Growth stocks have outperformed value stocks since the global financial crisis, resulting in the widest valuation gap between the two styles in decades. What could cause this phenomenon to reverse course in favor of value stocks? In Part II of our Rationalizing the Irrational series, we highlight two industry groups, banks and telecommunication services, which we believe present compelling valuations and potential for outperformance. In order to capture high dividend yields and participate in a recovery rally, we recommend owning value now.
These are odd times in global stock and bond markets. In equities, as we explained in our July newsletter, since the market trough of the global financial crisis (“GFC”) in March 31, 2009, valuation multiples for growth style indices have climbed, increasing to a Grand Canyon-sized differential versus multiples for value style indices. This chasm reflects a market preference for growth earnings over value earnings. Surprisingly, during this post-GFC period, stocks in non-US value indices have delivered more earnings growth than stocks in “growth” indices and kept pace with earnings growth rates in the US market. Some of the steepest multiple increases have come from companies expanding their revenues in excess of the competition, but delivering minimal, if any, earnings. As interest rates have fallen and economic growth has slowed, investors have indicated a clear preference for sales growth. Apparently, they will pay whatever it takes to get that exposure – in other words, Growth at Unlimited Prices (or GULP).
What could cause this phenomenon to reverse course in favor of value stocks? The extreme divergence suggests that deeply undervalued stocks could rebound robustly. In Part II of our Rationalizing the Irrational series, we explore two industry groups, banks and telecommunication services, which we believe present compelling valuations and potential for outperformance.
Although ultra loose monetary policy may hinder bank revenues, their earnings outlook is generally more sanguine.
Financials have been one of the largest detractors from performance for the value style indices in recent years. Investors seem to be asking – why invest in banks when they struggle to expand revenues in a climate of falling interest rates and declining net interest margins? Although ultra loose monetary policy may hinder bank revenues, their earnings outlook is generally more sanguine. Most banks have used this past decade to streamline operations and boost their earnings and capital ratios. Controlling what they can, competent bank management teams have cut costs feverishly and repaired balance sheets. However, valuation multiples have stagnated. Many bank stocks’ price-to-book (“P/B”) multiples have de-rated from the GFC trough to present, with Japan and Europe leading the pack downward.
Ironically, in 2008, banks typically had inadequate capital ratios and demonstrably riskier loan books than they do today. European banks have significantly improved their tier 1 capital ratios post-GFC, which increased from 5.6% in December 2007 to 15.8% in March 2019.
We have observed a de-rating of P/B multiples for banks in our international and global value portfolios, with what looks like financial Armageddon priced into their valuation multiples, despite materially improved capital positions. Many of these enduring institutions currently trade as if they won’t earn a return even half of their cost of capital.
In addition to improving capital positions, bank management teams are returning capital to shareholders via dividends and buybacks.
We believe the most undervalued of the banks are listed in Europe. In addition to improving capital positions, bank management teams are returning capital to shareholders via dividends and buybacks. As a result, total payout yields for European banks are reaching historic highs (Exhibit 3). In recent quarters, we have added significantly to portfolio weight in several of what we believe to be the better managed of these banks.
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