Markets & Economy
U.S. Value Stocks—Living Up to Their NameMarch 9, 2017
- A core aim of value investing is to identify those instances where the volatility in a company’s stock price is excessive relative to the fundamental health of its business.
- However, these so-called valuation gaps close very quickly today, and investors need to move swiftly in order to capture these opportunities while they exist.
- This is where T. Rowe Price’s research-intensive investment approach comes into play. With one of the world’s largest buy-side research platforms, our capability is built around experienced, long-tenured portfolio managers and industry-specialist analysts working in close collaboration.
- Two significant behavioral trends to emerge over the past decade have been the sharp decline in investor risk tolerance and investment time horizons growing ever shorter.
- This low-risk, “short termism” can, at times, create meaningful distortions in the market. We try to take a long-term view of the opportunities presented and, as such, are willing to tolerate some short-term volatility in order to realize the long-term potential.
- The challenge for value investors in 2017 is finding relative value winners when there are few areas left that are noticeably undervalued. Nevertheless, the broad market valuation is an average of cheap and expensive stocks and active managers can still add substantial long-term value.
As a value investor, you have spoken previously about needing to be more responsive than ever in today’s environment—quicker to identify mispriced opportunities and quicker to act once they are found. What is driving this pressure, and how have you adapted?
A core principle of value investing revolves around the fact that the amount of volatility in the market typically far exceeds the level of volatility in the underlying businesses. As an example, between 1881 and 2016, the volatility of the U.S. stock market has averaged at around 17%. In comparison, the volatility of the market’s dividend stream over the same period is only about 1%.1 This means that some 90% of the volatility within U.S. stock prices has been due to something other than the volatility of the underlying dividends paid by the actual businesses. This disconnect is what drives the real opportunity for value investors—in identifying those instances where the volatility in a company’s stock price is excessive relative to the fundamental health of its business.
With this in mind, one of the more significant market trends to emerge in recent decades, certainly as far as value investors are concerned, has been the rise in the number of hedge funds—and also in the level of shareholder activism seen across the market. Historically, corporate events like spinoffs, restructuring stories, and post-bankruptcies, for example, tended to be largely overlooked by investors, often providing good opportunities to find attractive valuation anomalies. However, the prevalence of hedge funds and activists in the market today means that these “valuation gaps” now close very quickly, so the window of time that companies are “undervalued” is growing ever shorter. What’s more, activist investors can often have a major impact with only a minimal outlay of capital. In many instances, activists holding only small ownership positions in a company have been able to affect significant change in a short space of time.
This means that investors today need to be able to move quickly in order to capture the “valuation gap” in individual companies before it closes. This is where T. Rowe Price’s active, research-intensive investment approach comes into play. With one of the world’s largest buy-side research platforms, our capability is built around experienced, long-tenured portfolio managers and industry-specialist analysts working in close collaboration. Our analysts are organized by industry and sector and are charged with understanding their industries comprehensively. Each analyst typically covers somewhere between 20 and 30 individual companies within their industry, allowing them to develop detailed expertise at the company level and to incorporate local market factors into their analysis.
Our research effort is focused on turning information into insights. Our core objective is to create value for our clients by investing in companies where we believe we have differentiated insights that the broader market does not yet fully recognize or understand. By knowing these businesses inside out, we seek to act early and with conviction as soon as relative valuation opportunities are identified.
Changing investor behavior over time is also often cited as adding pressure to the investment decision-making process. From a value perspective, have you seen any noticeable behavioral shifts that have proved significant in this way?
Two significant behavioral trends to emerge over the past decade have been the sharp decline in investor risk tolerance and investment time horizons growing ever shorter. Since the global financial crisis (GFC), aversion to loss has become extreme, particularly among many large institutional investors, like pension funds. Somewhat related, the knock-on effect is that investment managers today are being asked to outperform the market over increasingly shorter time frames.
This risk-averse, “short termism” can, at times, create meaningful distortions in the market. As an example, coming out of the GFC, we saw a sizable increase in interest for low volatility, more defensive stocks. Ironically, this can lead to a concentration of risk within those segments of the market that are traditionally considered to be relatively defensive. As an active, fundamental investment manager, we try to take a long-term view of the opportunities presented in the market. In this way, we are willing to tolerate some short-term volatility or weakness in order to fully realize the attractive long-term gains. Time and again we find instances of good-quality companies being disproportionately valued as a result of short-term influences or negative sentiment. Often these are market-leading, well-run, high-margin businesses, but risk-averse investors are simply not prepared to weather any short-term volatility or downturn in performance. However, this does create opportunities for patient investors able to look beyond the short-term “noise” and focus on the longer-term potential.
Here again, our global research capabilities and integrated, collaborative structure are all aimed at achieving information advantage and differentiated insights. This drives our ability to identify relative value opportunities ahead of the market and, similarly, where potential risks are underappreciated or unrecognized. As important as these differentiated insights are, the emphasis is on ensuring that they ultimately impact our client portfolios, something that is achieved through the close collaboration and interaction of analysts and portfolio managers.
Given value investing tends to be anti-consensus, is it sometimes difficult to maintain your conviction when opinion is largely against you?
An inherent part of value investing is this willingness to be contrarian; to think independently; and, when opportunities arise, to have the confidence in your judgement to go against the herd. Again, we have analysts who have in some cases covered their sectors for more than a decade and who know the companies they follow inside and out. This level of experience and understanding means that we may be able to step in early to take advantage of a downturn in pricing, occasionally in the knowledge that it may take some time to recover from this patch of weakness, but confident about the long-term potential. Indeed, sometimes the investment thesis takes longer to play out than other times, and when we have high conviction in our investment thesis, we are comfortable buying additional shares if the stock takes a further leg down. For example, if a stock is trading below the value of its net assets, or if the company is strategically important within its particular industry, then the cheaper we can buy the stock the better.
Coming off a strong year for value stocks in 2016, do you anticipate more of the same in 2017? Given the rally we have seen since November, there are those who believe that value stocks, and U.S. equities in general, are looking fully priced.
From a valuation perspective, it is fair to say that the market is somewhat less compelling today than perhaps six months ago. Cyclical areas of the market, where value stocks tend to be most concentrated, have typically outperformed when the economy is improving. Accordingly, value areas have been beneficiaries as the market has moved quickly to price in the likely winners and losers of the new, pro-growth administration. Banks have rallied on higher interest rates and hopes of a less stringent regulatory regime, steel companies have appreciated on the prospect of limiting cheap imports from Asia, and engineering and construction equipment manufacturers have rallied on suggestions of large-scale infrastructure spending.
Of course, the main risk to the outlook for value stocks and, indeed, for U.S. equities in general, is that the economic reality fails to live up to the rhetoric. Should this occur, then there is the real prospect of heightened volatility returning to the U.S. stock environment as uncertainty prevails and investors are once again left to navigate a path through the alternating positive and negative forces driving the market. In that event, we will do what we always do—rely on our meticulous research to identify higher-quality companies trading below their intrinsic value.
Finally, where do you see potential value opportunities arising in the near term?
The ongoing challenge for value investors over the coming year will be finding winners in an environment where there are fewer areas appearing dramatically undervalued. Nevertheless, the broad market valuation is always an average of cheap and expensive stocks and truly active managers can still add substantial long-term value.
Detailed research and strong stock selection will be more important than ever, with opportunities likely to come from sectors or industries experiencing short-term difficulties or periods of uncertainty. Our task is to sift through this mix with a clear, fundamental focus, drawing on the breadth of our analytical resources to find those individual, relative value opportunities. At the same time, we also seek to avoid those sectors/stocks where valuations are excessive and potential risk is unrecognized by the market.
While we understand that volatility can be unnerving for many investors, it also yields stock-picking opportunities for disciplined, active managers. Regardless of the stock market’s day-to-day performance, we are committed to our investment strategy of investing in high-quality companies that are trading below their intrinsic value and maintaining a long-term horizon to give them time to reach their full potential. Attractive valuations, sound financial health, the potential for fundamental improvement, and capable management teams should continue to prove a winning combination.
1Original study conducted by Robert Shiller and updated by Global Market Outlook through 2016.
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.
The views contained herein are those of the authors as of March 2017 and are subject to change without notice; these views may differ
from those of other T. Rowe Price associates.
This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.
Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.
Past performance cannot guarantee future results. All investments involve risk. All charts and tables are shown for illustrative
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