MASTERCLASS: Value Investing - March 2023

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  • 01 hr 04 mins 59 secs
2022 took a heavy toll on equity markets across the globe, but value stocks were relative outperformers and are seeing a resurgence in interest in 2023. Four value investing experts share the sectors they're seeing opportunities, compare domestic and international equities, and what they're staying away from.
  • Jeffrey Germain, CFA® Director, Investments Group - Brandes Investment Partners
  • Brian Barish, CFA® President & Chief Investment Officer - Cambiar Investors
  • Rick Taft, Senior Portfolio Manager - Columbia Threadneedle Investments
  • Scott McBride, CFA® Chief Executive Officer, and Portfolio Manager - Hotchkis and Wiley


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Jonathan Forsgren: 2022 took a heavy toll on equity markets across the globe. While value stocks did not escape the losses, they were relative outperformers for the year and are seeing a resurgence in interest in 2023. Joining us to share their expertise on value investing are Scott McBride, chief executive officer and portfolio manager at Hotchkis and Wiley. Jeffrey Germain, director in the investments group at Brandes Investment Partners. Rick Taft, senior portfolio manager at Columbia Threadneedle Investments. And Brian Barish, president and chief investment officer at Cambiar Investors. Thank you all for joining us. Scott, what does value investing mean to you and how has value investing changed over the years?

Scott McBride:E Okay. Thanks, Jonathan. Great to be here. So value investing, we start with a really simple idea, which is we want to invest in a business at a discount to what we think that business is worth. And the reason the market gives you that opportunity is really because markets are fickle, markets are made up of people and people have emotions and those emotions are influenced by short-term trends. So the old Ben Graham or Warren Buffett saying I think still holds true which is, "In the short term the market is a voting machine, and in the long term it's really a weighing machine." So the opportunity for a value investor is to really ignore the short term noise, don't worry about what's happening with stock prices, but really focus on the path of long-term earnings for a business and you want to value a company based on that.

And the further the price gets moved around by short-term sentiment, the more it gets disconnected from that long-term value and the more you should get interested in the investment. I don't really think those principles of value investing have changed at all. I don't think the reason that stocks become undervalued has changed too much. I think really what's changed in the market is the type of companies you look at. And so, a lot more of the market is made up of companies that invest in intangible assets rather than tangible assets.

So what that means is that the way that the accounting works is different and the companies, rather than investing through the cashflow statement, they might be investing more through the income statement. And so you have to change how you analyze companies. Traditional metrics like price-to-book, I think it still matters, it's still a good metric for when you're looking at financials for example. But if you're looking at a software company, price-to-book really not a valuable. Again, as those companies that invested in intangible assets have become a bigger part of the market, overall market measures like price-to-book have become I think less important.

Jonathan Forsgren: Jeff, over the past two years we've seen a resurgence for value. Does the style leadership change have staying power? If so, why?

Jeffrey Germain: Yeah, you're right. I mean, it's been a good couple of years for value investors and I think the staying power, it's hard to predict the future, but it's a really good question. And what we look at are a variety of things that get us more comfortable with value still being an interesting place to be from a style perspective in the market. The first thing is, if you look historically, regime changes between value and growth tended to be multi-year events. And so, it's not just one year outperformance and then it switches back, it tends to be multi-year. And we are early on with values resurgence, and so I think that's a positive.

The second thing, and probably the most important thing is just valuations. So despite the run for value stocks, I mean, they're still trading at a very steep discount versus their growth peers. And what's interesting about that, that discount is, one, it's historically very high and we have data going back to 1975 and you're near that historical wide discount, but it's present in multiple markets. So it's really a global phenomenon that you're seeing. And as Scott mentioned, we're looking at a variety of metrics for securities to see if there's value in a company, and it's not just price-to-book but it's across other flow metrics as well like P/E or price-to-cash flow, you're getting a very steep discount in the value part of that market today.

And then thirdly, a topic that we'll probably touch upon later is interest rates and how that influences multiples, and the influence is more extreme for growth companies. And if you disaggregate the growth part of a global equity market and its performance over the last decade compared to the value part of that market, it wasn't dividends that made growth outperform, it wasn't earnings growth, it was multiple expansion, and that multiple expansion came on the back of increasingly lower interest rates over the last decade. And so if you look forward, the question is, can we expect that to take place again? And currently, it looks like that's not the case, and again, that has a bigger headwind for growth than it does value.

Jonathan Forsgren: Brian, in your 2023 outlook, you detailed that value stocks are not in a bear market. Can you explain?

Brian Barish: Well, there's a factual and then more of a behavioral. So factually, they're not. So if you look at the Russell 1000 value index, we're doing this interview in mid-February, they're down about 6% from the high. That's not a bear market, that's very far from a bear market. Functionally, a bear market, and I've lived through a number of these, it's a very destructive process. You lose money, it's just a question of how much, all kinds of investment thesis go wrong, your stocks find ways not to work. It's just a very frustrating process.

And behaviorally, we're just not seeing that in what I would describe as our normal hunting grounds in industrial businesses, consumer businesses, financial businesses, even the more pedestrian parts of the technology landscape. The multiples have come in a bit, but it's nothing particularly damaging. I think when you look at the market and how challenging 2022 was, there was an overvaluation problem in digital economy type of stocks. That process of bringing those back down to more conservative multiples, that's still ongoing, in my opinion, but that's really where the problem was and why the bear market is more concentrated over there.

Jonathan Forsgren: Rick, how are current market events impacting value, and how do you anticipate that changing as we enter a new phase?

Rick Taft: Yeah. Thanks, Jonathan. It's interesting I think Jeff touched on it a little bit earlier. I mean, the last couple of years, we have seen a potential transition or regime change in terms of the macro environment. We've obviously potentially entered a higher inflationary high rate environment and that's following really 20 plus years of low rates and importing indeed deflation from China to the benefit of the consumer. There are other kind of megatrends going on here, you've got a de-globalization trend and onshoring, we clearly seeing this with some of the tensions, we're seeing in Taiwan and even in the Ukraine. And then there are other areas such as renewables where I think clearly we've had a reset of expectations in terms of renewables. Clearly I think we're going to double down on renewables in terms of the investment. But from an expectations point of view, I think there's some acknowledgement that fossil fuel has a role looking forward and that this transition's going to be longer than expected.

And so when you combine these factors, they do provide a decent setup for value going forward and clearly higher rates, some inflationary trends, I mean, that certainly favors companies with cash flows and dividends. De-globalization as I mentioned earlier and onshoring, that's going to encourage US infrastructure investment. We saw the IRA act that's going to stimulate a lot of spending in solar. We're going to start onshoring semiconductor fabs back in the US. You've got a lot of investment going on in networking and broadband. And so this is a pretty good setup, I think, from a value perspective because it really gets down to industrial investment, technology investment away from maybe what we've seen dominate the last 20 years of more on the intangible side and stuff that's really consumer focusing. I think there's been a longer term trend of underinvestment and we think that we're going to see an investment cycle that favors value stocks going forward.

Jonathan Forsgren: Brian, coming back to you, as the cost of capital continues to rise, how does this impact the value versus growth debate?

Brian Barish: I think as one of the other guests pointed out, when you have value to growth shifts or growth to value shifts, these cycles tend to be multi-year in length. So I believe as it sounds like many of the other guests do that we've had a regime change from a 0% cost of capital, very low cost of capital regime to a much higher cost of capital regime. And when that happens, the impact is much larger on the growth side. We were in a 0% cost of capital regime basically for most of the last 14 years. I mean, it really did go on for a long time and it does change the way people think about the payoff from investments. If the cost of capital is 0%, you're indifferent to whether you get an oil well that pays off immediately or a rocket to Mars that pays off in the year 2075.

I mean, it's literally that stark at an academic level. So it does change things. It means you expect faster payback periods. One other facet of value investing is that as a value investor, price is very important and you also want to demand a margin of safety. And in an environment where the cost of capital is rising and maybe we're not exactly sure where the fed is going to land or what interest rate policies really are going to need to be in the long run, having that margin of safety is particularly valuable at this time.

Jonathan Forsgren: Has the increasing rate changed the way that you strategize in your own hold periods in investment?

Brian Barish: It hasn't changed things too much for us. We're continuing to do what we've always done, which is we try to estimate fair value, and in addition, full value for a stock. And if it does get to full value, we are willing sellers, I do think you need to be at the margin a little more conservative about your target multiples. We just had essentially the second most expensive post World War II stock market at the end of 2021 over 20 times, some very ambulant earnings estimates that those type of levels have seldom been sustained for any great length of time. So I don't think we're going back to that anytime soon. It's probably going to be more of a mid to upper teens fair value multiple for the whole stock market and that colors how we need to think about targeting valuations for all kinds of companies.

Jonathan Forsgren: Jeff, we've seen some significant rerating for a number of companies that have been more associated with growth over the past decade, especially in the tech sector. Are these now more on the value investors radar screen?

Jeffrey Germain: Yeah. I mean, I think that question underscores the point that there's not just one type of static company or industry that value investors invest in. I mean, I think you're one of us call, we like quality, we like growth and we like high returns for businesses. The question is, what are you willing to pay for that? And we are all pretty disciplined in what we want to pay for a company like that. And as Brian just mentioned, it's not just paying fair value for it, it's then demanding a discount in case you're wrong on some of those assumptions. And so, what drives those mispricings tends to be sentiment in the market in the short term. And so, when there are contentious periods in the market that cause sentiment to change on quality and/or growth, that's when we start to look at that area again and it starts hitting our screens.

And I think there's been truly two periods over the last couple of years for us where you saw our opportunity set broaden out to areas that had been too rich for us to get involved with. The first one was 2020 in COVID, and that was a different type of downturn, it impacted companies differently than other past recessions. And you saw consumer staples that are dependent on mobility suffer. And that all of a sudden became an area which popped into the value area and we saw a lot of opportunities there.

Recently, as we mentioned before, you've had this derating of multiple with respect to technology. And I think the area so far, not in a big way, but the area so far that we see of interest are kind of the cyclical growers on the component side, the chip side, so areas where sentiment can change depending on demand supply imbalances. And we're coming off for semiconductors and memory of historically high peak in their market and now that they think the markets believe in there's a bit bit of a downturn, you've seen sentiment fall away quite quickly. And so, those are areas that we're seeing in our opportunity set and then a little bit in our portfolios currently.

Jonathan Forsgren: So you mentioned sectors that are particularly volatile right now, not that anywhere is safe and volatility, but generally, are you gravitating toward volatile sectors regardless of what period we are in just looking for that value? Is that your approach?

Jeffrey Germain: I think value, there's a lot of different flavors of what's interesting and volatility can be your friend in certain cases. And I think part of volatility and cyclicality that I think we tend to be a little bit more confident in are ones that have a secular growth behind it. So that you can be wrong and then the secular growth can help you out over a number of years. And so maybe the timing is a little off, but ultimately they will come back. I think you get into trouble where other industries has demand headwinds that are structural, and then you're grinding lower and lower with each different cyclical episodes. And so, I would say part of it is volatility and cyclicality and time arbitrage, for sure, is it plays a component and always has within value investing.

Jonathan Forsgren: Coming to you, Scott. A number of more traditional areas for value investors, energy, materials, financials have performed relatively well over the past two years. Is there still value in these areas?

Scott McBride: So we don't own a lot of materials, so I can't speak to that, but I think in energy and financials we do have a lot of investments and we do find them attractive. I'll start with energy. Energy stocks, were the best performing part of the market in 2022. And so, some might think that means that it's not the time to invest in them or still own them. I think if you take a longer term perspective, what you see is that they really haven't done well if you take a 10-year view, for example. And so, the world is moving to renewable sources of energy, but the reality is we're going to need fossil fuels for a long time, and I think that fossil fuel demand is going to continue to grow for some time. And with that context, our view is that there really isn't enough investment in supply to meet that long-term demand.

And so, that's really a good environment for prices. Lack of investment and ongoing demand means a tight market. And so, with that context, if you look at the valuations of the stocks in the energy industry, and we're talking about oil and gas, exploration, production and integrated and some service companies, if you look at the valuations, they trade at in many cases high single-digit multiples of turn earnings. And for us, what's really most important is something we call normal earnings. Maybe others use that term, that's really mid-cycle or average earnings. And they trade for us at high single-digit multiples of not only current earnings but our normal earnings. So that's an attractive valuation relative to the market. And then the companies are being disciplined in terms of how they use the free cash flow the businesses generate. And a lot of that cash flow is going back to owners in the forms of dividends and buybacks, which is what we want them to do.

Then moving to financials, really where we find a lot of value is in banks. Banks in the US and in Europe is where most of our investments are. And it's actually a pretty good en environment for banks, maybe a little bit of a goldilocks environment, in that the movement up in rates is a real tailwind to earnings. As I think Brian talked about, we've had a long period of very low interest rates and that was a headwind and a lot of companies tried to get efficient to deal with this environment at low rates. The movement in higher rates is a tailwind. And so along with that tailwind, it's still a healthy enough economy that you're not seeing a big increase in provision for credit losses. And so earnings for the businesses are very good. Again, we would say in the mid to high single-digit multiple of our estimate of normal and also on current.

Now, I think that part of the reason the stocks are priced where they are is that the world is worried about a recession and what that will mean for bank earnings. And if we do have a recession, I think that will pressure earnings in the short term. Our view would be that an increase in credit provisions would have an impact on earnings for sure, but the stocks would be somewhere mid-teen multiples of trough earnings. And so, still even cheaper than the market. So good valuations. And again, similar to energy companies, the banks are returning a lot of capital to shareholders. So we talk about a payout yield, which is a dividends plus buyback yield. In the US, you see mid to high single-digit payout yields. If you go to some of the European banks, you can get double-digit payout yields. So still value in those two sectors, even though they both relatively did okay last year. And in the case of energy, did very good.

Jeffrey Germain: I had something to add on top of that too. We agree here at Brandes with what Scott mentioned with respect to financials and energy and materials as well. And so, we do get asked, why don't you have more material exposure, especially given the energy transition and EVs? And if you think about copper and nickel, those do play a role in that transition. I think when you look at the actual numbers though, with respect to that, the energy transition and batteries and the infrastructure for copper and nickel, the demand is still less than 10% of global demand goes into those sectors. I mean, it's still the same old fixed capital investment, half of which with respect to copper and nickle of China, and China's been on historical very high growth rates with respect to fixed capital. So you still have the same kind of risks that are there despite what looks to be a positive sector or growth trend. And not to mention, the pricing of those materials outside oil are elevated and above the cost structure, which indicates to us that maybe there's risk with whether priced today.

Jonathan Forsgren: Rick, how do you think about quality and value? In this environment, is quality as a factor becoming too expensive? As markets have sold off, are there companies with higher quality characteristics coming into your opportunity set?

Rick Taft: Thanks. It really is an interesting question because there is a bit of a mismatch or dichotomy sometimes when we think of quality and higher valuations and finding value opportunities. And indeed, one of the things we really take pride in our strategy is really trying to avoid value traps. And I think one of the things that's a little bit unique about our strategy is our average holding period is over five years. So we really take the approach of measure five or six times and cut once, and we do that just to try to make sure we avoid many of these value traps. So the stuff we look at, we will try to focus on competitive positioning and durability. In the long term, we focus on what's a management team's ability to improve the business over multiple years. We're not looking for one catalyst, we're looking for multiple catalysts because we're holding stocks for five years.

And so, we need the combination of a great management team, but we need a set of assets that can be improved somewhat continuously over a number of years. And then finally, we really look for longer term growth. I think it was Jeff touched on it earlier, maybe it was Scott, in terms of secular growth, you don't necessarily associate value funds with secular growth, but it really is critical to have that type of a tailwind, especially for a fund that tends to hold stocks for a longer period of time. So we fundamentally look for better growth, not necessarily high growth, but for longer term growth.

And so, how do you find quality within value? I think somebody touched on it a little bit earlier, you could call it volatility, we call it controversy. And reality is if there's no volatility or controversy, then great companies are not cheap, so you're not going to get an opportunity to buy them. And so we don't necessarily chase controversy, but we look for those types of disconnects or the opportunity to be contrarian, the opportunity to buy a high quality company that for one reason or another, whether it's regulatory, whether it's a change in technology, whether it's a change in sentiment. For one reason or another, there's an opportunity to buy it. And if we do it well and we buy a great company and own it for a long period of time, as that volatility recedes, the multiple will go up and our shareholders will benefit.

Jonathan Forsgren: So I'm going to stick with you for a second, Rick. You mentioned that you're looking at five-year hold periods, we've come into many are agreeing as is an unprecedented period. So if you set a five-year hold period just before the pandemic, how do you balance that kind of, "Okay, we're not going to react to market activity, but also, okay, we might need to because this looks like it could be a totally new regime and we might be looking at a totally different market landscape"?

Rick Taft: Yeah, absolutely. I mean, I think to start, you really going to have to probability adjust your conviction. I mean, there are a lot of factors and you don't want to try to chase all of these factors down, but you try to come up with some weighting in terms of those things that you can really sink your teeth in or anchor your investment thesis in. So just for an example, some of these five to 10 year trends, we touched on renewables and EVs and we're not top down in investors at all, but again, we're looking for something with longer term growth that offers an opportunity potentially through a down cycle. We look at stuff like AI and 5G and cloud, which you might not associate with value companies, but the reality is there are a lot of semiconductor companies that you have big dividend yields with good growth rates that are really levered into these trends.

I think we've talked about digitalization in the banks, you've clearly seen that, in terms of what's happened with e-commerce. But the same thing's going to happen in healthcare, we're going to end up in an environment with one digital record. And if you look at the inefficiency in the healthcare system, that's caused because doctors don't have a full dashboard as to what some a patient's records are. These are really big numbers, you're talking 10%, 20% type cost numbers. And so, that's another long-term trend that we can sink our teeth into. And then I think earlier I touched on a little bit the onshoring and de-globalization, we certainly look at whether it's sensor companies or semiconductor companies or solar companies bringing solar back into the US. These all present pretty good opportunities in the longer term.

In the shorter term, we try to use this cyclicality and season cyclicality to our advantage because it does create a lot of volatility. I mean, if you look at China right now, a lot of the numbers that came out of China, whether it was autos or smartphones or TVs, were quite a bit worse than the global average the last year. And so, it's likely that as China reopens, the Chinese consumer will come back over the next couple of years and we're willing to time arbitrage that a bit, understanding that the stocks are down now, the numbers are down now, but that longer term growth trend is absolutely there. And so, we try to use these cyclical opportunities as an opportunity to buy into longer term growth.

Jonathan Forsgren: Brian, why is it important to utilize active management in this type of market environment?

Brian Barish: Occasionally it's worth pointing out the weaknesses of passive. People love to talk about the positives in terms of low cost and the propensity of passive to do very well over time. But think about mechanically what you're doing. You're buying the most of what's gone up the most and you're buying the least of what has relatively speaking underperformed. And we've just come out of what was an unbelievably long time period of having zero, in effect negative real loss of capital, which flattered the returns, created a lot of multiple expansion in particular for growth companies. So if you're buying the S&P 500 index as a pretty easy example, I mean, it's very, very concentrated right now in a very small number of companies, it's not nearly as diversified as you might suppose.

Moreover, in a new regime, it's not reasonable to expect the same companies to keep being the big winners. It's just not reasonable to do. So, that ultimately argues in favor of using active management in either as a substitute for passive or in compliment with passive, we're able to react to things. A big part also of active management is alpha through abstention. There's certain parts of the market you just say, "You know what, I don't like this story. I don't like how this is going. I don't want to own very much of this or I don't want to own any of this stuff." In a higher cost of capital regime, lower multiples, more volatility, different geopolitical, framework that alpha through abstention, that's also worth considering in terms of what active management can do.

Jonathan Forsgren: Scott, how are you approaching risk management in the current environment? What are you seeing as areas of greatest potential risk right now?

Scott McBride: So for us, when we talk about risk management, we really spend most of our time thinking about company specific risks, and that's where a lot of our effort is. So we have our own proprietary risk rating system, and what we try to do is give a risk rating for all of our companies on three different categories. One is quality, one is balance sheet, and one is governance. So just a couple comments on each, as a couple of the others here on the show have talked about, we do care about the quality of the business we're investing in. I mean, all else being equal, we want to buy the better business if we can get it. We think there's a price for most businesses, so we want to pay attention, we're very disciplined about what we pay, but we want to understand the quality of the business and come to agreement on what that is. And I think if you're investing in lower quality companies, that just means you're investing in riskier situations, situations that are harder to predict. So that's one.

Second is, and again, some of the folks here have talked about this is often the opportunity. The reason we find a great opportunity to buy a good business at a good price is because the company is dealing with an issue in the short term. So earnings are depressed. For some reason, it may be a macro issue, it may be an industry cycle, it may be a company issue, but that's often why the opportunity is presented to us because there's something going on right now in the market that's spooked the market. And so, for us, because those are the kinds of names we traffic in, it's really important to invest with companies that have a balance sheet that can withstand a downturn.

Here at Hotchkis and Wiley for over 21 years, we've had 100-year floods in my 21 years. So you never know when the next crisis is going to come, but you want to make sure you're prepared. And then the last thing is governance, and governance is critical. We want to invest with companies that have management teams that think like owners and that have governance structures that are shareholder-oriented.

And so when you put all those things together, really the risk we're trying to get at is that the risk of being wrong in our assessment of value, in our assessment of how that value will grow over time, and that's the focus. When you think about macro risks, I think we are macro aware, we don't want to spend too much time trying to predict short-term cycles in the economy. I think we know those will happen. The focus should be on the business and making sure that the business can withstand those recessions and hopefully get stronger competitively when those recessions do come. And so, again, that's our focuses on the companies.

Jonathan Forsgren: Rick, are there any themes or trends present within your portfolio and does this impact your portfolio construction and conviction?

Rick Taft: Sure, absolutely. I don't want to rehash what I touched on already in terms of renewables and 5G, digitalization, we're exposed to a lot of these trends. But for example, we're overweight technology. Now, we're overweight technology companies that are trading at a discount to the whistle and a dramatic discount to the NASDAQ. And these are more industrial like technology companies. And I think to one of the points earlier, our discipline hasn't changed, but the merchandise has changed. And as a lot of these technology companies have become immature, they're kicking off a lot of cash flow, dividends and they really are better risk rewards. I mean, when we compare some of our industrial techno names to industrials, they're trading 25% discount for very similar merchandise. And it's interesting that some of the tech industrial names trade cheaper than the traditional industrial names. Other areas we invested behind EV, I think somebody earlier talked about copper.

We certainly have exposure there from a cyclical and secular perspective. I talked earlier about we have exposure. From a China recovery perspective, we're very bottom up stock pickers, but we do try to anchor ourselves in some of these longer term trends. So also, we're overweight materials, I think I mentioned earlier, we're overweight the tech industrial names also, and then we're underweight a lot of the consumer names. We're more concerned about the consumer. Fortunately for the consumer, they've benefited from deflation over the years. And as inflation comes back, the reality is the consumer's going to have less leeway to buy. And so, in general, we're somewhat less exposed to the consumer staple and industrial names in the portfolio. And we think that it's going to take some time for consumer balance sheets to burn down and then reset going forward as we end the next cycle.

Jonathan Forsgren: Jeff, earlier you were talking about how the inflationary environment was impacting value and growth strategies, but are there certain businesses that you and your team are favoring in this inflationary environment, and what are the characteristics of those businesses that you look at?

Jeffrey Germain: Yeah. For inflationary time periods, I mean, there's really three things that we think about. One is just making sure there's pricing power in the business is number one. Two is you got to be careful with low margin businesses. It's much better to be in a higher margin business where there is room for cost-cutting. I mean, a little bit of a hit does doesn't really hurt the investment proposition. And then debt, how that debt is structured, is there debt at all, so you don't want to be that levered. I mean, you definitely don't want to have a lot of leverage with variable interest rates. And so, those are three attributes that we look at.

Now, the key point is we're not just going to invest in businesses that have those attributes, the market has to underappreciate what we see as positive attributes for a business in an inflationary environment. And so, the areas we've seen so far, one is consumer staples has been an area. I think the market was pretty concerned heading into 2022 and then plus the Russian-Ukraine conflict with the cost inflation. But our view was a lot of these businesses do have good pricing power and yes, it will be margin percent dilutive, because you're pushing through a price component without a margin attached to it. And that's okay because you're preserving the absolute earnings, and as that raw material cost inflation starts to die down, you may be able to keep some of that additional price.

And so, there's been opportunities there. I mean, healthcare is another key part of the portfolio which has high margins proven over time during different inflationary times to be able to cut costs, preserve that margin. And on balance, the portfolio has a good balance sheet and it paid a lot of attention to, like I said, the maturity schedule and that fixed variable rate split. And it's still surprising for me in talking to doing due diligence with managements that a lot of management still haven't moved over to fixed rate debt. Water is still renewing with variable rate debt. And so it'd be interesting to see how that plays out in the next number of years.

Jonathan Forsgren: When you look at companies in an inflationary environment, are you slowly moving away from that inflationary strategy because we're seeing a disinflation or are you still looking at it as, "Hey, we're still in a very high inflation environment relative to what we're used to and so our strategy stays the same"?

Jeffrey Germain: Yeah. We try to look through cycle is the one part of it. And when you're thinking about different inflationary environments, part of that that's risk in assessing what a business can do if things were to get out of control. And I would say that speaking with a lot of companies, seeing a lot of different companies as a portfolio manager, we appreciated that part of this inflationary environment was temporary, in our view. So you had pretty big shocks to the system and it took a lot to iron that out. And one of the components that moves to try and rationalize things is price.

And so, there was a view that some of this was going to come back, but albeit still a higher inflationary environment in general than the decade preceding yet. So I think there were certain macro events that were going on in the last 10 years and I think there is a regime change on what the reality looks like today, but we're not pricing in river thought kind of peak inflation rate, something that would continue for a long period of time. So I would say it's still a blend between the two, disinflation and inflation and just assessing the risk profile of the portfolio.

Jonathan Forsgren: Rick, how does your team identify the best opportunities that others might be overlooking?

Rick Taft: It's a good question. I mean we use a lot of resources, we have a large internal research group that's both domestic and international. We travel, we use external research, but we really try to look for opportunities that are between the seams or where there's a disconnect per se, or it's a bit of a contrarian view. Because those are the real opportunities where I think you can add alpha and do some differentiated research that allows us to invest hopefully in front of other investors. And so, between research, it could be companies that are difficult to follow, it could be companies that are in transition, but we want something that there's an opportunity for us to peel the onion back and really add value by going deeper. I think I mentioned earlier we run a concentrated product, it's only 35 stocks in our portfolio. My partner and I both have over 25 years of experience, and so we really look for the opportunity to roll our sleeves up and dig in.

Jonathan Forsgren: Scott, you mentioned European banks earlier. Are you looking and finding other opportunities overseas and other sectors?

Scott McBride: Yeah. So I think there are. We find a lot of opportunities outside the US in general, valuations outside the US are lower. I think it makes sense that they're lower, the growth rates are lower, returns tend to be lower. The areas we find the most value outside the US is continental Europe, the UK and Canada. I mentioned the European banks and so maybe just digging in a little bit more about them. So it was a really difficult decade for European banks in general. They pretty much spent most of the last 10 to 12 years dealing with the after effects of financial crisis, the European crisis. Most of the capital the businesses built went right on their balance sheets to build capital ratios or to pay fines, and they had to deal with low rates and zero rates or negative rates, which is a real headwind to earnings.

And so, I think they're in a better spot. Again, I talked about this earlier, but it took out a lot of costs to try and deal with low rates and now you have a tailwind from higher rates and we're finding that earnings by need better than we expected. And then the capital they're generating, instead of going to build capital on the balance sheet or to go back to pay fines to regulatory issues to their regulators, they're going back to shareholders. And so, that's a good environment for us. And so we do like those.

Other areas, if I had to think about broadly, it's across a number of different sectors, but one area we still have a lot of value in would be in travel-related businesses. So businesses who were really impacted by the pandemic and the lockdown globally, and while the businesses have certainly, in most cases, recovered off the worst of it, they're still really underearning what we consider to be, again, normal or long-term average earnings. And so, the market is still pricing them at a good price relative to what we think they should generate. So those are the hotel companies, companies in aerospace or other business models that are just travel-related. And that's another area if you look across a number of sectors in our portfolios where you'd see investments.

Jonathan Forsgren: And Jeff, are you finding the opportunity for value better in international or US markets today?

Jeffrey Germain: Yes. No, we are, and you shared a lot of the same sentiment that Scott mentioned. It's been a long time since international markets have outperformed the US market. It's one of the longest time periods of US outperformance for a long, long time. And I think that weighs on sentiment for the market. And I think the market tends to forget just how important X US international markets are. 75% of global GDP comes not from the US, so it's Global X US. If you look at market cap companies, about $5 billion or more, just under 70% of them are non-US companies. And so there's a lot of opportunities to find value. And as Scott mentioned, the evaluation discrepancy is really, really wide with the international part of the markets trading at historically high discounts to the US. And we look at this using a sector neutral composite valuation, discrepancy evaluation between international and US.

And so, it's very low. It's one of where the spread is very... Let me restart that. When we assess the valuation discount for international markets, we look on a sector neutral basis and across a composite valuation metrics. And right now, you're sitting near a 19-year extreme discount for international markets versus the US. In the US, it's been mentioned before, it's been concentrated around technology. And again, that's been a really great place to be over the last 10 years. And as we mentioned again on this call, just respect to interest rates and some regulatory issues that are maybe coming up that may not be the best place to be for the next 10 years. And so again, it speaks to the opportunity is we see as being better internationally.

Jonathan Forsgren: And sticking with you, and also, Scott, geopolitical risks have always been inherently tied to emerging market stocks. In the last two years we've seen Russia's invasion of Ukraine, trade tensions between the US and China and now balloons, and then political instability in Latin America and also balloons. Have any of these factors changed the way that you view and value emerging market stocks? In other words, do you see these as new risks that are associated with emerging markets?

Scott McBride: So I guess just a couple comments on that. One would be, I think geopolitical risks are maybe a little bit more at the forefront of your mind just based on some of the things you talked about. I think they're not only risks for emerging markets, there are risks to investing in develop markets. And I think if you go back to the discussion we're having on risk, I think implicit in when we're making assumptions around companies and what they're going to earn, and I think implicit in those assumptions is the idea that GDP of the world will grow, decades of the future will look like the decades of the past. And if anything that would threaten that basic assumption, if worst case scenarios come to bear, that's obviously a threat for any market.

When you think specifically about investing in emerging markets, we think a lot about what I talked about earlier, which is governance. And as I said, with any investment we make, we want to invest in a company where the governance structure is oriented around shareholder returns and where the management team act and think like owners. And each company that we look at, you want to treat each company separately and you can find great companies with great governance and great management in the emerging markets, but they tend to be harder to find. And the reality is that the developed markets governance structures tend to be better. And so, for that reason, we really have had very limited investments in emerging markets for a long time and we continue to have very small investments in the emerging markets.

Jeffrey Germain: I think emerging markets is a good example where active management matters. The indices tend to be very highly concentrated, given where the big market caps are and still developing areas. And so, being able to pick through the risks and the opportunities, from an active manager standpoint, I think there is value that can be brought to emerging markets. You look at the laundry list of risk that you mentioned, I think obviously a war is new and as Scott mentioned is something that not only impacts the markets in which is happening, but broadly the ramifications. And so, I think that creates opportunities when there's too much negative sentiment given the knock on effects of that war for a long-term value investor. But the other risks, I mean, we've all been doing this for a long time, we've seen political changes and saber-rattling, and a lot of these risks that we mentioned are not new and it's par for the course. And so, it's just trying to assess how much of it is real going to impact the fundamentals of the business earnings and how much of it is just noise and we can capitalize on.

Jonathan Forsgren: Brian, bringing it back stateside, can the US avoid a recession? If not, how bad could it be for the US economy?

Brian Barish: That's a complicated question. Independently of the respondents of the Bank of America survey that you just mentioned, if you look at the yield curve, it is unbelievably averted, it's the steepest inversion other than during the peak vulgar years ever. So the yield curve expects a recession, and that is a huge multi-trillion dollar market that is almost impossible to manipulate. So let's go with that, is the operating assumption. What I always find worthwhile to do for myself in my company's investments is to think about, "Okay, fine, we need a recession." Well, what is it that needs recessing exactly because not everything does? And in the last 30 years, this is an interesting statistic, the percentage of the population that works for a VC sponsored business has risen tenfold as compared to the early 1990s. So that sounds like a lot. Even if you had 30% drop in the employment of people working in VC sponsored businesses, it's still, we have sevenfold. I mean, it's still a huge number.

So I think it's that area, the disruptors of the future, the sparkly sexy stories that have yet to turn into big, profitable scaled businesses. We might just need fewer of those and more people and more resources and more capital in, let's call it the more normal part of the economy, the physical economy, building stuff, providing various services, that sort of thing. So that's what I think the recession is going to look like. I think one other point that's worth mentioning here in terms of your question is that the last recession that actually lasted for any length of time was the one that happened in the wake of the financial crisis in 2008 and in 2009. And that was not a normal recession, that was practically a depression. And we all know stocks lost 60% of their value at the trough, it was catastrophic, but it was a financial heart attack that brought about the recession.

In this case, we're talking about causality going the other way. A recession brings lower earnings, which brings stock prices potentially lower. Those are two very different characters to how this occurs. So we have had other recessions in, I think, all of our lifetimes here on this panel that they really weren't that bad. I mean, unemployment goes up, but if you're one of the people that becomes unemployed, that ain't fun, but it's not this catastrophic situation. So I'd focus more on businesses that don't need recessing, focus less on businesses that seem like they have very demanding expectations and growth requirements embedded in them and make your stock picks from there.

Jonathan Forsgren: Well, you're talking about different areas that need recessing. We're looking at a labor market at a 50-year high. Is that an area that needs recessing, and how are we going to get there if we do need that?

Brian Barish: That's a very good question. So if you look at the labor market and you divide it into cohorts, so 25 to 35, 35 to 45, so on and so forth, what you will discover is that compared to late 2019, before we ever had a pandemic, basically the percentage of people working in the 55 and under cohorts is back to what it used to be as very fully employer. However, when you get to the 55 and up cohort, there is a meaningful reduction in the number of people that are engaged at all in work. So we've basically lost a component of labor supply and it's tended to be older workers and given the stage of life that they're in, it's not easy to see how it is we're going to be pulling them back into the labor force, they're just not that interested for whatever the reason.

So in the fed's version of the world, they do use a bit of a Phillips curve model to think about whether or not there is inflationary pressure and given how high the labor market is, there should be, and there is evidently inflationary pressure. So they are using the blunt tool that they have, which is kind of a sledgehammer to tap down on demand, to tap down on finance ability and cause some of these workers that are currently occupied to get freed up and move into other things and ultimately create some more loose form of labor support.

Jonathan Forsgren: And in light of the market outlook and recession likelihood that you've given us just now, what areas of the market are you finding most interesting right now and what areas are you avoiding?

Brian Barish: I'll start with the avoids. So there's a couple areas that they just scare me right now, I'll put it to you like that. Commercial real estate scares me. A lot of stuff built over the years assuming cap rates that are at this point in imagination land. So that scares me. I think private capital has overperformed, I think that was a derivative beneficiary of low interest rates and people's assumptions about where they might be able to get excess return. We're a little cautious on the banks, I think, not hyper cautious, but that some of these issues will inevitably land on their balance sheets. Although that said, this is not anything like the playbook going into the financial crisis back 15 years ago. So those are the avoids right now and just all the overvalued stuff in the digital economy disruptor space. On the more positive side, two areas that we really like for the long run are the broad industrial space and semiconductors is essentially the industrial components of the technology sector.

So for industrials, you've just got a whole lot of things that will benefit them. You have of onshoring business, you have de-carbonization, you have substitution of capital for labor, speaking of the last discussion point, and just general, drive for efficiency. That is reflected in valuations to some extent. They're not super cheap right now, but it is a very good story long term. In semiconductors, you've probably heard the term Moore's laws stress used here and there. It doesn't mean Moore's law is canceled, it means it's harder, it is just harder to stick with this. And that's one of the reasons why we saw semiconductors being one of the first areas when a demand came back after the peak of the pandemic period for there to be outages. It's just very difficult to bring on incremental capacity, there's only a few companies in the world with the know-how really to do it. So that's an area that we like. Again, valuations are not dirt cheap, but I think long-term you've got a lot of tailwinds there.

Jonathan Forsgren: Thank you. And Rick, at risk of being redundant here, what are the sectors that you're finding most attractive? What are the sectors that you're staying away from?

Rick Taft: Absolutely. And if I might, I follow up a couple of Brian's comments about the economy and the outlook. Clearly the last great recession we've had was back in the financial crisis. And if you look at what we went through in COVID, it really was kind of an upside down scenario. I mean, we have an environment where a large part of the population is not currently employed or actively working yet disposable income went up. And so, it really did reset expectations, and you almost wanted me to throw out the old playbook a little bit. On top of that, when you look at the inflationary pressures we've had over the last couple of years, some of this was somewhat artificially driven, obviously, by government stimulus. And on top of that, you had supply chains that drove a lot of inflationary pressure. And so, it's very difficult I think to forecast the environment the next couple of years because some of these factors that drove inflation up, they drove it up very rapidly, and it's not as clear what the true durability or tenure of these trends are.

And we're already seeing a lot of supply chain pressures come down in terms of exports out of China, and the cost of a container has gone from $15,000 to $5,000. Yet from a labor perspective, the market remains very tight. And so, we continue to focus on the bottom up stock picking, but it really is a challenging environment, I think, to make a big macro bet. From a sector perspective, there's a number of sectors we like. I mean, to start, we do think comp services is interesting, it was the worst performing sector last year in the S&P 500. If you looked at the numbers, I mean, many of these stocks were down 30% to 50%, yet their earnings were down 5% or 10% or even less than the overall market. And so, that's a pretty good recipe for an area that you should look at and that you've had a major derating in stock prices that wasn't necessarily driven by earnings.

We like utilities, believe it or not, which is somewhat counterintuitive in a rising interest rate environment. Why do we like them? We like them because we think they have better than average earnings growth relative to the S&P 500. And we think that longer term, back on the renewable side, utilities are going to be some of the major beneficiaries of this transition to renewables. I don't want to rehash, but we do like the brick and mortar industrials and technology companies. And we're keeping an eye on financials. We kind of missed the typical credit cycle you'd expect to see coming out of COVID, and so the cycle is a little bit upside down, the valuations are very attractive in financials. These are absolutely better companies, they're better balance sheets. I think it's just a question of, when does some of this pressure we're seeing from employment, when does it really flush through the consumer? But we definitely have our eye on adding to financials. And then from the perspective of areas we're avoiding, I mentioned earlier we were avoiding the consumer staples and discretionary, and as Brian mentioned, we're also underweight and avoiding commercial real estate.

Jonathan Forsgren: Thank you. And now I'm coming to you, Scott. What are some of the areas in the market that you're most excited about and least excited about?

Scott McBride: Okay. So I talked about earlier some of the areas we liked with energy and financials. I'd say we also have pretty big investments in industrials. Industrial is a bit of a catchall, maybe one common theme would be also the one I mentioned before, which is businesses that are still recovering from the travel aerospace industry where it was really impacted by the pandemic and the companies are still recovering. One area that's probably a little different, I do think that one of the members of the panel said earlier that the selloff was broad-based. So there were more tech companies that got on our radar screen last year. A little bit in semis for some of the reasons why were mentioned before. But one area that might surprise folks was an enterprise software. And so, there are a couple comments around that. One was these are some of the best businesses in the world.

The customers really can't leave, customers are captive, that means you're very high margins. So 80% plus gross margins, 30%, 40% operating margins. And most of the mature software companies have been LBOed. So when you're looking at software companies in the public markets, most of them have pretty good growth trajectories and some that are in different forms transitioning to cloud computing. And so some of them were off as much as 50% last year. That creates an opportunity to buy very good companies. These are not nearly as cheap as the financials or energy on our estimate of normal earnings, but they are market multiples for businesses that, in most cases, don't have debt, grow very fast and return capital to shareholders. Areas that we are really don't have a lot of would be consumer staples and utilities. And nothing wrong with those businesses, there's some very good businesses in those sectors.

It really comes down to us valuation, and we thought those sectors would do poorly with a move to higher rates. We thought a lot of folks were for the last decade chasing yield in some of those sectors, but what happened was the movement higher rates, it immediately sparked fears of recession of we've talked about. And those are viewed as places to hide, in essence, those are safe havens. Now, if we do have a recession, their earnings will not be impacted too much by that recession, that's clearly true. But I think if you take a long-term perspective and it's a three or five year time horizon, let's say a five-year time horizon, it's hard for us to see how those will beat the market. I think the return will be positive, but it's hard to see how they'll beat the market. And so honestly, the tech names to us, the valuations are similar, maybe lower, the growth opportunities are much better and they're not levered.

Jonathan Forsgren: And finally, Jeff, where are you seeing the areas of greatest opportunity and least opportunity?

Jeffrey Germain: Yeah. Maybe I'll go back also to some of Rick's and Brian's comments regarding resection and community observation of how value investing does during those periods of times. Because we shared the view that the two most recent slowdowns, global financial crisis and COVID were unique periods. And it just so happens that those are the slowdowns where value actually underperformed during that period of time. If you actually go back longer term history and look at typical recessions, especially those that are preceded by an asset bubble. Value has done very well relative through history. And some of the comments we've talked about with respect to low interest rates, high multiples impacting technology companies, it's interesting that the period today maybe fits that profile versus a unique slowdown. So we're finding, I guess, some similar, some different. For us, a lot of it has to do how inexpensive something is now versus when we entered it.

And so, we still like staples as far as the weights we have relative to the index, not as inexpensive as they once were. And so we're looking for opportunities to that be a source of cash to invest in other areas. And while we're still underweight industrials and still underweight technology, those have been areas that we've been increasingly adding to. And it sounds like we have a lot of the same views and where value is in technology so far with respect to large European software company that's pretty dominant, and then the chip side of the business. Also, healthcare, so we like the large pharmaceuticals, but there's also been some businesses in healthcare that have been hit by COVID and the lack of mobility and how that impacted their business from a cost and demand perspective. And those look interesting to us as well. I think Rick also mentioned communication services, advertising businesses are also of interest to us in the portfolio.

Jonathan Forsgren: Well, Brian, Rick, Scott, and Jeff, thank you for joining us today and sharing your insights on value investing.

Scott McBride: Thanks, Jonathan.

Jeffrey Germain: Thanks, Jonathan.

Jonathan Forsgren: And to our viewers, thanks for watching. For Asset TV, I'm Jonathan Forsgren. We'll see you next time.


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