Portfolio managers Andrew Brandon and David Silberman from the U.S. Value team discuss the current market environment and where they are finding opportunities in quality companies at reasonable valuations.
“Value investing” means different things to different people. How do you think about value as an investor?
We look to invest in quality companies at reasonable valuations. Our premise is that owning durable franchises led by management teams with sound capital allocation strategies when the valuations are reasonable will compound value for shareholders through a market cycle. Our investment philosophy has remained consistent for multiple decades and is rooted in a disciplined approach to bottom-up, fundamental investing focused on generating alpha through stock selection, rather than beta. Said another way, we believe the “value in value” is smoothing out the ride (aiming for less volatility) through these quality compounders at reasonable valuations.
For example, Proctor & Gamble has been a long-standing quality compounder within the portfolio given its strong balance sheet, a clear focus on shareholder returns and a savvy management team with room for multiple expansion.
Can “value” companies be a beneficiary of the expected growth in AI?
Short answer: Yes. While the Magnificent 7 and many of the growth darlings have captured headlines, we are more focused on companies that have yet to see a meaningful re-rating of earnings and valuations. Numerous companies in our universe are not only benefiting today from the secular growth opportunities resulting from AI adoption, but also are expected to participate in the longer-term runway for future margin expansion.
When looking at utilities, Dominion, a power provider in Virginia, home to the largest data center market in the world, plays a crucial role in powering the increasing infrastructure demands from advanced technology. Eaton, an industrial company with products and services needed in power management, is well positioned to continue reaping the rewards from its part in facilitating an increasingly electrified world. Additionally, Seagate, a mass-capacity data storage company, is also expected to continue gaining market share and growing earnings alongside the increasing need for data storage.
With that said, it’s important to point out our emphasis on a company’s consistent cash flows when evaluating quality, and we remain focused on companies where their expected return is not exclusively reliant on continuous AI spend. These companies are quality businesses with long track records of executing with superior capital allocation across various market cycles.
Not only did we avoid a recession last year, but instead, we continue to hit all-time highs in the equity market. How are you thinking about the strength of the equity market today and return potential moving forward?
While our investment approach is rooted in bottom-up, fundamental research, one cannot ignore the macroeconomic influences on future economic growth. Specifically, the significant and historic fiscal spending via the government’s Inflation Reduction Act and CHIPS and Science Act (as shown in the following graph), which totals over $2 trillion spent over the next 10 years, as well as the enthusiasm around generative AI, provide an accommodative backdrop for secular growth. These dynamics paired with today’s resilient consumer give us confidence that there is a combination of substantial liquidity in the system and structural growth drivers that can continue to offset part of the drag from a higher policy rate environment.
When thinking about what this means for our portfolio, the team is embracing cyclicality within our own conservative footprint. We see many examples of a coiled spring: companies with improving fundamentals as earnings are set to re-accelerate, yet with no near-term catalyst that is causing valuations to trade at a significant discount to the broader market, creating ample investment opportunities.
For example, we are positive on the rails, such as Union Pacific, which underwent a freight recession and absorbed wage increases last year; yet, we expect volumes to improve due to a healthy economy and the growing need to move said materials associated with fiscal stimulus, as well as margins to expand as price and efficiency initiatives kick in. We’ve also added to analog semiconductors, notably Texas Instruments, as we anticipate a snapback in demand and, subsequently, earnings in depressed areas like personal electronics, communications and enterprise, end-markets where TXN is a leading player.
Could you elaborate on opportunities your team is finding within financials, given that is the largest absolute weight?
After two years of relative underperformance, we are constructive on banks and diversified financials as earnings and valuations are near trough levels versus the broader market, while fundamentals are improving. We continue to keep a close eye on the credit cycle, yet the consumer remains largely employed and resilient, and we believe liquidity, regulatory and cash sorting concerns have largely abated. Indeed, financials were the best performing sector in the Russell 1000V Index for the second half of 2023, and second best for the first quarter of 2024 (behind energy), which indicates a broadening out of sector performance compared to the technology, media and telecom dominance we experienced for the majority of last year.
While the Magnificent 7 stocks were responsible for the entirety of the earnings growth within the broad market for 2023, our U.S. Equity team expects over half of earnings in 2024 to come from the other 493 companies in the S&P 500. Said another way, we see earnings breadth as the key driver for value companies to catch up in 2024.
2023 was a challenging year for value. Looking ahead, what is your outlook on the style and opportunity set?
Sentiment in the first half of last year was seemingly dominated by the collapse of Silicon Valley Bank, which sparked a mini banking crisis, followed by “lights out” earnings from Nvidia in the spring. This backdrop fed momentum in the perceived growth-oriented parts of the market, and we ended the year with performance and earnings growth concentrated in the Magnificent 7. However, it is important to remind clients that part of the value in value is smoothing out the ride for clients when paired with higher-growth equity counterparts. In fact, when combining calendar years 2022 and 2023, value outperformed growth.
Moving forward, we are optimistic that broadening profit leadership should present meaningful opportunities for other parts of the market. In fact, we have already seen a broadening in recent months and, importantly, our core research team forecasts over 60% of expected earnings growth in 2024 will come from the 493 names that were left behind last year. That said, our portfolio is trading at more than a 40% discount to the top 10 names in the S&P 500, while expecting attractive earnings growth around 7%.