, for single digit multiples of earnings and significant discount to bulk. And this is to be put in the context that when you look at the loan bulk should be in a decently good shape even in a recession. At the end of the day, what we've seen over the last decade in Europe, it's actually Europe wide loans as a percentage of GDP has actually shrank from 2009 consistently almost every year. And usually banks get into trouble after they go through a lending splurge when the controls around their lending went a little bit haywire. And if you've seen actually lending reduced in Europe, that risk is much lower. So we feel very comfortable with the loan bulk, the excess capital, the quality of the management and improving ROE for a valuation that basically is already pricing in a recession and a deep recession in Europe.
Jenna Dagenhart: Now Ken, does value as a style tend to be more effective in the US or in international markets?
Ken Little: If you look back at the data, the MSCI value and growth indices go back nearly 50 years now. And that out performance of value has actually been fairly strong, both in US markets and international markets. But they tend to come at slightly different times. They're not always on the exact same cycles. Part of that has to do with the economies themselves not always being synchronized, but a lot of it also has to do with the makeup of the universes of those markets. So if you think about technology, for instance, which tends to have a large percentage allocation in US markets. For instance, the technology and communication services sector makes up nearly 36% of the US market today, even with prices coming down. If you think about that same sector or combination of sectors in non-US markets, it's only about 12%.
Ken Little: So not nearly as much technology waiting, and that's made up by ... Some of its financials, some of its materials. So a slightly different mix of types of companies that lead to performance timing differentials between the two markets. But ultimately if we think about value as a style and why it works, we think the dynamics that go into it are just as relevant outside the US as they are in the US. And that comes back to some behavioral finance issues of investors. It comes to the mindset or the timeframe by much of the market being very short term focused. So thinking about what does the next six months look like, or are we going into recession, as opposed to thinking about longer term of what is the true value of these businesses? That's a dynamic that we continue to see outside the US and in the US. And I don't expect that's going to change going forward. So we still think value has relevance and has efficacy both in the US and outside the US.
Jenna Dagenhart: And why are value opportunities in an international context, particularly interesting to you right now, Alessandro?
Alessandro Valentini: Yeah. Comparing what has happened over the last few years in the US versus Europe and international markets in general, we've seen the US out performance being driven mostly by multiple expansion. Earnings have improved coming out of the GFC in most geographies. US probably outpaced slightly in terms of earnings improvement, but we were really seeing it's an out performance driven by multiple expansion. A lot of it has to do with what Ken just said. Different composition of the index technology gather, a lot more multiple expansion because of expectations of this being a very attractive area for growth investors. But we've come to a point where the US markets are trading at a premium that is double or more, almost five times actually at this point, the long-term average premium to the European and to the global markets in general.
Alessandro Valentini: And as we see some of these areas in the US that have higher valuation be impacted with higher rates and this valuation contract, it's reasonable to expect that we should move back towards a long term average premium for the US. And that is an enormous tailwind for international companies. When you just think about sheer valuation. And then right now, you also have the additional kicker valuation. I mean, we've seen what currency like the Japanese Yen or the Euro have done versus the US, and that is improving dramatically the competitive position of some of the global companies, some of the great global industrial companies and companies with an export bias in Europe where the currency differentiator is really positive for them. So we are seeing that as an additional kicker in terms of the opportunity in international markets that are value driven over maybe the US.
Jenna Dagenhart: Yeah. I had to do a double take when I saw the headline that the Euro and the dollar reached a parody. Kari, circling back to you, why specifically are midcap value stocks a great opportunity?
Kari Montanus: Midcap stocks have got this connotation, midcaps, middle seat, middle school, middle child. They're definitely an overlooked area of the market, but we think that's an opportunity for investors. It's a very attractive area of the market in our opinion. I've been running money based on this same select value process and philosophy since 2003, across the market cap spectrum, large caps, midcaps, small caps. And as a fundamental stock picker, I can attest that midcaps are really the sweet spot of the market. These are companies that have the stability of large companies. They've got established business models, but they're not as picked over by the market. They are less followed by the analysts on the street, and they've got the runway and the potential and the upside of small cap companies, but without the risk and the volatility. So you really get the best of both worlds. Our research suggests that midcaps at the index level outperform both large and small caps pretty consistently over time. And due to the makeup of the benchmark, it's annual rebalancing, we also get looks at undiscovered opportunities that others are probably not paying attention to. Whether it's stealth growth stocks or fallen angels from the large cap space that just aren't on people's radar. It's a dynamic opportunity set for us as active managers that we are always looking to take advantage of.
Jenna Dagenhart: And Alessandro, in the past you mentioned the COVID recovery as an area of opportunity. Is this still the case and where are you seeing the most attractive opportunities right now?
Alessandro Valentini: Sure. And I think Kari mentioned that at the beginning of the conversation that we are not through with COVID. We're seeing what's going on with China, we're still seeing impact on air travel, et cetera. So there's still a lot that we think many companies there are still going to benefit as we eventually move through the pandemic phase for COVID. An example is Rolls Royce. This is a company that manufacturers, installs and maintains engines for airplanes. We've seen air travel traffic improve dramatically, mostly leisure. And we are starting to see that on the corporate side too. But we what haven't seen is airlines putting more routes and more airplanes in the air. And that's when Rolls Royce would really benefit. More airplanes in the air means more engines being installed, means more engines being serviced, means better cash flow for Rolls Royce.
Alessandro Valentini: So this is an example of a company in the portfolio where we see this recovery from COVID not having completely played through, and still significant amount of upside. And then there's other opportunities. And I will mention Prudential. Not Prudential in the US, but Prudential PLC in the UK being very interesting in terms of COVID recovery. Not immediately what you think about as a COVID recovery investment thesis. But this is a company that has shed a lot of the businesses that weren't core for them. They shed the UK business, they shed the US business. And now it's a company that provides life insurance in emerging markets in Asia. China is an emerging part of their market. They have a very big presence in Hong Kong and a big part of their business is people going from mainline China into Hong Kong to buy these policies. Given the current situation in China, you're not seeing a lot of that.
Alessandro Valentini: But there's an enormous amount of pent up demand for Prudential in order to write those policies. And we expect that as China eventually starts relaxing some of the zero COVID policies, or as we start seeing some of that restrictions being relaxed, we're going to start to see that. And this is a company that trades almost assuming zero growth into the new policies in a market that is extraordinarily under penetrated. So I think there's still a lot of opportunities that are COVID related. That being said, COVID related opportunities is not the only opportunity set we have seen. I mentioned earlier some of these valuation discounts that European cyclicals are trading at, whether it's banks, whether some of the industrials, so that's another emerging area. But I think COVID recovery is still an important driver in terms of these value opportunities, especially internationally.
Jenna Dagenhart: And giving some historical context here, Ken, some people have opined that the under performance of value through most of the 2010 to 2020 period and the recent sharp reversal of that under performance is reminiscent of the 1999, 2000 tech bubble. What do you think is similar or different between these two periods?
Ken Little: Yeah, it's certainly an interesting analogy. I started in business in 1996 and a number of our investment professionals here were in our firm at that same time and lived through the '99, 2000 period of the internet bubble. And really it does have many of the same characteristics. And it kind of started with a questioning of value as a style and leading to big under performance. And whether it was an outdated style and whether it was at a competitive disadvantage in that '99, 2000 period. So that part is very similar to what we saw over the last few years. The other part about the makeup of the universes or the indexes themselves, you saw an increasing concentration of what was driving performance of the market. And we saw that again over the past few years is fewer and fewer large companies namely in the technology sector and consumer discretionary sector, really driving most of that performance, leaving behind a large number of companies, very good companies trading at much more attractive valuations.
Ken Little: So that part also very similar. And then importantly, it was a very narrative driven market where you saw fundamentals really detach from prices. That is also a very common characteristic that we saw back in '99, 2000 and we saw over the last few years. Now, some of those came from different areas. If you think back about that '99, 2000 period, that was very much driven by the really introduction and widespread adoption of the internet and what impact that was going to have on businesses. So a lot of the focus was there on internet, was on networking. Fast forward to over the last few years, what's driven the market here. It's been more social media related companies. It's been cloud storage companies, security companies. And then certainly in the COVID period, it's been the work from home beneficiaries that were driving a lot of that.
Ken Little: So slightly different areas of driving that relative performance, but again coming back to the disconnect between true fundamental valuation and what those prices are. So those are some of the similarities. What's different, I think arguably, even though the market had become more concentrated over the past few years, I think there's a good case to be made that a number of these companies were in stronger competitive positioning and will continue to do well over time from a fundamental perspective. It's just a matter of what price are you paying for those companies and does that justify a good rate of return in buying those at those prices. And I think from a sector standpoint, there was slight differences. If I think back to that '99, 2000 period, some of those companies that were really left behind tended to be the "old economy companies". They were utilities, they were consumer staples, they were industrials and materials. While some of those have underperformed in this last cycle, a little bit different in that if you think about the consumer staples companies, the utilities, real estate, some of these companies that have been viewed as more stable businesses, more dividend friendly businesses actually have done very well in a low interest rate environment until the last year or so.
Ken Little: So they've actually been bid up to pretty full valuations and it's left behind slightly different areas. Areas like financials, areas like healthcare tend to look more attractive to us today. So a slightly different environment in terms of the opportunity set. But again, the main common characteristic from a historical perspective is this disconnect between price and fundamental value and this historically wide spread between value stocks and growth stocks. That part of it is very similar and we think that's been one of the big drivers of starting to see this value, growth reversal, and one that we still think can continue to go on for years to come.
Jenna Dagenhart: And there sure has been a lot to dissect over the past few years. Kari, as a long tenured, large cap value manager, what differences have you seen applying your process to the midcap space over the last four years?
Kari Montanus: Yes. We've applied a proven process and philosophy that was originally successful in the large cap space, literally for decades. We've taken that process and applied it to the midcap universe and have done very, very well with this. The Russell midcap value index, it's a subset of the Russell large cap value index. It just excludes the mega cap stocks. Russell midcap value, the benchmark goes from two or three billion all the way up to 40 billion in market cap before it stops. But that being said, if you own just the Russell large cap value, you are really missing out in our opinion, on the attractive returns and the potential of the midcap stocks, because the returns of the large cap benchmark are really quite dominated by the larger names. We have had to make some adjustments though in midcap, in terms of name count. We own 45 to 50 stocks in our select midcap strategy compared to 35 to 40 in large. Really just because smaller companies are a little more volatile.
Kari Montanus: The benchmark's exposures are somewhat different in terms of sectors. Utilities and REITs, for example, are very big in the midcap benchmark. And then finally our philosophy, long holding period and letting our winners run. We do have to be a little more quick to replace our winners in midcap just because they can't get too big. We have to stay within the midcap universe. But we do think that investors need to have, as others have talked about, at least some value exposure here, even if just to hedge or to diversify given the inflationary regime that we are now in. It may last longer. We think it will last longer than people think. In midcap, we own in our portfolio our fair share of regional banks, energy stocks, material stocks, real estate REITs. These are companies that are inflation hedges. We also own companies that have pricing power.
Kari Montanus: We have exposure to the reopening plays. Travel and leisure are a big part of our benchmark. And even in recession, even if consumer demand falters a little bit, we still see these reopening stocks as relative winners due to all of the pent up demand that others have alluded to. This shift from goods towards services. There's still a lot more room to go here. People want to take vacations. They want to go to concerts. They want to shop in person. And they are buying now more formal dress clothes and shoes for the office and to go out to parties and weddings again. On the industrial side, we like the auto and aero sectors as well. It's pretty interesting because production here is still at trough levels. It has been at recessionary levels. It's really never honestly recovered because of all the chip shortages and the supply chain bottlenecks.
Kari Montanus: So even in recession, we think these companies may actually fare much better now than they did in previous recessions. We're hearing from management teams that ironically a recession may almost help them because it will help free up labor. It will help reduce their raw materials costs. And if we do see a fallback in demand, which is so overheated now they can't even keep up. And the final thing I would mention is that our midcap value portfolio, even as a value portfolio, we still have exposure to a lot of favorable secular trends in electric vehicles, in renewable energy, in cloud computing. It's a value portfolio, but it's not expensive. We own companies with real earnings in the portfolio so we think it's quite compelling.
Jenna Dagenhart: And Ken, given value's under performance for over a decade until the turn in late 2020 many question the efficacy and relevance of the style. Can you comment on its relevance today and how it's changed and evolved over the past few decades?
Ken Little: Sure. I think both value and growth as styles ebb and flow over time and the period up to 2020 was certainly one of the longest periods of values out of favor from a style perspective. But we still think it's very relevant today. It really comes back to the core concepts that I mentioned of thinking about these companies as a business owner would. That dynamic and that fundamental, we don't think will change over time. But that doesn't mean the application of value doesn't change and doesn't evolve over time. I think sometimes there's a misconception about value as a style that's just focused on low price to book companies or low PE companies and that's all the focus is. That could be replicated easily today with computers and ETFs are doing that all the time.
Ken Little: So as fundamental value managers, we have to continue to evolve and think about the business dynamics themselves and some of those are different today than they certainly were 10, 20 and 30 years ago. So there's more focus on intangible assets at companies and some of the value that's being driven by these companies aren't the factories on the balance sheet and aren't the land and materials on the balance sheet. It's more intellectual capital. So factoring that into valuations, thinking about the network effect of these businesses and their customer bases is important. Thinking about the competitive modes of these companies. Those all go into thinking about the businesses and how to come up with a value for these business. But ultimately we're still coming back to these are underlying intrinsic value of businesses. And that's what we want to focus on as long term holders of these companies and businesslike owners of these companies. So from that perspective, we think value is just as relevant today and will continue to be relevant in the future because of that core fundamental focus.
Jenna Dagenhart: Alessandro, I saw you nodding your head. Anything you'd like to add? Any final thoughts you'd like to leave our viewers with?
Alessandro Valentini: Yeah, I couldn't agree more with Ken when he mentioned arithmetic cheapness versus value. It's a very different concept. Just because a company is trading at seven times earnings doesn't mean it's value. It means it's cheap. There could be value there, but the market has really evolved from there and I agree with what he said that value needs to evolve with that too. And that's why the focus that we have at Causeway is to find the marginal safety and build a differentiated investment thesis as the market. If you agree with the market and a company's cheap, you're probably facing a value trap. If you can, through thorough fundamental research, find something that the market is not understanding, whether it's a change in management we mentioned, or the market is too short term focused on like a cyclical and your fair value is higher and you have the marginal safety, then you have a real value opportunity. And that's important in order to differentiate value and value traps.
Jenna Dagenhart: Well, it's been a pleasure hosting all of you. Thank you so much for joining us.
Alessandro Valentini: Thank you so much for having us.
Ken Little: Thanks, Jenna.
Kari Montanus: Thanks, Jenna.
Jenna Dagenhart: And thank you for watching this value investing masterclass. Once again, I was joined by Alessandro Valentini, Fundamental Portfolio Manager at Causeway Capital Management, Kari Montanus, Senior Portfolio Manager at Columbia Threadneedle Investments, and Ken Little, Managing Director, Investments Group at Brandes. And I'm Jenna Dagenhart with Asset TV.