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High beta is value [ClearOnMoney]
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Commentary

High beta is value

2 Oct 2012 by Jim Fickett.

Don't completely avoid cyclical stocks. Yes, the market is overvalued, and a recession is likely enough. But avoidance by the majority of investors has made highly cyclical stocks relatively cheap.

The Brooklyn investor has recently written two posts about Pzena Investment Management. Pzena is a fund manager focusing on what they call “deep value”.

Here is the main idea of the Pzena approach to investing. Start with any set of stocks, say those of one country or region, or else large or small cap – whatever interests you. Then for each stock calculate the price to normalized earnings. Pzena has its own approach to normalized earnings, which they do not share, but the goal is the same as that for the Shiller CAPE – to approximate sustainable long-term earnings. Given some such version of P/E, take the cheapest 20% of all the stocks in your starting set. Now go through these in more detail, and find the ones that not only have a low P/E, but have earnings that are, for some fixable reason, temporarily low. Those are the ones to buy.

If the basic idea interests you, Pzena has a white paper with a little more detail. If investing with Pzena interests you, I hope you have a lot of money. Their form to request further information has a set of tick boxes for investable assets, starting at $25 million. In the white paper, Pzena show that even with a fully automated approach – just doing the basic screen for low P-to-normalized-E and rebalancing regularly towards the bottom quintile, outperforms most assets, including the broader stock market, and improves volatility to boot.

I was interested and glad to see that in their July 2012 quarterly newsletter they have some particular suggestions. The most interesting comment on the current market was that, using their valuation measure, highly cyclical stocks (those with high beta) are, as a group, currently much cheaper than those with low beta. In fact the spread is close to a 30-year record. I, just as, apparently, everyone else, have been nervous about cyclical stocks because I think a recession is quite likely. This result suggests that one should just look for cheap stocks, and not worry too much about whether they are cyclical or not.

Here are some excerpts from the newsletter, including some specific stock picks worth thinking about:

in our Global and International Value portfolios we have significant exposure to European companies. It is important to note that this is not a contrarian view that European economic activity will prove more robust than the markets fear. Our European holdings, in large part, comprise companies that have a global footprint and are not solely exposed to activity in the European region. Their low relative valuations illustrate how broad macro fears create exploitable opportunities at the company level. Our holdings of this nature include names like Volkswagen, Philips Electronics, Akzo Nobel, Cap Gemini, Royal Dutch Shell, BP and Total. Consider two examples. In the integrated oil sector, Shell trades today at 6x our estimate of normalized earnings, about half of our estimate of fair value. By comparison, Exxon Mobil, with a similar business mix, return on capital, and free cash flow profile, which we also view as undervalued, trades at 8x. In the coatings industry, Akzo Nobel trades at 7.3x our estimate of normalized earnings, while U.S. company PPG Industries trades at 9.1x. Both have international business, with Akzo developing a strong franchise in China.

… We profess no edge in predicting macro events, but we do think carefully about scenarios that might affect the companies in which we invest. Typically, we find the type of consensus macro expectations we have laid out above (i.e., conventional wisdom) are already priced into markets and individual company valuations. And in today's environment of increasing skepticism over global growth, we see opportunities emerging in industries where earnings estimates are declining and valuations are starting to react accordingly.

Valuations in the U.S. small cap universe reflect an asset class which is viewed as less exposed to European stresses. We continue to identify what we consider to be some excellent unique small cap opportunities. On page 9 we highlight Actuant Corp., a global leader in hydraulic tools and lifting solutions, which has been discounted in part due to its European operations.

High Beta Is Value

Looking at the various sectors of the markets, we find that premiums are being paid for earnings certainty. Valuations in sectors like health care, consumer staples, utilities - the lower beta sectors - are at significant premiums to the higher beta sectors where fear is most acute …

With the macro-driven risk-on/risk-off trade such a constant over the last two years, investors seem to be overlooking the value of good businesses that happen to be cyclical in nature, creating opportunity. Although consensus global GDP forecasts remain in the 2% to 3% range, markets are skeptical and seem to be pricing in something more pessimistic. Managements have been cautious, taking a wait-and-see approach to hiring, investing and making acquisitions until the prospects for sustained growth become much more visible. This has helped sustain corporate margins and cash flows at historically high levels.

Technology and defense are sectors where top down concerns and fears of structural change have generated some outstanding opportunities. These are high quality companies with very strong free cash flow profiles and flexible business models. Investors are not rewarding the strong cash flow these businesses are generating, driving cash flow yields to near peak levels. In fact, the free cash flow yield of the non-financial holdings in our portfolios is 10% in our U.S. Large Cap Value strategy, and 7% in our Global Value strategy.

Below Trend Earnings Create Value

Two areas of the market stand out where earnings are well below trend. The first is housing, where building materials companies trade at modest valuations as investors extrapolate the currently low level of housing construction and renovation activity into the future. In our view, current activity levels are unsustainably low and will recover dramatically at some point. Meanwhile, there are many well managed companies generating solid operating results amid the difficult environment. Examples include Travis Perkins in the U.K.; Akzo Nobel in Europe; and Masco Corp., Fortune Brands Home and Security, and Owens Corning in the U.S.

The other area where earnings are significantly below trend is financials, a sector that is trading at historically low relative multiples on a price-to-book value basis.

Practically all of our financial holdings trade at substantial discounts to book value, and are among the cheapest companies in our investment universes on a price-to-normalized earnings basis. …

We acknowledge that the current economic and financial climate continues to represent a risky backdrop for banks. … Picking outcomes in southern Europe is dubious, so we do not own banks listed in Greece, Spain or Italy. We have very limited and carefully sized exposure to European banks, and our holdings in U.S. and U.K. credit-sensitive names are individually modest across our portfolios. These leading franchises are trading at between 2x and 3.5x what we estimate they are capable of earning in normal conditions, which makes them compelling value and attests to the very gloomy scenario that has been priced into their valuations by the market today.

Portfolios Reflect Deep Undervaluation

Often, when economies go into recession it is after a period of boom conditions, when companies have been thriving and managements are taking more risks. Today, in developed markets, this is not the case. GDP is still below trend and companies have been very cautious, limiting capacity-extending capital expenditures, paring cost structures and generally cleaning up their balance sheets. Most are entering this period of economic uncertainty with very strong financial credentials.

Only hindsight will allow us to make a pronouncement on the ultimate length and magnitude of the current value cycle. But one thing is clear: as a result of investor uncertainties, we have been left with a wealth of deeply discounted, cyclical businesses with sustainable franchises, strong balance sheets, and a demonstrated ability to adapt to a wide range of economic scenarios. Many of these businesses have global footprints, are industry leaders, and have demonstrated their ability to restore profitability quickly after an economic shock.