The expected returns on US value stocks are attractive compared to growth stocks. As a coronavirus vaccine is now around the corner, the global economy will pick up next year. This will be supportive for long-term outperformance of value stocks, according tot Christian Correa, President and Chief Investment Officer of Franklin Mutual Series.
Optimism about a rapid upturn in the global economy has triggered a rotation from growth to value in recent weeks. Correa believes this trend will continue. ‘We have had a very long period of outperformance of growth stocks and trends such as these eventually turn. We see that many stocks are recovering as one or more corona vaccines are likely to be available in 2021. This will allow a resumption of normal life in much of the world. The tailwind of economic growth will support continued outperformance of value stocks.’
Correa’s optimism is partly based on the low valuations of US value stocks. ‘We believe that many stocks are trading at a discount to their fair value. As value investors we focus on valuing equities based on the long-term outlook for the underlying assets and businesses, rather than using traditional measures such as price/earnings ratio and price/book value. What matters to us is the free cash flow that a company can generate. In our investment process, we make a detailed analysis of the volatility and sustainability of those cash flows and ultimately their valuation by the market.’
Nevertheless, according to Correa it is evident that the valuation gap between ‘value’ and ‘growth’ based on traditional valuation indicators has widened in recent years. ‘Compared to growth stocks, the expected returns on value are very attractive. Many growth stocks have benefited from the pandemic and the valuation gap with value is expected to narrow as the global economy recovers.’
However, he does not recommend ignoring growth stocks altogether. A value strategy can complement rather than compete with a growth strategy. Many investors have been overweighting growth stocks, especially those that mainly exposed to benchmark-weighted strategies. Value can provide diversification for this group of investors.’
Business travel
Correa expects most sectors to eventually recover from the crisis, with the exception of business travel. ‘During the pandemic, people stayed at home, worked at home, shopped at home and were entertained at home. We do not expect these trends to continue in the foreseeable future. With the availability of a vaccine, people will be going about their normal lives again. They will return to bars and restaurants, fly to distant destinations and go to the office again. However, one part of the economy that we are particularly negative about is the return of business travel. The pandemic has made it clear that online meetings also work and we expect the trend of videoconferencing to continue in the future.’
In any case, there are many sectors facing structural challenges, says Correa. ‘The oil and gas sector is a well-known example, but the retail, automotive and real estate sectors are also in a difficult situation, he says. These companies will have to rethink their business models. As value investors, we need to find out which business models have a future and which do not.’
Comcast
Correa manages the Franklin Mutual U.S. Value Fund. With a weight of approximately 24%, the fund has an overweight in the communications sector. In the S&P 500 Value index, this sector has a weighting of 16%. According to Correa, this is a typical sector where traditional valuation indicators can provide a misleading picture. ‘A good technology company continuously invests in research & development to create value. These investments do not appear on the balance sheet, but are seen as expenditures. However, we estimate the value of past R&D investments and use this in our analyses. As a result, we have found many more attractively valued, innovative companies than traditional value investors.’
In addition, Correa considers a good understanding of the business model and competitive position of IT-companies to be crucial in determining the value. ‘A local telecoms company with its own fibre-optic network is able to provide consumers with a better service at minimal extra cost than competitors without a network. This results in a strong competitive position, which is not reflected in traditional valuation measures.’
The American telecom and media company Comcast is one of his favourite stocks. ‘Comcast is the largest cable supplier in the US and has a dominant market position thanks to its superior network. The speed and reliability of the network proved very valuable to customers during the pandemic. In addition, Comcast has film studios and amusement parks. These were hit hard by corona. That is why the share is also a recovery candidate.’
Correa also thinks Merck is an attractive stock pick. ‘This pharmaceutical company has leading positions in the field of cancer medicines, vaccines and animal diseases. Merck is very profitable thanks to its focus on innovation. The high R&D expenditure is not included in the balance sheet. We think that the value of Merck is therefore probably much higher than the market indicates.’