Value stocks (stocks trading below their historical valuation levels) reverted and jumped sharply in September taking many investors by surprise while defensive and staple stocks fell sharply in comparison (see chart below). It begs the question: Is this a short term shift in sentiment or the start of something more significant and sustainable? Have valuations reached extremes to the extent that the market is saying enough is enough and there is now a fundamental rotation taking place in the market? Bond yields are at levels not seen before, I recently met one bond fund manager who is going short some bonds in his portfolio, a strategy on which he is not alone I imagine. The MSCI EU Beverage and Food sectors are trading at significant premiums to the market valuation and their historical valuations. Consumer staples have been a great place to hide and depending on one’s global outlook, maybe they still are, but these valuations possibly look stretched. The MSCI EU Beverage is trading at a c54% premium to the market and a 45% premium to its 5-year average, while the Foods are trading at a c58% premium to the market and a c41% premium to its 5-year average.
The flip side: Does the financial sector offer “value” and long term risk/reward optionality for investors? If one believes that bond yields have bottomed or at least stabilised then maybe the answer is yes.
European financials are reflecting deep pessimism in terms of current valuations and may offer investors a compelling long-term risk/reward. Valuations are low, given the challenging operating conditions and the geopolitical risks (trade war & Brexit). Interest rates are low and possibly lower for longer. Global growth is slowing, capital markets have been sluggish, lending volumes have been light, and market volatility has been benign. Layer on the political uncertainty and it’s not a very constructive environment to grow revenues.
If we park politics for a moment and look at the fundamentals, valuations are near 10-year lows, forwards price to earnings of 8x or book values c.0.7x. The last time banks traded at these levels it was through periods of extreme distress like the financial crash and sovereign debt crisis. Since then, bank balance sheets have been repaired, capital levels have nearly doubled, and liquidity issues have been addressed, one of the keys factors that got banks in trouble in the past. So one could feel that downside protection has improved considerably from the dark days of 2008.
The doubters would point to the bottom line, and they are right to do so. One of the key metrics used in investment markets is Return on Equity (ROE). For banks this has fallen nearly 50% pre the financial crash, but given interest rates have come tumbling down, regulation has forced banks to hold more capital on their balance sheets this is not a surprise. They also have taken on huge restructuring costs – branch closures, selling non-performing loan books, staff layoffs etc. Interest rates are low and will remain so for a while more, but management teams are well aware of this, and are realigning their business for the future. So what are they doing to stabalise or even grow the bottom line. Given the macro challenges much is coming from self help initiatives, like cutting costs, investing in IT, exiting unprofitable lines of business and improving capital allocation. If one believes that, and that rates will rise at some stage over the next few years, the financial sector offers an optionality that is not priced into valuations today.
I’m not recommending selling some of the food stocks, the purpose of this article is merely to highlight the disparities in the market and maybe highlight a value opportunity for the long term. “No to the banks!” I hear you shout, and I understand the argument of negative rates/lower rates for longer impacting margins; pricing power or lack of, given the over-supply of banks in Europe; the disruptors or neobanks like Revolut and Nubank will take market share. Couple that with some of the meetings I’ve had with bank management teams, the mood is grim and casts a shadow over the sector, but balance sheets are stronger, businesses are more efficient and realigned, offering 5/6% dividend yields with capital optionality over the long term. In this case value stocks can flourish and deliver meaningful returns.
The catalyst in the short term, is a bottoming of macro data, such as the Purchasing Managers’ Index “PMIs” next month. Eurozone economic activity has been poor, with PMIs last week making a new multi-year low. The positive is that the Money Supply or the the total quantity of money in circulation in Europe has been improving and tends to lead PMIs by 2-3 quarters. The recent restart of the European Central Bank’s Quantitative Easing programme (QE) should also bode well in this regard. Historically, better money supply trends and a bottoming in PMIs would support the rotation into value stocks. Also, if there is a Brexit deal, UK domestic stocks, (banks and cyclicals) will get a boost, as will sterling along with some of the European cyclicals. A US/China deal will also support the cyclical stocks.