Long Live Value Investing

Growth stocks have crushed value stocks over the past decade: The Morningstar US Growth Index has an annualized return of 12.4% through August, compared with 9.3% for the Morningstar US Value Index. The difference is particularly pronounced over the past year: 30.5% versus 14.7%. Is it time for a turnaround? I spoke with two top value managers who believe that rising interest rates may finally reverse that dynamic. We explored what that might mean at a sector, market-cap, and global level.

David Green, principal at Hotchkis & Wiley, is a portfolio manager on two funds that are Morningstar Medalists, Hotchkis & Wiley Small Cap Value HWSIX and Hotchkis & Wiley Value Opportunities HWAIX. Charles Pohl, chairman and chief investment officer at Dodge & Cox, is a member of the investment committees running five Gold-rated funds, including Dodge & Cox Global Stock DODWX. Our conversation took place on Aug. 23 and has been edited for length and clarity.

Kevin McDevitt: You’ve both written about the potential narrowing of the growth and value spread. What is the likely catalyst?

Charles Pohl: The most likely one is continued strong economic growth and, along with that, rising interest rates. Historically, we've observed a strong relationship between interest rates and the performance of value stocks versus growth stocks, and we've certainly seen that in the recent period.

To put this in context, the Fama-French value/ growth series goes back to the 1920s. If you look at rolling 10-year periods since that time, the current period is one of the absolute worst on record for value stocks. The only one that’s really comparable is the one that includes the Great Depression. It’s no coincidence that came after a period of subpar economic growth when interest rates were very low. At the end of the internet bubble, there was also huge valuation disparity, though not quite as severe as this one.

So, why do we believe there are return opportunities in value stocks? We have endured extremely low interest rates for the last decade, and the value/growth disparity is related to interest rates for two reasons. One is that for a growth stock, more of the earnings are in the future, so if you apply a lower discount rate, it becomes worth relatively more. If you raise that discount rate, a growth stock will be hurt more than a value stock that has more of its cash flows in the near-term period.

The other reason is that if you look at the industry differences between the value and growth indexes, the value indexes have most of the financials, and financials themselves are very interest-rate-sensitive. For the banks, some of that sensitivity plays out in the net interest margin effect. They’ve been hurt by the near-zero interest rate, and their earnings will be helped by higher rates. Energy is also an over-weighted area in the value indexes, and the price of oil and energy stocks in general are very sensitive to economic growth. Stronger economic growth around the world is going to drive rates higher, but it will also drive the price of oil higher and the earnings of these stocks higher. Both the financials and the energy companies tend to have more of their value in the nearer-term years, as opposed to some of the growth names, where a lot of the value is way out in the future.

David Green: If you look at history, the best-performing group when interest rates go down is large-cap growth. The best-performing group when interest rates go up is small-cap value.

Over long periods of time, value has outperformed its growth counterpart historically. The last 10 years have been anomalous. The valuation spreads are quite significant now, and ultimately present value of cash flows is what determines a stock price. We can have periods where we get disconnected from that, but those periods ultimately reverse.

McDevitt: One other aspect of higher rates is the effect it'll have on balance sheets. The average company in the Russell 1000 Growth has a debt/cap ratio about five percentage points higher than the average company in the Russell 1000 Value. How might value-oriented companies handle higher rates from a balance sheet perspective versus growth companies?

Green: If you're a company that has a liquidity issue, if you have a stressed balance sheet, and interest rates go up, especially if you're funding short-term debt, that's going to be a challenging situation. And our view is that interest rates are going to go up. If you go back to 1964, the average 10-year yield has been a little over 6%, so we're well below historic averages. The lowering of the corporate tax rates has been very stimulative to the economy. As the economy grows, that's going to increase demand for money. At the same time, the government is going to have less revenue come in, at least in the short term, because of the lower taxes, so they're going to have a demand for money. All these demands for money are going to pressure interest rates to go up.

When valuing a company, we look much more on an enterprise value basis as opposed to just the price/earnings basis. We look at what we’re paying for the whole company, both the market capitalization and the debt, and we divide that by the operating income. If a company is leveraged, then we’re going to be very wary, especially if it has short-term funding. That’s especially true of small-cap stocks, because small companies do not have a lot of opportunities to get funding, especially when times are tight. Large caps tend to have more access to the market.

If interest rates rise, and we think they’re going to, it’s going to benefit value disproportionally. It will hurt growth, and those companies that have leveraged balance sheets will be potentially in a very risky situation under that scenario.

McDevitt: Do you consider the risk/reward trade-off for small- and mid-cap stocks worse than for large caps because of rising rates?

Green: I wouldn't say that. A lot of small-cap companies will be able to fund themselves, and if we do get rising rates, we'll probably be met by a strong economy. I think small caps will do fine. Usually, large caps trade at a premium to small caps because they're more liquid to trade and because they tend to have, all else being equal, more access to capital. They're more diversified. People pay a little bit more for that.

But in the financials sector, this has flipped significantly. Wells Fargo WFC and Goldman Sachs GS are the leaders in their business, yet they’re trading at essentially single-digit multiples. Contrast that with the small-cap banks, which don’t have nearly the geographic footprint, don’t have nearly the deposit penetration, and don’t have nearly the diversification within their businesses—yet tend to be trading at multiples of 14 times. That’s one area where large caps are significantly cheaper than small caps. In Value Opportunities, which has the flexibility to go anywhere with regard to market cap, we’re concentrated in the large-cap banks, as opposed to small caps.

Other than that, I don’t see big differentiations between small and large caps, with the exception of financials.

McDevitt: Dodge & Cox also owns both Wells and Goldman. Why are they trading at such a discount?

Pohl: It's regulatory scrutiny, and it's also capital ratios. The smaller banks are not systemically important financial institutions, so they get away with lower capital ratios, and they face a less severe regulatory environment, as well. That's part of the discount.

Adapting to Disruption

McDevitt: Charles, looking at the challenges value stocks have had more broadly, people have speculated about the role of technological disruption. We’ve seen the Amazon AMZN effect on retailers, for example. How much has technological disruption caused you to rethink business models?

Pohl: We've spent a lot of time researching these issues. We're also investors in some of the disruptors. Dodge & Cox Global Stock has a position in Google GOOG. It's got a position in Tencent TCEHY through the Naspers NPSN position. It's got a position in JD.com JD.

The insights that we’ve gained from our research have driven our investment decisions there. It’s no great revelation that a lot of the retail sales dollar is migrating toward online. This has caused at times, certainly at the end of 2017, some of the retailers to trade at big discounted valuations. That can create opportunities. The important thing to do is to stay on top of the changes and to take advantage of times when the marketplace is willing to write off the whole sector.

I’ll give you a couple examples from our portfolio. Target TGT has been responding pretty aggressively with their own online offering. Because they have all the physical locations, they can offer pick up in the store or outside the store, where somebody brings you the merchandise as you drive by. They’ve been getting some traction with that. They’ve also improved the traditional retail blocking and tackling. Overall, you had a stock that dropped to fairly inexpensive valuations because people were afraid of the Amazon effect, but the company is finding ways to fight back.

We had a significant investment in Walmart WMT until the end of last year, when the valuation got a bit ahead of itself. We had spent some time with Marc Lore, who they brought in with the acquisition of Jet to revitalize their online offerings. He’s doing a lot of impressive things to make Walmart a stronger competitor in online.

Some of these traditional retailers come with a lot of advantages in the online world, too. They can combine the advantages of their distribution network and their physical store presences in interesting ways with the online business model, to deliver the product more quickly to the customer, to maintain a greater inventory that’s closer to the customer, to allow for in-store pickup. The creative ones are adapting.

McDevitt: David, it’s interesting, given your deep value leanings, how big Value Opportunities’ tech stake is. Is there a value/growth divide within that sector?

Green: A lot of our tech holdings are what I would call traditional deep-value tech, like Hewlett Packard Enterprise HPE and Arris International ARRS, which are trading at very low multiples. We do own Microsoft MSFT, which sometimes surprises people because it's trading around a market multiple, maybe slightly above. But at the end of the day, a stock is valued on the present value of its earnings, and a stock that's trading at a relatively high multiple can still be a value stock.

The reason our portfolios tend to skew towards low P/Es is because most of the time, people extrapolate growth well beyond what it ends up being. They’re far too optimistic. Look at some of the highfliers during the dot-com boom, like Dell and Cisco CSCO; those growth projections never materialized. However, there are a few situations, Microsoft being the most notable, where we think the growth trajectory is very well laid out. Microsoft also has an overcapitalized balance sheet, excess cash, and is expensing a lot through the income statement as it is funding its growth. People are missing that.

Arris is going to earn about $2.90 this year, according to consensus estimates, and the stock is trading at $24.75. What’s interesting is that they’ve got essentially two businesses. One is a networking business, which is a very good business. The other is a business that sells set-top boxes to cable companies. The set-top box business is now only about 29% of the operating income, but there’s a lot of negativity around it because of worries that people are cutting the cord.

Meanwhile, DRAM prices have been going through the roof, and Arris has been penalized because they’ve had to pay higher prices that they haven’t been able to pass on to their customers. If DRAM prices ever normalize—and if you look at where a DRAM company like Micron MU is trading, at five times earnings, that tells you the market thinks they’re going to normalize—then we estimate Arris will have another $1 a share of earnings.

It reminds me of banks about three or four years ago. They were trading at very low valuations and interest rates were very depressed. We like to find situations where there’s something going on in the income statement that we think is temporary and will reverse over time.

Patience Pays Off

McDevitt: Is this another duration issue—are investors not willing to wait around until DRAM prices come down?

Green: Yes, people do not want to look a couple years ahead at what the situation could be. One of our largest holdings is Seritage SRG, which owns 250 stores that used to be part of Sears, including some real gems. They own a store here in Santa Monica that's probably one of the best pieces of real estate outside of Manhattan. It's about three blocks from the beach, right across the street from the train. It's going to be a high-end food court down below and office on top.

They have other properties throughout the country that are also quite interesting. It’s going to take probably four or five years to develop the bulk of the portfolio. But when you get there, we estimate you’ll have about $8 of earnings in a stock that’s now around $50. But estimated current earnings are about $1.50 and people aren’t willing to look ahead.

What will Seritage look like as it builds out its projects? That is our biggest advantage. We model what a company will look like in what we call a normal environment five years out. (For example, our normal energy price is around $75—so when oil was $120, we were using $75, and when oil was $30, we were using $75.) We have a deep research team here, and we’re not reliant at all on Wall Street research. By being able to do proprietary research, we’re able to figure these things out, and then when it comes to fruition, we’re already there. We can buy things at a discount to intrinsic value.

McDevitt: Charles, Dodge & Cox tends to have low turnover ratios, too. What kinds of opportunities does that create for you?

Pohl: Low turnover creates a lot of opportunities for a long-term investor. I first got into this business in 1980. In the 38-year span of time since then, you've seen the rise of investors who are focused on very short-term events, particularly hedge funds with a clientele that's demanding results every quarter. A lot of hedge funds are event-driven, trying to second-guess what the quarter's earnings are likely to be.

This creates opportunities for people who are instead focused on long-term shareholder value. When we’re talking to management teams, we’re much more interested in where they want to take the business. What are their long-term goals in terms of trying to gain market share? Where are they directing capital? What are they trying to do to build a business franchise over time?

McDevitt: Charles, we’ve talked about the gap between value and growth. Another persistent gap has been between foreign stocks and U.S. stocks. Do you see that valuation gap narrowing over time?

Pohl: There is a significant gap on the surface between the foreign indexes and the U.S.— certainly on a P/E basis, and on a number of other valuation metrics. We've asked ourselves, is it just that foreign stocks are cheap, or is there something else going on?

As the first cut, there is something else very obvious going on. In the S&P 500, the technology weighting is much larger than in the EAFE. Not only does the S&P 500 have that weighting in technology, but it’s got the FAANG stocks, these real growth-oriented stocks that have done extremely well in the last few years. Those stocks are big enough in terms of their market cap to have driven the overall valuation for the S&P 500 higher compared to some of these foreign indexes such as EAFE.

That’s not something that’s directly exploitable. You’re not going to say, OK, I’m going to sell this U.S. chemical company, for example, and buy an identical, or very similar, German chemical company at a lower price.

There are some valuation differentials, but you’ve got to be very careful. One of the value-adds that we bring through fundamental research is being able to differentiate in terms of management quality. For example, the Japanese market looks quite inexpensive, and it is relative to history. But if you take a look at Japan—and this is also true for Europe—over decades, these companies have persistently earned a lower level of return on equity and lower level of return on capital relative to comparable U.S. companies. The incentives that management has to maximize shareholder return are much weaker than they are in the U.S. These companies are just not run as aggressively to create long-term shareholder value. There are other constituencies and other values in some of these societies that prevent them from being run in as profit-oriented a manner as the typical U.S. company.

In Europe, economic growth has been quite weak for some time and continues to be much weaker than in the United States. That has probably created a lower valuation for some of the companies in Europe in comparison to their U.S. counterparts—a differential that you can’t explain away with these other factors. So there are some opportunities there, and we’re trying to take advantage of those.

McDevitt: David, you run a U.S.-based fund, but you sometimes invest opportunistically overseas. What’s your take?

Green: One of the areas that is starting to look interesting is European banks. They may be at the stage that U.S. banks were just before we entered a rate-rising cycle here. We expect interest rates to rise in Europe, so we think that that's an interesting area. They're also trading at very low multiples, like six or seven times earnings.

One of our largest international holdings is WestJet WJA:CA, where we find a tremendous amount of value. There are basically two airlines in Canada, Air Canada AC:CA and WestJet. Any Canadian can tell you all about WestJet; it’s sort of the Southwest Airlines LUV of Canada. But a lot of Americans have never heard of WestJet unless they’ve traveled within Canada, because of cabotage rules that require travel on domestic airlines within a country. If you go from Toronto to Vancouver, you have to fly a Canadian carrier, and there’s essentially two, Air Canada and WestJet.

Within Canada, WestJet is a very well-respected, excellent franchise. It’s actually trading at less than its tangible book value, which is airplanes, so it’s really its tangible assets. The reason for the discount is twofold, and this is an example of a situation that we think is temporary and will resolve itself.

The most important reason is that the pilots there decided to unionize. They’re currently negotiating a new contract. The original contract was very generous, so we don’t think there’s going to be much of a difference, but it is disruptive and some passengers have chosen to book on other airlines. That disruption has affected the near term.

The other reason is that about 40% of WestJet’s revenue touches Alberta, which is where they’re based. Alberta is an oil economy, and oil has been depressed. So, the economy in Alberta has been depressed. That will resolve itself and normalize. It’s starting to as oil prices have gone up. So, we have two situations we think are temporary, and we’re buying a great franchise below its tangible book value. Those are the sort of opportunities we’re trying to identify, and when we do, we take advantage of them.

In the Pipeline

McDevitt: You have an overweight in energy and are presumably bullish on energy. How much of that latent energy exposure factored into your thinking there?

Green: Quite a bit of that went into our thinking. It's an airline, so higher oil prices will hurt their costs, but that will hurt all their competitors' costs, too. The difference is that WestJet has an offset on the revenue side, because the Alberta economy will be so strong there.

We are very constructive on energy. We’re currently running a deficit in terms of global supply; you’ve seen that with a significant decrease in inventories last year, continuing this year. We think the market is quite tight in energy.

McDevitt: Charles, you’ve been buying and adding to pharmaceuticals over the past 12 to 18 months. Some investors have been worried about regulatory issues and pricing power. What opportunities have you seen within healthcare?

Pohl: On a long-term relative basis, these stocks are trading at pretty attractive multiples of current earnings. But that's just the starting point. As you look into the pipeline for the whole pharmaceutical industry, you see they've gone through a long period of time where a significant number of blockbuster drugs went off patent and pricing fell quite sharply. The pipeline of new drugs was quite weak. A lot of companies had to struggle to even just keep earnings from declining.

That’s been changing over the past few years, because most of the big blockbuster drugs that were coming off patent have done so. However, the number of patent expirations on large drugs is falling off quite sharply, and it’ll stay down for a while.

In the meantime, the FDA pipeline has built up pretty impressively. There’s exciting stuff going on, particularly around immuno-oncology, but in a lot of other areas, too. In some cases, the drugs have already have hit the market, and they’re starting to build in terms of revenue. We think that there’s a structural shift that’s going to drive a more favorable growth dynamic going forward for the drug industry. At the same time, we are seeing a number of companies valued at low multiples.

The other thing that’s interesting is that a lot of these companies have very significant exposure in the emerging markets. As more people enter the middle class or have more disposable income, one of the things that they start spending money on—once they’re able to feed, clothe, and house themselves—is healthcare and pharmaceuticals. The businesses of some of these companies in the emerging markets are growing very rapidly. Admittedly, it’s not at the same margin levels that you see in the U.S., but it’s still at fairly high growth rates.

It’s a business that’s very hit and miss, which is one reason why we have diversified with quite a few names in the portfolio. You never know when something’s going to wind up having adverse side effects and it’s going to wipe out years and a billion dollars’ worth of research. But we are selective. We look at these companies on a case-by-case basis, because some of them are developing more interesting franchises than others.

McDevitt: Has the market been skeptical about these pipelines because of past history?

Pohl: I think that's true. We went through about a decade where the safe assumption was that there weren't going to be very many new approvals. Over the last several years, we have seen a change in that dynamic, and I don't think the market has fully appreciated that yet.

McDevitt: Charles and David, thank you for your insight.