As after the bursting of the internet bubble at the beginning of this century, there is a danger that growth stock valuations will fall significantly, according to David Cohen, co-fund manager of the Robeco BP US Large Cap Equities fund. Meanwhile, higher interest rates are actually benefiting value investors.
This fund (ISIN LU0474363545) is managed by Robeco’s US subsidiary Boston Partners. Since its inception in 1995, Boston Partners has focused on value investing. The team looks for undervalued stocks of good quality and with positive earnings momentum. “Any Boston Partners portfolio will always exhibit attractive valuation, fundamentals, and momentum characteristics, which is achieved solely through our bottom-up stock selection process,” says Cohen, speaking to Investment Officer.
US large cap value stocks have performed much worse than the S&P 500 over the past 15 years and investors began to doubt the existence of the value premium. But according to Cohen, the tide has turned and value stocks have posted excellent returns in recent years. “We are now in an environment where interest rates and inflation are expected to remain at high levels, something the market has not experienced in the past 10-15 years. Historically, high interest rates favour value stocks and our fund has performed strongly during these periods.”
This is also reflected in the track record. For example, over the past three years, returns have averaged 10.6 per cent per year, compared with 8.1 per cent for the Russell 1000 Value Index. Since the fund’s launch in early 2010, returns have been on par with the benchmark.
Multiple expansion
The growth side of the market may have more flashy names attracting investors’ attention, but the opportunities at the moment are mainly on the value side, according to Cohen. “We see many attractive quality companies with clearly more reasonable prices compared to the well-known growth stocks. Whereas growth stocks are quoting at a premium of 10-20 per cent compared to their own history, the valuations of large value stocks are in line with their historical averages.”
On the value side of the market, Cohen sees a lot of room for multiple expansion. “Many companies are trading at a discount despite very strong earnings momentum and high quality. On the other hand, on the growth side of the market, there are many downside risks, with potentially significant declines in valuations.” He sees similarities between the current market and the internet bubble around 2000. “The stock market value and price-to-earnings ratios of many companies went sky high then, before eventually falling sharply.”
Growth stocks, he says, had the wind at their backs in recent years thanks mainly to the very low cost of capital, which made high debt financing advantageous. “But with high interest rates, leverage becomes less favourable and investors look for companies with attractive valuations, which generate significant free cash flow and achieve high returns on invested capital.”
Cheap tech stocks
Relative to the benchmark, the fund is particularly overweight in financials and technology, while real estate and utilities are underweight. Within financials, the team finds credit card companies particularly attractive, as consumer spending and employment continue to develop better than expected. Real estate and utilities are “expensive defensive stocks”, according to Cohen, which quote at a premium despite weak growth and earnings momentum. “However, we have no sector view and the fund’s positioning is purely the result of our bottom-up stock selection,” Cohen said.
Although the technology sector looks on the expensive side, he also sees opportunities for value investors. “The tech stocks in our portfolio are trading at 17 times earnings, in line with the tech sector in the benchmark and much cheaper than the p/e of 24 for tech stocks in the S&P 500”. Within the sector, the fund has significant exposure to chip makers and equipment suppliers to the chip industry. Among software companies and IT service providers, Cohen also finds stocks that meet his criteria.
The fund manager stresses that the fund does not have a deep value approach but includes companies that are cheap relative to their quality and earnings momentum. Some stocks in the portfolio may therefore have a relatively high price-to-earnings ratio, provided the analyst team sees upside price potential. “We avoid bubbles in the market and you won’t see companies in the portfolio trading at exorbitant valuations. But we certainly have some names in the portfolio that deserve to be quoted at relatively high price-to-earnings ratios and which we think are worth much more.”
This article originally appeared on InvestmentOfficer.nl.