Dear Clients and Friends,
As we embark on the new year, itâs reassuring to see that the value run that started a little over two years ago continued through 2022. Over the past year, value stocks have outpaced their growth counterparts across various markets, as shown in the table below.
The value run is one answer to the question that some investors had during the previous decade, âis value investing dead?â We dedicated a lot of ink on our past quarterly letters defending the value investment approach, cautioning investors not to abandon value and consider always maintaining an appropriate allocation to the style. We believe the fundamental concept of value investing has alwaysâand will alwaysâremain relevant, regardless of the value/growth cycles.
Value Investing
The Brandes organization was founded in 1974 with the express purpose of applying a value investing approach to global financial markets. While the way we implement that approach has evolved over the intervening 49 years, the core principles never change. A value investing approach seeks to take a business-like approach in establishing a long-term fundamental value of a company. We purchase securities when we believe they are sufficiently undervalued by the market due to temporary challenges or market overreactions. Since there are no guarantees when it comes to investing in the stock market, seeking to purchase a company at a discount creates a powerful concept called âmargin of safetyâ (the discount of a securityâs market price to its estimated intrinsic value). The concept of margin of safety was coined by Benjamin Graham, considered the father of value investing. In his seminal book, The Intelligent Investor, Graham wrote â[T]he function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future. If the margin is a large one, then it is enough to assume that future earnings will not fall far below those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time.â
While value investing can cycle in and out of favor, its efficacy over the long term merits attention, in our opinion. When you compare the Fama/French US market value and growth parts of the total market between 1927 and 2021, on average, value has outperformed its growth counterpart by 4.1% each year.1
It's a fact that for much of the previous decade, growth stocks handily beat value stocks. But just as trees donât grow to the sky, the conditions that are favorable to one style donât persist forever. However, when one style dominates for an extended period of time, some investors are prone to certain behavioral biases. For example, extrapolation bias refers to a tendency to expect the current environment to continue. This is often mentioned when a gambler enjoying a run of good luck (albeit entirely random) extrapolates his recent success and doubles down, confusing the string of good luck with random events. In the context of value investing, many in the investment world exhibited extrapolation bias. In some of our previous letter, we wondered where had all the value managers gone? The chart below shows that value-focused funds now make up only a sliver of large-cap global equity assets under management (AUM).
This chart shows that a significant majority of the AUM in the Morningstar Global Equity Large Cap category have portfolios more tilted to companies with growth characteristics (71%) than to value characteristics (8%).
It was created by evaluating the open-end and exchange-traded funds in the Global Equity Large Cap Category with at least $100 million in AUM. Each portfolio was classified based on exposure to the value style (as defined by Morningstar), with greater than 35% exposure defined as âmore value focusedâ, 25%-35% core/blend-focused, and less than 25% âmore growth focusedâ.
The dark green line denotes the % of AUM (Y-axis) across the value exposure spectrum (x-axis), moving from the most âvalueâ (left side of the x-axis) to least value (right side of the y-axis).
Of course, not all investors abandoned value investing entirely, yet many struggled to remain invested with the value style over the past decade. As legendary investor the late Sir John A. Templeton once remarked about the four most dangerous words in the world of investing: âthis time is differentâ, such a mindset began to take hold. This time itâs different or falling prey to confirmation bias such as weâre in a ânew normalâ to explain recent stock price movements can cause investors to give up on an otherwise sensible asset allocation approach.
Over the past several years, the most common question we received from investors was âwhat are the catalysts for value investing to make a resurgence.â We provided examples of catalysts but were quick to caution investors that we had no way of knowing whether or when an event would happen to cause these catalysts to take hold. Instead, we often urged investors to have an appropriate allocation to value for when some of these catalysts would take hold. While we knew it was very likely that eventually interest rates would rise and the rate of inflation would increase (and create a potentially more favorable environment for value investing), we did not know when this would happen or what would be the exact cause.
While we feel vindicated by the resurgence of the value investing style and the recent outperformance of most Brandes strategies (see table, Brandes Strategies with Excess Return vs. Benchmark), we continue to caution investors to remain diversified with their investments.
Our client letters over the past several years have focused on defending the entire value investing style and we have tried to make top-down arguments in support of the style. However, as a fundamental investor, we build portfolios from the bottom up, one company at a time. We value companies with a business-like mindset taking into account the material issues impacting the business. Having insight into how we think about business valuations is key to understanding Brandes and our value investing approach. To illustrate this, we have profiled below two companies currently held in a number of our strategies.
Fiserv Inc (FISV, Financial) â currently held in the following strategies: Global Equity, U.S. Value Equity, Enhanced Income
Fiserv is a leading provider of financial technology services for merchants worldwide, including governments and companies, as well as financial institutions such as banks and credit unions. After its 2019 merger with First Data, a leading payment processing company, Fiserv holds a strong market position in each of its three key business segments, which comprise of:
- Merchant acceptanceâprovides merchants with a wide range of products and services, including the means to accept payments through equipment, underwriting and transaction processing. This segment includes Fiservâs high growth Clover product offering for small- and medium-sized businesses. Clover boasts a gross payment volume similar to its competitor, Square.
- Financial technologyâprovides financial institutions with technology solutions, such as back-end payment processing, to run their businesses.
- Payments and networkâprovides products and services, such as outsourced information technology software, to process digital payment transactions.
We first purchased Fiserv as its price declined in 2021. The companyâs share price continued to retreat in early 2022 due to several factors, including increasing competition in the merchant acceptance space and the overhang from KKRâs sale of its ownership stake (private equity firm KKR held a major portion of First Data). We added to our position in Fiserv amid the share-price decline as we believed it traded at an attractive valuation relative to its favorable economics and long-term secular tailwinds. As banks increasingly outsource their payment transactions (including debit- and credit-card processing) and consumers progressively shift from cash to card payment, Fiserv couldâin our opinionâbenefit from these trends. We also believe the company has the potential to improve its operating margin and free cash flows as it continues its integration with First Data, and to strengthen its earnings per share growth once it resumes share buyback program. Prior to the First Data merger, Fiserv had used its strong free cash flow generation to repurchase 30% of its shares outstanding over an eight- year period.
While competition will likely remain intense given the long-term secular tailwinds of the industry, we believe that Fiservâs strong relationships with large banks and merchants, as well as with smaller businesses through its Clover product offering, put the company in a strong competitive position. At its current valuation, Fiserv represents an attractive risk/reward tradeoff to us.
Sanofi SA (SNY, Financial) â currently held in the following strategies: Global Equity, International Equity, European Equity, U.S. Value Equity, Global Opportunities Value, Global Balanced, Enhanced Income
Sanofi is one of the worldâs largest pharmaceutical firms, with a well-diversified business portfolio that includes pharmaceuticals, generics, vaccines, and consumer care products. The company is also diversified geographically: the U.S. and Europe represent approximately 40% and 25% of total revenues, respectively, while emerging markets and Asia make up the rest. Sanofi has top positions in drugs aimed to combat rare genetic diseases, and in a broad range of vaccines and consumer products.
We have held Sanofi in various portfolios for well over a decade. At the time of our initial purchase, Sanofi, along with many of its pharmaceutical peers, was struggling with several challenges, including patent expirations for its large products, increased competition, and poor research and development (R&D) productivity. We believed these issues led the market to be overly pessimistic about Sanofiâs long-term prospects.
While revenues were impacted by patent expirations, Sanofi managed the difficult period through cost reductions, asset restructuring, and strategic capital deployment. At the same time, Sanofi continued to strengthen its pipeline through investing a meaningful portion of its revenues in R&D, licensing, and bolt-on acquisitions. During this past decade of transformation, the company has been able to consistently generate healthy free cash flow, continuously increase its dividends, and optimize its business portfolio through divestments and acquisitions. Furthermore, the launch and subsequent success of asthma/atopic dermatitis medication Dupixent (co-developed with Regeneron) has helped the company revert to revenue growth.
Recently, investor concern about the uncertainty related to the litigation focused on heartburn medicine Zantac led Sanofiâs share price to decline meaningfully, driving its market cap to drop by over $20bn in a weekâs time in August 2022. While the market seems to assign close to a worst-case scenario, we believe the ultimate liability will likely be split among multiple companies and any subsequent charges may take some time to be paid out.
Despite this recent market negativity, we believe Sanofi merits a continued inclusion in our portfolios. We appreciate the companyâs ongoing efforts to cut costs and strengthen its margins. The pipeline has been improving, revenues have been growing, and there is minimal patent expiration risk over the next few years. We also take comfort in the substantial value of Sanofiâs franchises in vaccines and consumer products, which the market may be underappreciating. Moreover, litigation risks have always been a consideration in our valuations for pharmaceutical firms, and we reflect this in our assumption of a higher cost of equity/higher discount rate for these businesses. We believe Sanofi has a strong balance sheet that should help protect the downside of potential damages related to the litigation. At its current valuation, Sanofi offers an appealing margin of safety to us.
Closing Comment
We remain convinced that value investing has a place in most portfolios. Brandes has sought to be a faithful practitioner of the style for nearly five decades, and we do not think that itâs different this time; there may always be a new normal, but the core principles of value investing will always make sense to us. As we embark on this new year, we are mindful that we canât predict what the world has in store for investors. Thatâs why the concept of margin of safety is so key to our approach. To quote our founder, Charles Brandes (Trades, Portfolio), paraphrasing his mentor, Benjamin Graham.
âValue investing is timeless. Itâs as relevant today as it was 100 years ago. The principles havenât changed and never will.â (Charles Brandes (Trades, Portfolio), Value Investing Today).
"In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, "This too will pass." Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety." (Benjamin Graham, Chapter 20: âMargin of Safetyâ as the Central Concept of Investment, The Intelligent Investor.)
Thank you,
Brandes Investment Partners
1 As of 12/31/2022. Source: Ken French Data Library. The universe and value/growth distinction is defined by HML (High Minus Low) is the average return on the two value portfolios (small value and big value) minus the average return on the two growth portfolios (small growth and big growth). The portfolios, which are constructed at the end of each June, are the intersections of 2 portfolios formed on size (market equity, ME) and 3 portfolios formed on the ratio of book equity to market equity (BE/ME). The size breakpoint for year t is the median NYSE market equity at the end of June of year t. BE/ME for June of year t is the book equity for the last fiscal year end in t-1 divided by ME for December of t-1. The BE/ME breakpoints are the 30th and 70th NYSE percentiles. Includes all NYSE, AMEX, and NASDAQ firms. HML for July of year t to June of t+1 include all NYSE, AMEX, and NASDAQ stocks for which we have market equity data for December of t-1 and June of t, and (positive) book equity data for t-1.
The information provided in this material should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any security transactions, holdings or sectors discussed were or will be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance discussed herein. Strategies discussed are subject to change at any time by the investment manager in its discretion due to market conditions or opportunities. Market conditions may impact performance. The performance results presented were achieved in particular market conditions which may not be repeated. Moreover, the current market volatility and uncertain regulatory environment may have a negative impact on future performance. The Brandes investment approach tends to result in portfolios that are materially different than their benchmarks with regard to characteristics such as risk, volatility, diversification, and concentration. Diversification does not assure a profit or protect against a loss in a declining market. International and emerging markets investing is subject to certain risks such as currency fluctuation and social and political changes; such risks may result in greater share price volatility. Current and future portfolio holdings are subject to change at any time at any time at the discretion of the investment manager. The declaration and payment of shareholder dividends are solely at the discretion of the issuer and are subject to change at any time.
The foregoing reflects the thoughts and opinions of Brandes Investment PartnersÂŽ exclusively and is subject to change without notice. Brandes Investment PartnersÂŽ is a registered trademark of Brandes Investment Partners, L.P. in the United States and Canada.
