Time for value Time for value http://www.federatedinvestors.com/static/images/fhi/fed-hermes-logo-amp.png http://www.federatedinvestors.com/daf\images\insights\webcasts\hourglass-on-beach-small.jpg June 11 2021 June 11 2021

Time for value

Why we think this cycle is different.

Published June 11 2021
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Podcast Transcript
Linda Duessel: Hello, and welcome again to the Hear & Now Podcast from Federated Hermes. I'm Linda Duessel, Senior Equity Strategist. And today I'm joined via phone by Linda Bakhshian, Senior Portfolio Manager and Head of the Value Income Team and Steve Gutch, Senior Portfolio Manager. Today we're going to discuss why investors should consider value now. Linda, let's start with you. First of all, how would you define value for the group?
Linda Bakhshian: Well, thank you so much for having us here first. In terms of how we define value, we characterize value as companies with strong balance sheets, cashflow and management teams with improving fundamentals. We can find value in all areas of the market. For us, we bucket value in three categories; cyclical value companies that are in more cyclic areas of the market, such as materials, industrials, and energy. The second bucket is we like quality value, which we can find again in many sectors. And really this is characterized by companies that are driving fundamental change, but valuation doesn't exactly reflect this improvement. And again, you can find these quality companies in all areas in the market, including sectors like technology at the moment. And finally defensive value. And these are your traditional sectors such as healthcare and utilities.
Linda Duessel: Okay, well, excellent. So it's not just as simple as these sectors or industries of value, and these are growth. It's much more nuanced than that. That's good news because I suppose that gives a lot more for you to choose from when you're putting together your portfolios. I'd like to now turn to Steve and ask you, Steve. I saw a statistic recently that said as of late last year value, which is all know has underperformed growth for quite a long time, has underperformed it so badly it was in the top 1% of worst periods since 1929. Is value particularly inexpensive now, Steve?
Steve Gutch: Well, no pun intended, but value certainly has valuation on its side. And there's no question that growth valuations are expensive, and this is not only absolute, but it's relative to the rest of the market. Whether you look at enterprise value to sales or a price to earnings ratio, there's just no question that growth is a very expensive part of the market. Now you're correct, Linda, after 14 years of under-performance by value, we believe value has a lot of attractive valuations and investment opportunities. And this is because there is very strong earnings growth over the next few years, and we think it's a very attractive space to be in.
Linda Duessel: Yeah. It seems like it's almost been like waiting for Godot and it's cheap and it's cheap and it's cheaper and it's cheaper, but gosh, the worst one percentile, you might think if you were a long-term investor, you might take a look over there for truly, truly great values. Go back to you now, Linda, as you said in your definition of value, there is all kinds of value. I know that among the portfolios that you work on are some balanced portfolios that have some income in there. I know I'm a good baby boomer, a good aging baby boomer. I know there's a lot of us out there. As we get older, we've always understood that we're supposed to be investing ever more for income and for so-called safety. And for decades and decades and decades, we always turn to the US government bond, notwithstanding concerns right now about where that long-term government bond is. If I give my money to the US government today for 10 years, I think they're paying me in and around 1-1/2%, and I've read that's the lowest yield versus dividends since at least 1955. So when I consider I'm supposed to find reasonably safe income, how can one find safe income, Linda?
Linda Bakhshian: Yeah. Well, safe income is really about positive fundamentals and cash flows. So we try to balance income, total return and risk to really deliver a consistent monthly income and total return over a business cycle. So you ask, what does that really mean in terms of safe income and what you just described? It really means that we have a diversified portfolio that can invest in cyclical value companies, such as energy, materials and financials, and find quality tech companies as well to meet those fundamental parameters. And these companies can be income also. The other issue to note is that as you mentioned the tenure is rising and we believe that it will move more towards the 2% branch by year end. Hence, companies that can pass on those inflationary costs will be able to maintain the margins and grow cash flows and are likely to be companies that maintain and grow that dividend also. And that's more on the equity side.
Linda Bakhshian: It's noteworthy to mention that on the fixed income side, you can't find good income as well. For example, munis are in a good place at the moment we believe. And also the credit side of fixed income given they have lower duration, which means that they are less sensitive to the 10 year movements. We can find income in those areas also. But we still prefer equities in our portfolios at this point.
Linda Duessel: Okay. That's very interesting though, what you said about other areas. For my part, as I've used to travel the country and meet with advisors for more than 10 years, it seemed the most common question was where do I get income from my clients? And clearly in this day and age, you need to be much more imaginative in terms of where you look for income. I think that your comments about kind of the more balanced portfolios as a way to really boost your income and stay with what I know is the value that you're looking for and the quality that you're looking for has to be part of the toolkit these days. So it's great that you're considering those two and that you're using those. Now, speaking of what everybody's talking about these days, and this one goes to you, Steve, I saw that Google searches for the word inflation are at an all time record high. Everybody wants to talk about inflation, and everybody's worried about what inflation is going to look like in the next number of months and indeed, perhaps in the years ahead. How does inflation worries fit in with the value style?
Steve Gutch: Yeah, it's an interesting question. It's been so long since a lot of people have considered what inflation can do to their portfolios, and where should you go when inflation rears its ugly head potentially. But honestly, if you look over time, inflation is very positive for value-oriented portfolios, and this has to do with a cyclical orientation of value portfolios. Think about what we're talking about, inflation. There are many different types of inflation. You can have labor inflation; you can have a commodity inflation. What we're thinking about and how we're invested is thinking about the commodity inflation and where they have pricing power, where they can pass it through to their customers. This is in the energy sector and this is in the materials sector. We think there's some really unique opportunities there. Obviously you have to be concerned about labor inflation and can they pass it through? And this is why sometimes on the retail side it may be a little more challenging, which we have not overestimated and not had a strong presence in the portfolio.
Linda Duessel: Okay. Okay, so inflation has been dormant for so long now it may be rearing its ugly head, and that might be a very, very powerful reason why the time is now for value. Sticking with you, as we said, growth had outperformed for so very long, and we did see some value starting to pick up, particularly in those cyclicals and at the end of last year and into early this year. Is the value rotation going to stick this time, Steve? Will it stick with us?
Steve Gutch: It's amazing how often we get these questions and it's only been seven months of value outperformance. Now, if you go back in history, the performance cycles of growth and value are actually very long. They're not very short. It's been 14 years, actually since 2006, that growth has outperformed value. So why does value have legs now? One of the most important parts that I think everyone needs to consider is the earnings growth potential of many of the value sectors. A lot of them are cyclical, but it's really broad based. When value doesn't outperform, it's really because there isn't earnings growth. We see a huge demand coming through out across many sectors. And as everyone knows, there's extremely low supply and there's very low inventory. What this leads to is strong earnings growth, not just this year, but for multiple years down the road. That's why we think this value cycle is different than the fits and starts that we've had over the past 10 years.
Linda Duessel: Multiple years down the road for earnings; that's very exciting.
Steve Gutch: It is.
Linda Duessel: Now, we've had some serious stimulus here, Linda, as you know. Much more stimulus than we had at the aftermath of the housing bubble bursting. I noticed that low quality stocks in both of those occasions with outside stimulus, spiked versus high quality stocks. Now you mentioned in your remarks about how you look for companies and value, how you define value, you speak of high quality, Linda. Is now the time for high quality versus low quality do you think?
Linda Bakhshian: Yeah, you're absolutely right. The huge amount of stimulus that has been injected into the system over the past year has really meant that some of the companies that are lower qualities have been really beat up by the market and valuations are expensive. I think the classic example that comes to my mind is really the retail industry. A couple of years ago, with Amazon coming into the mix, a lot of these retail companies thought that they're going to go bankrupt, however over the last year or so, the amount of stimulus that has been pushed through the economy has basically given them a second chance. Now we don't know which ones will survive, and I'm sure there's going to be more bankruptcies down the line, but valuation in some areas of the market, in my opinion, are actually stretched.
Linda Bakhshian: So in our investment process, it does guide us towards the quality company, especially as inflation is on the rise. And Steve mentioned, we are looking for companies that have real pricing power and are likely to be the winners in this inflationary gain here. So that's really the key to think about is pricing power. As the economy improves, inflation and interest rates are steadily rising, we do believe that the cyclical sector are going to outperform. That's really the current environment. And as the global economy starts to open up, inventory still remain low, there's still huge amounts of pent up demand and high amount of consumer and companies that are flushed with cash.
Linda Bakhshian: So as we move through the cycle then, we think that at the moment cyclicals are going to outperform and as we go down the cycle, we think that this is going to hand over to quality companies. So I think it's all about relative valuation and this is really important why you should really look at various parts of the business cycle and the different areas of where value work can work and the handoff between each of those as the value cycle is elongated.
Linda Duessel: Okay. That's excellent. I love what you said about quality coming into play, and now you have to focus on pricing power, which kind of leads me to the next question that I wanted to ask Steve. As we look at the incredible changes in our economy in these last few years where we fell into a terrible recession because of the COVID shutdowns, then we've had kind of a V-shaped recovery where I think all boats were lifted to include those low quality ones that now Linda's suggesting, maybe we've got to be more careful now in terms of picking, and I'm reading more about the fact that we may now be in our economy more mid-cycle. Do you agree with that, Steve? How in your portfolios is that being reflected, if you believe we're not moving towards mid-cycle?
Steve Gutch: No, I agree, we are moving towards mid-cycle. Remember last year we were trying to determine which companies are going to survive, as Linda said, and this was to some of the consumer names, were some just absolutely excellent opportunities, and also in early cycle industrials. And this is where the valuations we thought were just well below what was fair value. But as you said in a true V-shape recovery, many of these stocks in these sectors, especially in the early cycle parts, have appreciated materially.
Steve Gutch: So what we've done is we've transitioned out of those, and now it's more like a mid to late cycle in industrials. Think commercial aerospace, also think banks and financials. Now, many people think they're early cycle, but early cycle people are worried about credit there. And we don't believe we're in any type of a credit situation. So banks are really a nice mid to almost late cycle opportunity. And also, which is very interesting, is in the energy sector, the services part of energy, where you see an increasing demand from the energy sector. And the services component, we think can be a very strong beneficiary. So we're not quite towards late cycle. I think we're still getting to that mid-cycle. And it gets to be a very interesting handoff as the year goes on.
Linda Duessel: Well, you really have to stay tuned don't you as the sands keep shifting. We have just a few minutes left here and I want to come back to you, Linda. I hate to bring it up, but I have to bring up some politics here. President Biden has some really powerful fiscal policies that he's proposed. Do you believe that the Biden administration's policies if enacted would have favorable implications for the value style?
Linda Bakhshian: Well, no one really knows what the fiscal policy changes will be at the moment. I mean, they're going to take a lot of different shapes and a lot of different debates to finally get to the final product. What we know currently, or what is being debated currently is that corporate taxes will rise to somewhere about the 25% range. President Biden's proposed 28, probably current rate is about 21, so they're going to probably settle somewhere around 25% rate. I think this will be very manageable by companies. The higher taxes will probably be offset by cost savings and the business cycle itself and higher productivity, for example. And companies that can offset these higher taxes, tend to have more value characteristics. They're going to be more mature companies, established revenues, balance sheets, and cost savings programs. So they tend to have more value characteristics, and we do think that value style will outperform even if corporate taxes rise.
Linda Bakhshian: I think the issue is it's really driven by foreign taxes, the foreign earnings, and those tax increases will disproportionately hit or impact companies that have more foreign sales, or growth type companies that pay minimal taxes currently, and they tend to be centered around technology and communication services. So we believe that those high growth, high price to sale companies, will be more crosshairs of foreign taxes, and value companies will be a much better place to offset the increase in corporate taxes.
Linda Duessel: Okay. Yeah, it does seem obvious that tax hikes are coming and really not sure that the market is paying much attention to that yet. Coming back to those aging baby boomers, those savers out there and looking at tax hikes, final question here to you, Linda, how can a balanced portfolio help if and when taxes rise?
Linda Bakhshian: Sure. First balanced portfolios, we do remain overweight equities. We do think that with rising interest rate, environment and inflation equities are a real hedge here to these balanced portfolios. However, we're not completely abandoning fixed income. As I said before, I think there is some real interest in some real value in the fixed income. For example, we like credits due to the short duration of the instrument. And if taxes do rise, we think munis are particularly interesting here, given that they will remain fairly tax-free even with income taxes rising. Hence, the munis can potentially have a distinct advantage here, especially as the economy improves and the state budgets are becoming much more balanced.
Linda Bakhshian: So if you can combine a federally tax-free muni and equities in a portfolio, you can take advantage of income variable and offset inflation interest rate. And I think that's a really pretty good combination. Or really move towards equities in a portfolio with credit that has the shorter duration and can withstand those interest rate movements. I think a balanced portfolio really works well in an environment where there is a lot of policy changes that are going to be occurring over the next few quarters.
Linda Duessel: I've seen that with the previous administration's huge tax cut. The market didn't seem to react until after it actually was signed into legislation. And to the extent that that would happen again, this time it could be that we're still staying tuned to see the reaction. I think there's been a lot of evidence over many decades that when taxes go up, the well-to-do tend to race towards munis, don't they?
Linda Bakhshian: They do.
Linda Duessel: Well, great. Thank you. Thank you very much, Linda and Steve, and thank you to all our listeners. We look forward to you joining us again on the Federated Hermes Hear and Now Podcast. If you enjoyed this podcast, we invite you to subscribe to the Federated Hermes channel to get every Hear and Now episode, plus our other series, Amplified, and Fundamentals, for a global perspective on the issues, challenges and trends shaping the investment landscape.
Disclosure: Views are as of May 27, 2021 and are subject to change based on market conditions and other factors. This should not be construed as a recommendation for any particular security or sector. Past performance is no guarantee of future results. Investments are subject to risk and fluctuate in value. Bond prices are sensitive to changes in interest rates and a rise in interest rates can cause a decline in their prices. Municipal securities may be subject to the alternative minimum tax and state and local taxes. Value stocks may lag growth stocks in performance at times, particularly in late stages of a market advance. Due to their relatively high valuations, growth stocks are typically more volatile than value stocks. Federated Equity Management Company of Pennsylvania 21-10079 (6/21)
Tags Markets/Economy .

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Past performance is no guarantee of future results.

Investments are subject to risks and fluctuate in value. There is no guarantee that any investment approach will be successful.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Municipal bond income may be subject to the federal alternative minimum tax (AMT) and state and local taxes.

Value stocks tend to have higher dividends and thus have a higher income-related component in their total return than growth stocks. Value stocks also may lag growth stocks in performance at times, particularly in late stages of a market advance.

Federated Equity Management Company of Pennsylvania