Large-cap value stock funds in the U.S. have seen an exodus of capital, as the category suffered its worst month of outflows ever. According to Morningstar data, investors redeemed a total of US$ 15.1 billion from large-value funds. This could be performance-related – the bull run in U.S. thus far this year has been heavily titled to growth stocks. An average large-value fund has returned 3.9% through mid-June, versus a 20% average return from large-cap growth funds.
Should investors chase growth stocks, or buy the dip rotating to value stocks, given the highest interest rates in 16 years coupled with high inflation?
The Cheapest U.S. Stocks are Even Cheaper
John Bailer, a portfolio manager at BNY Mellon Investment Management, is among those who think a value catch-up hasn’t finished. He observed that the cheapest quintile of constituents in S&P 500 Index have become cheaper over the years. Thus, from a price perspective, value stocks look like the better long-term investment today.
“If you look at that cheapest quintile stocks in the S&P 500, they've averaged around 10 times since 1996. Now they are trading at 8.5 time price-to-earnings ratio. The cheapest stocks in the U.S. market are actually cheaper.”
He adds: “I'm still very bullish that there’s more room to go for this value re-rating. There’s still opportunity because of a lot of skepticism… It's very early in the move away from the growth-oriented stocks in favour of value-oriented stocks.”
Investors Need to be Careful of the Type of Businesses They Buy
While value stocks are generally appealing from a valuation standpoint, Bailer also warns that “investors have to be very careful with the type of businesses they buy in this environment.” To Bailer, in an environment where money is going to be more expensive, there's a little bit more than to being a deep value investor.
His portfolio buys stocks in which the market has a lot of skepticism, and are trading below their intrinsic value.
“But we're looking for opportunities for that perception to change from a momentum standpoint, and that doesn't enable us to avoid the value trap,” says Bailer.
He continues: “When I say momentum, it might not be just price momentum, but also fundamental momentum and estimate momentum. We would like to see estimates moving higher, or that the catalyst for estimate momentum moves higher, free cash flow accelerates, and returns on investment capital improve.”
Moreover, Bailer avoids companies that need to grow and need to finance either through issuing equity or debt. High-levered companies raise some red flags as they will have to refinance for bonds that are maturing over the short term. Plus, they have to pay much higher interest rates. He would also avoid companies sitting on a pile of floating-rate debt.
Why Bailer Thinks Boring Companies are Better Right Now
Bailer likens picking stocks to running a digital media company.
He says: “For an advertising agency, instead of having those non cash-flow generating companies as clients, you’d prefer the customer base to be the biggest global pharmaceutical and staples companies in the world. These weren't great customers to have a couple years ago, because they weren’t growing as fast as those small companies that were spending a lot on digital advertising.”
“But now, the customers you really want to have are these boring old companies with slow-growing cash flow and great balance sheets. Those are the type of companies you want to have as customers and I think those are the type of stocks you want to own in this environment,” he says.
“We would rather have companies that have a lot of cash on their balance sheet, which obviously they’re earning more money on that cash in a higher rate environment,” he continues. One sector that he likes is insurance companies as a beneficiary of the higher-rate environment.
BNY Mellon’s Biggest Overweight Is in Financials
In the US$ 274 million BNY Mellon U.S. Equity Income Fund that Bailer manages, one-third of the assets goes into the financials sector, above the S&P 500 benchmark index’s 12.5% level. Within the sector, there are three different opportunity profiles.
“Insurance companies benefit from float income, investing policyholders’ premium at much higher rates. Float income really wasn't worth much for the last 10 years because interest rates were so low. Now, finally floating incomes are going to be worth something,” he says.
In banks, what Bailer looks for is also a ‘fortress balance sheet’ and strong deposit franchise.
“We’re going to keep the cash here in case there's any issues with the economy. It’s going to be very safe. If interest rates move higher, [the banks with high cash level] are going to earn a lot more money on that cash and that’s exactly what happened. They’re able to raise their net interest income guidance where most the other banks in the U.S. are lowering their net interest income guidance.” The portfolio’s largest holding is JPMorgan Chase & Co, with a 5.1% weight.
The last segment under financials is security exchanges.
“[Exchanges] just benefit from people trading securities or commodities. That’s why we think they are very conservative-oriented investments in the financials that don’t have a lot of market exposure, deposit risk exposure, credit risk exposure,” explains Bailer, who allocates 3.4% of the fund’s assets to CME Group Inc at the end of May.
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