- The newly formed divergence between stocks and Treasurys represents a major change in the correlation between these two asset classes.
- The challenge of massive beta waves has truly opened an opportunity that our long-standing active valuation process is designed to help capture.
- Under the surface of market noise, we are observing major improvements in capital allocation in certain areas, derisking of balance sheets and fundamental improvements that are starting to nudge some depressed stocks higher.
Market Overview and Outlook
For most investors the mother of all behavioral biases is overconfidence. Overconfidence hurts good decision making, hampers sound judgement and leads to excessive risk taking. Behavioral biases are typically attached to individuals rather than aggregated at the market level, but lately this doesn’t seem to hold true. Over the last two quarters the financial markets have been swinging wildly on a massive beta-driven wave, which broke historic records on the downside in December (worst S&P 500 return since 1931) only to recover in the first quarter (its strongest quarter in almost 10 years).
At the depths in December the equity market embedded a confident view that very bad things were on the immediate horizon, only to completely reverse this view so far in 2019. The key for investors to navigate this volatility was to be less reactive and to realize that in complex systems like financial markets randomness plays a huge role. We must always incorporate a wide range of possible futures. Yes, sitting tight also requires confidence, but not as much as aggressively trading extreme, but opposite, embedded views over a short period of time.
Not only has the U.S. equity market been disagreeing with itself lately, but a major disagreement has also now broken out between the U.S. equity and Treasury markets. For most of this market cycle, these have been steady and diversifying dance partners, with yields and equity prices dropping together whenever concerns about slower growth and deflationary risks grew. During the first quarter, however, equity markets rallied strongly while the Treasury market entered a brief, but ominous, inversion as 10-year Treasury yields dropped below the short end of the yield curve. An inversion is considered by most investors as the big signal that fixed income markets send when recessionary risks are truly rising.
This newly formed divergence between stocks and Treasurys represents a major change in the correlation between these two asset classes (Exhibit 1). Major changes are often opportunities, and here one of these major markets is going to be proven wrong and mispriced. For now, we think the Treasury market is embedding excessive confidence in its negative view. Why?
Exhibit 1: Diverging Stock Prices and Bond Yields
The beta cycle we witnessed in 2018 and so far in 2019 has been driven by the draining of global liquidity, which seems to have abated since the Fed pulled a Crazy Ivan and abruptly reversed policy course in early January. The bigger direct effect, however, will be the feedback that lower interest rates will have on key economic activity. The critical driver here will be better housing activity, as the housing sector proved to be extremely sensitive to higher mortgage rates in 2018. Not surprisingly, we are already seeing nascent signs of a rebound as lower mortgage rates take effect. In addition, as we argued in last quarter’s commentary, the U.S. consumer remains in extremely good shape. Despite a robust job market and household wealth near all-time highs, the personal savings rate has recently risen to near 8%. The U.S. consumer, not having overspent, has dry powder, and it really is hard to have a bust when roughly 70% of the U.S. economy never had a boom.
Why has the market become more prone to pricing in extreme views and showing overconfidence? We think a major driver may be the role of passive flows that create feedbacks driven by price trends. Passive investors are surfing these beta waves, and as more capital is added the wave gets bigger in both directions. At the same time, quantitative strategies that focus on factor-driven or “smart beta” strategies reinforce the feedback cycle at a lower level. As more capital has been allocated by factors, the correlation between factors has risen above the correlation between individual stocks. This gluing of factors together has created another reinforcing beta wave, as previous alpha strategies have become beta.
As the quarter progressed, however, there was some divergence at the factor level, as we returned to the old pattern of the value factor underperforming other factors, and especially strategies trying to capture growth (Exhibit 2). Thus, investors do have some choice to “diversify” by adding value, but most are avoiding value given the continued underperformance.
Exhibit 2: Value Has Derated Vs. Growth Despite Lack of Divergence in Earnings Growth Expectations
While most investors are trying to surf increasingly large beta waves, our process keeps us focused on a simpler game of understanding fundamentals. We are finding that in some cases the beta waves are overwhelming stock-level fundamentals and creating large price-to-value gaps. This can create some headaches on the timing of entering and exiting positions, which we are adjusting to. However, it is giving us the opportunity to focus on companies with improving fundamentals, yet with low expectations embedded in their stock prices. As these fundamentals play through, they are starting to drive abrupt and historically large price-and-value convergence, despite the incredible noise of the market’s beta waves.
This active management advantage manifested itself in the first quarter as we outperformed despite the continued headwinds to value, the dominant factor surfacing from our bottom-up valuation driven process. Why? At its simplest level, the portfolio’s fundamentals improved during the first quarter as earnings estimate revisions were positive, while the S&P 500 Index experienced negative revisions and garnered all its year-to-date return from multiple expansion. Not only was the portfolio’s position-weighted estimate revision positive, but we also enjoyed positive revisions on most of our stocks despite the market entering a broad “earnings recession” with negative expected growth in the first quarter. Not only did we have this very clear fundamental advantage versus the market, but we also didn’t have to pay up for it, as the portfolio has lower valuation metrics and much lower embedded expectations than the overall market.
"In some cases, beta waves are overwhelming stock-level fundamentals and creating large price-to-value gaps. "
For most of our career, to get a stock with low embedded expectations selling well below value you had to typically take on some fundamental issues. With the market’s extreme shift away from stock-level considerations and judgements, we no longer must make the fundamental versus value sacrifice in many cases, as we can buy improving absolute and relative fundamentals well below business value. The challenge of massive beta waves has truly opened an opportunity that our long-standing active valuation process is designed to help capture.
To illustrate our valuation process I will discuss a large performance contributor during the quarter, Synchrony Financial, which had been a performance headache until events started to turn in the stock’s favor during the first quarter. Synchrony was certainly a cheap stock trading at 7x earnings, a discount to its credit card peers, despite excess capital and a very attractive return on equity in the high teens. More importantly, our valuation work suggested Synchrony stock was trading well below business value, as investors feared that it and all credit card stocks could not be owned this late in the economic cycle. In addition, Synchrony had just lost a major customer in Walmart, and the market was concerned that Synchrony would continue to lose key customer relationships and were questioning the business model.
These were real risks, but they were already in the price. Plus, the market was also ignoring some key positives: Synchrony’s ability to generate cash earnings and continue to build business value through a recession; PayPal is a major and growing customer; and excess capital is being used to buy back significant amounts of stock far enough below business value to generate a greater than 20% return.
Stocks can continue to fall away from below business value for extended periods of time, however, and what is often required to drive price and value convergence is a realized event that clearly exceeds embedded expectations. In Synchrony’s case, this was renewing the Amazon and Sam’s contracts, and a clear path to higher earnings once the Walmart loss is lapped. Our patience was tested with Synchrony, but we now should enjoy a convergence toward a business value well above the rebounding price. For valuation investors, underperformance often comes before the value harvest, but our continued goal is to shorten the initial period if possible, and fully capture convergence once it is underway.
At the moment, one sector that combines incredibly depressed valuations despite better fundamental realities is energy, which is the second-biggest overweight in the portfolio. Despite oil prices being up over 30% year-to-date, energy stocks have continued to get cheaper with relative price-to-book valuation multiples near record lows (Exhibit 3). Long-term demand remains a concern, but in the intermediate-term global oil demand continues to grow, and the market is currently in a modest supply deficit that could deepen. The real opportunity is that energy management teams may have been bludgeoned by the incredibly low embedded expectations that they will finally show capital discipline. Despite higher oil prices, we are seeing producers focused on free cash flow generation and corporate, not bogus “well” level, returns on capital. If the capital discipline holds as higher oil prices improve fundamentals in 2019, we should get a convergence event that starts removing some of the historic valuation discount.
Exhibit 3: Energy P/B Multiple Has Decoupled from Oil Prices
Outside of broader opportunities in energy, we continue to find very idiosyncratic opportunities across sectors. Early in the quarter we added four new positions in four different sectors:
- Capri Holdings owns the largest handbag brand Michael Kors. The stock fell well below business value after losing more than a third of its market value on a weak quarter. The market is valuing Capri like a challenged retail stock, with a double-digit free cash flow yield, despite its portfolio of brands. Capri is three years into turning around its core luxury handbag brand and will start to drive growth in the ultra-luxury space with its newly acquired Jimmy Choo and Versace brands. The stock has rebounded almost 25% since our purchase, but it is still trading at a significant discount to similarly positioned luxury brands.
- On the more defensive side, we took the opportunity to add consumer staple food company Conagra Brands when it traded down by 40% on disappointing results of the newly acquired Pinnacle Foods. Despite their having overpayed for Pinnacle, we believe this management is competent, as manifested by their success in improving the legacy Conagra business. More importantly, we like both the Conagra Brands and Pinnacle product portfolios, especially their dominance in the growing frozen category that is on trend with the consumer shift toward healthiness and has ample opportunities for premiumization. At the time of the purchase, Conagra was trading at single-digit price-to-earnings multiple, an extreme discount to the staples group. The stock has subsequently rerated by almost 25%, but management is showing signs of stabilizing Pinnacle, which should drive further upside.
- Our most controversial new position is the global mining and trading firm, Glencore. Glencore is the best-positioned miner in all the critical metals, including copper and the core metals required for electric vehicles. This positions it very well for the future, but Glencore has a dirty past with its coal business. We will join most investors in encouraging Glencore to stop investment in coal, while delivering long-term value from the metals portfolio. Despite a massive derisking of its balance sheet, Glencore still trades at a double-digit free cash flow yield, which it is returning to shareholders. This great capital discipline echoes the pivot underway in energy, and it is the behavior you see close to troughs in cycles, and certainly not what we saw at the top of the commodity bull market over 10 years ago.
- Finally, we added super regional bank, KeyCorp. The new CEO has improved operations and taken risk out of the loan portfolio since she arrived, with KeyCorp’s return on equity improving to peer averages. Despite these improvements the stock sells at a discount to peers and reflects a recessionary hit to earnings and a level of interest rate sensitivity that is not justified. With the stock at just over book value and with a starting dividend yield of over 4%, KeyCorp should compound value that drives convergence with peers and underlying value.
While the market’s beta waves get all the focus, the decade-long underperformance of value is planting the seeds for its eventual turn. Under the surface of market noise, we are observing major improvements in capital allocation in certain areas, derisking of balance sheets and fundamental improvements that are just starting to nudge some depressed stocks higher. On the flip side, we are seeing plenty of classic later-cycle risk taking in the areas where a decade of rising valuations and floods of capital has emboldened big-wave surfing. We remain focused on the much less noisy task of finding mispriced stocks where the future has a high probability of exceeding depressed expectations. In many cases that combination of low expectations and better fundamental outcomes is really starting to work in the portfolio’s favor, and we are focused on continuing the journey.
The ClearBridge Value Equity Strategy had a positive absolute return for the first quarter, outperforming the benchmark S&P 500 Index. On an absolute basis, the Strategy had gains in all 11 sectors in which it was invested during the quarter. The primary contributors to the Strategy‘s performance were the health care, energy, financials and information technology (IT) sectors. The main laggards were the materials and real estate sectors.
In relative terms, the Strategy outperformed its benchmark during the quarter due to stock selection decisions. Stock selection in the health care, energy, financials and consumer staples sectors contributed to relative returns during the period. Conversely, stock selection in the industrials and IT sectors dampened relative results. An underweight to the IT sector and an overweight to the financials sector also weighed on relative results.
On an individual stock basis, the greatest contributors to absolute returns during the quarter included positions in Alexion Pharmaceuticals, Kinder Morgan, Synchrony Financial, Oracle and Alphabet. Biogen, Bristol-Myers Squibb, KeyCorp, QUALCOMM and Volkswagen were the largest detractors from absolute performance.
During the quarter we initiated positions in Capri in the consumer discretionary sector, KeyCorp in the financials sector, Glencore in the materials sector and Conagra in the consumer staples sector. We closed positions in Cisco Systems in the IT sector and Celgene in the health care sector.