Time for value stocks to shine? An in-depth interview.

Union Investment’s value investment style focuses on companies whose profits in the short term appear to be below their long-term potential and that meet a minimum quality threshold. In the following interview, Stefan Brugger, Senior Portfolio Manager for Equities, explains why the time could be right for value stocks to shine.

Union Investment has a unique approach to value investment – can you briefly explain what makes it so special?

Our investment philosophy sits somewhere in the middle of the two extremes in the market, i.e. ‘deep value’ and ‘quality value’. Unlike deep value investors, a bargain price is not the only factor in our stock-selection process. When making our picks, we also look for a minimum level of quality and some sort of trigger that will unlock the stock’s upside potential over a medium-term horizon. And unlike quality value investors, who simply seek to buy high quality at a low price, we also factor in company-specific profit cycles. As contrarian investors, we buy when a company’s earnings are below its long-term potential and sell if they are above it. Our management style is therefore very active.

Stefan Brugger

Stefan Brugger joined Union Investment’s equity team as a portfolio manager in 2007, taking on responsibility for the finance sector. Since 2009, he has also been the global research coordinator for this sector. From 2006 to 2007, Stefan did a trainee programme in portfolio management at Union Investment. After an apprenticeship in banking at HypoVereinsbank in Munich, Stefan completed his degree in business administration with a major in Investment Banking and Capital Markets at Friedrich-Alexander-Universität Erlangen-Nürnberg (FAU), Germany. During his studies, he spent one term at the Ocean University of China in Qingdao. Stefan is a CFA charterholder.

 

It sometimes appears to be almost an article of faith for investors whether they opt for highly valued growth stocks or less strong-growing value stocks . What would you, as a value expert, say are the arguments in favour of the value style right now?

We are in the midst of a paradigm shift in the macro backdrop. For many years, low inflation, ultra-low interest rates and sluggish growth were the defining features of the market environment. The biggest beneficiaries of this in the equity markets were fast-growing companies – so-called growth stocks. Now the tide has turned. The waning of the coronavirus pandemic across most of the world triggered a rapid economic recovery, also impacting on an already tight labour market. At the same time, there has been a growing trend towards deglobalisation.

Of course all this has consequences. Weak growth and the uncertainty brought by coronavirus meant that companies went for years with barely any investment in expanding their production capabilities. So when demand rebounded, supply in various areas of the economy was suddenly overwhelmed. This heralded the return of inflation – and thus expectations of rising interest rates. The war in Ukraine added further inflationary pressure from the commodities side. What’s more, prices are also being driven up – and efficiency down – by the onshoring of production and supply chains for strategic reasons.

What conclusions do you draw from this? What effect do rising interest rates have?

The kind of trend reversal that we are currently experiencing is often followed by a shift in preferences in the equity markets. This means the superior performance of growth stocks relative to their value counterparts is now likely at an end. An environment of structurally higher interest rates should prove advantageous to financial stocks, for example, which sit firmly in the value camp. These are companies with modest growth and high dividends available at what is hoped will be a cheap price.

Growth stocks, on the other hand, tend to suffer when interest rates rise. Because their valuation prices in a large amount of future profit growth, the prevailing interest rate has a huge bearing as it is used to discount these future earnings. As market conditions have shifted, it is now value stocks that have the advantage – and this is still the case despite many growth stocks having already undergone a price correction. Essentially, value has stayed relatively cheap.

Growth went on an extended streak of outperforming value after the financial crisis of 2008. Why is that now likely to change for the long run?

A key argument here is that the fundamental shift in growth trends plays right into the hands of value stocks. The underinvestment that has been evident in many sectors of the economy in recent years is a boon for the value segment. This has led to scarcity in goods that were once in plentiful supply. A prime example is the lack of investment in the energy sector. The uncertainty associated with the shift to a more sustainable economy and with ESG issues (Environmental, Social and Governance) play into this too. As a result, companies that once had little leverage on margins now increasingly hold pricing power. This is opening up the path to rising profitability – at least temporarily.

Why are you so sceptical about growth stocks?

For many stocks in this category, the exceptional growth potential of recent years has now simply been exhausted. Phenomena such as the shift to online shopping and the switch from cash to card payments have been with us as structural growth trends for many years now. They were then given a turbo-boost by the coronavirus pandemic. However, this spectacular growth could only continue until online consumer spending had exhausted its potential, and that is exactly what has happened since the coronavirus lockdown. When this point is reached, these companies will only grow in line with wider consumer demand rather than at an accelerated rate. And often the competition will get tougher too, as suddenly the market pie is not expanding fast enough to satisfy everyone’s ambitious growth plans. This is quite evidently the case with social media platforms right now.

Our economists are expecting a challenging environment and, for 2023, a recession in the eurozone. Will this not affect value more than growth?

There will undoubtedly be both winners and losers as a result of the energy crisis in Europe – and the value camp is no exception. However, value stocks should generally come up trumps in a recessionary environment. The value segment is currently underpriced and, with its high proportion of pharma, telecom and consumer staples stocks, contains relatively defensive business models. By contrast, we are expecting the growth segments to start showing stronger cyclical tendencies. E-commerce and social networks, for example, are highly dependent on advertising and consumer spending and therefore very cyclical. The markets appear to completely underestimate this point because in past recessions these companies were still benefiting strongly from the shift to online consumption.

Furthermore, we are working on the assumption that the era of negative interest rates is over. Our economists’ short-term and medium-term baseline scenarios do not anticipate any falls in interest rates. However, if there is a drop in interest rates, the value stocks that would be most affected are financials. But even then, the downside potential is limited as their prices are already being squeezed due to fears of a recession. Of course, a fall in interest rates would have a positive impact on growth stocks because of the discounting and valuation effects. Fundamentally, however, the fact that the growth prospects look much better for value companies than they do for growth companies is likely to have a greater bearing going forward.

What does your investment style look like then?

Under our value approach, we invest in companies whose near-term profitability lags behind its estimated long-term potential but where there is a prospect of this gap being closed over a period of, say, two to three years. It is therefore critical to our investment process that we keep a close eye on mechanisms that will lead to adjustments in the market and in the wider economy.

In terms of specifics, it sounds like profit cycles and the modelling of these are at the core of your investment decisions?

That’s right. We analyse the specific profit cycles of mature companies whose products are firmly established in the market. Over the long-term, the profits or losses of a company or even an entire industry will generally follow the structural demand trend for certain products, driven by factors such as global population growth, rising prosperity and an ageing population. Another factor is a proven ability in the past to maintain margins throughout the economic cycle. In the short term, however, the prevailing picture in terms of profit or loss may deviate quite significantly from the long-term potential. There could be many reasons for this – for example, a temporary imbalance between supply and demand, investment cycles in new product generations, temporary spikes in costs, supply chain disruption or demand shocks triggered by external events, such as the coronavirus pandemic.

As we are investing in companies at a time when the earnings situation is difficult, we need to factor in the risks associated with this contrarian style when picking our stocks. So, aside from our main criterion of low valuation relative to long-term potential, we also pay attention to the quality of the individual company. And also to the presence of a factor on the horizon that can unlock this upside potential.

 

As at 1 October 2022.

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