It takes a lot of guts to come up with the proposition that this is the moment to shift the emphasis from growth to value stocks. But John Bailer, US equity income manager at Newton Investment Management, is certain. The reason: structural changes in the macroeconomy. Soaring inflation, for example, is giving rise to a veritable “value renaissance”.
Over the past 15 years, value investors have repeatedly lost out in their competition with growth-oriented equity investors. But, said Bailer, manager of the U.S. Equity Income Fund, “soon that battle will turn in favour of the value investor”.
Comparing the historical performance of these two investment styles shows that value investors have very rarely been able to win the battle for yield. But the tipping point in this will be the return of inflation. “We have seen a strong deflationary period over the past decade, where globalisation, demographics and disruption have depressed producer price,” said Bailer.
He explained that it is logical to think that inflation is currently priced in by the market because everyone is talking about it. “But I believe that if you look at the underlying matrices, it is not yet. The top 20 per cent of stocks that should benefit most from higher interest rates are currently at their cheapest since 1970.”
So, compared to the market, value stocks are still trading below their historical average. The current difference between value and growth, he said, is greater than during the run-up to the dot-com bubble in 2000.
“Clearly, inflation has not yet been factored into prices here in the US. Despite Fed President Powell’s renunciation of the word “transitory”, the market still believes the Fed’s rhetoric.”
Monetary easing
Ten years ago, Bailer said, it was all about reducing government deficits. “Governments weren’t spending money and even the Fed’s monetary easing was nowhere near the current levels of easing. Our view of debt has completely changed, both with respect to the Republicans and the Democrats.”
“The stance on monetary easing of both camps will create more inflation. That means higher interest rates again and therefore good expectations for value investors.”
“Central banks worldwide added an unprecedented amount of money to the financial system after the global crisis of 2008. Banks had too much debt on their balance sheets, making them vulnerable to customers who could not pay or repay their debts. As a result, they were reluctant to lend out new capital.”
“Now, however, we have the opposite situation. Most financial players in the US have - under the influence of tighter laws and regulations– increased their buffers to such an extent that the FED has now allowed banks to substantially increase the payout of excess profits. Some financials have had dividend accumulation of up to 100 per cent for this reason, such as Morgan Stanley, for example.”
Globalisation and ESG pressure
Over the past decade, companies have increasingly focused on optimising the supply chain by entering into “just-in-time contracts”. At the same time, they tried to reduce costs by moving production and operations abroad, Bailer said.
According to Bailer, the process of globalisation slowed down economic growth in the US. Meanwhile, policy in the US has changed. The emphasis is now on so-called “reshoring”: production must take place in the home country. Especially the semi-conductor industry must be brought to the US in its entirety, or at least that is the aim.
“Bringing such an industry domestically will give inflationary impulses to the US economy. Higher inflation and eventually rising interest rates. That combination is beneficial for the value investor,” said Bailer.
Meanwhile, ESG will also provide an inflationary boost, as it will increase the cost of financing for companies involved in oil and gas production. There has been a turnaround in that sector, said Bailer.
“Ten years ago companies were mainly interested in drilling. They didn’t care about profitability. It was all about building up reserves and improving and increasing production. Today, there is a realisation that the demand for oil may not be what it once was. Disciplined management of capital and supply are the new priorities and that also leads to higher prices in the long run.”
Companies that do badly when interest rates fall and do very well when interest rates rise are still undervalued, in Bailer’s view, despite recent developments. “If you want that inflation protection, it’s really cheap in the US market right now.”
Opportunities are in financials
Asked about value opportunities in the market, Bailer - without naming individual titles - cites the financial services sector, to which the fund he manages has a 29.3 per cent allocation compared to an 11.3 per cent weighting in the S&P 500. On 30 June 2021, the portfolio’s price to book ratio was 2.2 compared to 4.6 for the S&P 500 Index. On the same date, the P/E ratio stood at 13.7 versus 20.6 for the S&P 500.
“To me, that’s very inexpensive,” said Bailer. “We achieve that without sacrificing dividend yield, which is 2.6 per cent in the portfolio versus 1.4 per cent for the S&P 500. If you want to protect the income stream in an inflationary environment, those are the numbers you should be looking at. A fixed-income coupon doesn’t change, but if you buy a stock that produces income, you can beat inflation.”
The BNY Mellon U.S. Equity Income Fund has $290 million under management and is over 29 percent invested in the financial sector. In addition, healthcare and industrials are the second and third most important sectors for the fund with respective weightings of 18.38 percent and 10.32 percent.
BNY Mellon U.S. Equity Income Fund - USD W (Acc.) (ISIN: IE00BD5M7221)
