While value stocks tend to be cyclical and more vulnerable to economic downturns, we believe the economy remains on solid footing to continue growing, albeit at a slower pace because of tightening monetary conditions. When faced with inflation, near-term profitability is more important than longer-term cash flows.
As monetary conditions continue to tighten in most countries, shrinking liquidity and rising bond yields likely spell trouble ahead for stocks. Where can investors take shelter Some of the best stocks for downside protection should also be capable of delivering consistent earnings and cash flow growth over the next several years. All roads lead to health care, specifically pharmaceutical stocks.
The best of the cyclical stocks, those well-positioned competitively, are likely candidates for outperformance as markets anticipate the re-start of economic growth. A disciplined strategy of buying world-class cyclical companies during the downturn may prove very rewarding when markets begin to price in recovery.
Historically, this group rode the wave of demand for chips in PCs and smart phones, only to collapse with the overabundant supply response. Unsurprisingly, memory-chip stocks have lost favor with investors as a downcycle appears likely next year. However, due to industry consolidation into a few scale players, formidable barriers to entry and supply discipline, this cycle should be brief.
So where to put that cash Market laggards might be a great destination. Economically stable sectors such as healthcare, consumer staples and utilities underperformed overall markets in the past 12 months. Currently, the large-cap pharmaceuticals are trading at the lowest valuation relative to global markets in over 20 years. Historically, pharmaceutical stocks underperform when politicians start paying attention to drug prices, as they have lately, before the industry returns to favor. And Covid-19 has actually been a drag on revenue: The pandemic interrupted normal hospital admissions, doctor visits and interrupted people getting and filling prescriptions. After the pandemic, a permanent shift to more-convenient telemedicine should mean more prescriptions will be filled.
To temper volatility from cyclical stocks that are influenced by the economy, adding equities with consistent earnings growth seems prudent. A good example of this are companies that provide outsourcing for operations such as finance and accounting, reporting, web development, call centers, HR functions, marketing, and so on.
In Asia, the larger countries tend to have three telco competitors controlling the bulk of market share and enjoying favorable regulation. Several of these stocks trade at extremely low valuations relative to their markets and their own history. In Europe, the telco companies have acquired spectrum in various countries, defended their market positions against telco upstarts and are consolidating operations to improve returns.
Value stocks have underperformed growth for much of this post-2008 period, resulting in historically wide gaps between value indexes and growth indexes. From the year 2000, cheap stocks in the MSCI All Country World Index have outperformed expensive stocks by more than 40 percent over the next 12 months when the earnings yield spread (earnings yield of cheap stocks minus earnings yield of expensive stocks) has been in the top decile. At the end of March the earnings yield spread was in the 92nd percentile. At some point, extreme levels of depressed valuations will inspire buyers to snap up bargains.
The most undervalued stocks in many markets globally discount recession and structural disruption. Banks, maligned in a period of falling interest rates, trade at near-crisis levels, especially European ones. Global auto stocks trade at meager valuations versus history and compared with other cyclical segments of the markets, such as capital goods. Energy stocks are also trading at historically depressed levels.
For many growth stocks, earnings and cash flow are promised far into the future, which makes them the most sensitive to interest-rate fluctuations. As rates rise, these types of stocks typically swoon. In contrast, companies that generate surplus cash flow today, and return much of that to shareholders, offer immediate returns. With liquidity ebbing, a bird in the hand will (once again) be worth two in the bush.
High-dividend-yielding, undervalued stocks may finally reign over growth stocks. In this global environment of gradually tighter monetary policy, the cash that a company returns to its shareholders in the next few years may be much more valuable than a potentially unfulfilled promise of rapid growth in profits many years ahead.
The massive growth in liquidity created by global central banks after the financial crisis has stalled in 2018, and will likely shrink in 2019. Meanwhile, valuation spreads between expensive and cheap stocks, measured by relative price-to-earnings ratios, are at extremely wide levels vs. history. In the past 20 years, these especially wide valuation spreads typically led to a narrowing of the gap and subsequent outperformance of cheap stocks.
One of the most undervalued areas of the U.S. unconventional oil and gas industry is oilfield services. Of the onshore oilfield service stocks, the pressure pumpers have sagged significantly in price.
Oil and gas companies exhibit cyclicality in sales and earnings, traits that investors have shunned in recent years in favor of steady growth. Relative to high-flying technology stocks, the recent performance of energy equities looks abysmal. Over the past 12 months, global energy indexes have underperformed global technology by more than 30 percent and are trading at a sizable valuation discount.
The forces of supply and demand dictate the price of semiconductors as well as oil, with the lowest marginal cost producers having a distinct advantage over the competition. Advertising, including the internet, also has a cycle. The last time markets ignored the cyclicality of technology was in the late 1990s, a rough period for the most overvalued stocks.
Why do several of the large global pharmaceutical stocks trade at above-market dividend yields and below-market price/earnings ratios Perhaps the repeated threats by President Trump to cut drug prices have scared investors.
Famously profitable, the best-managed pharmaceutical companies should be able to offset reduced unit prices with volume growth. In their report dated January 2017, Evercore ISI analysts Umer Raffat and Akash Tewari note that most of Medicare/Medicaid spending increases are due to higher enrollment, not because of pharmaceutical costs. While total U.S. health-care spending continues to increase, the percentage attributable to prescription drugs has stayed flat, at around 10 percent.
As of late May, over 200 Japanese stocks with market caps above $1 billion also have dividend yields greater than 2 percent (several offer yields of 4 percent), with dividend payout ratios less than 50 percent. In other words, these dividends should be well covered by earnings, and (thanks to the low payout ratios) have room to grow.
In the U.S., investor demand for high-dividend-yielding stocks, and exchange-traded funds that track such stocks, has risen sharply in our own prolonged low-interest-rate environment. Perhaps the same will happen in Japan. Mrs. Watanabe, the proverbial Japanese retail investor, wants income. It may make sense to own some of these income-generating, better-quality Japanese stocks before she does.
There will likely come a point to add back to stocks. For now, the likelihood of slower growth, stubborn inflation and tighter financial conditions suggests a more modest approach: a conservative allocation and income to get you through to better times.
Year-to-date, GARP names have performed in line with the market. While GARP is an effective, all-weather style, it can struggle when inflation is accelerating. However, the environment may be shifting again. Inflation is probably close to peaking and investors are becoming equally concerned with slowing growth. Many growth names were overpriced, but their unusually high pandemic premium has dissipated. Going forward, investors should revisit profitable growth stocks where valuations have become more reasonable.
Despite this unique set of circumstances, year-to-date consumer discretionary stocks have trailed the broader market and other cyclical sectors. While concerns over the delta variant create near-term uncertainty, investors should take advantage of any weakness to build positions in consumer-oriented names. I would favor companies tied to housing, specialty retail and media/entertainment.
Since November, several related themes have dominated equity markets: a remarkably quick vaccine effort, layer-upon-layer of fiscal stimulus, fears of inflation and higher interest rates. Given this backdrop, investors have rotated towards value-oriented, high beta, cyclical stocks. [High-beta stocks are stocks that are more volatile than traditional stock-market benchmarks.] Going forward I would stick with two of these themes: cyclicals and value.
After being written off as dead, value stocks have staged a comeback. The rally is part payback following years of underperformance and partly a reaction to the best growth in decades. However, today the more speculative parts of value are stalling. For example, recently small-cap value has struggled relative to large-cap. Part of the headwind for small caps is that they are inherently more volatile. While investors are looking for cyclical exposure, they are turning more cautious on pure market risk.
Household demand, particularly for durable goods, has supported manufacturing. In August, the new-orders component of the ISM manufacturing survey hit its best level since 2003, and recent data confirms that orders remain robust. A combination of low inventory levels and solid spending should continue to support manufacturing. 59ce067264