It has been a “spring of discontent” for Berkshire Hathaway this year as investors increasingly run out of patience with investment guru Warren Buffett. Still considered one of the world’s most admired investors, his value investing strategy increasingly looks out of step with the post-pandemic stock market.
The “Oracle of Omaha’s” reputation has increasingly come under scrutiny as his strategy of buying undervalued stock saw Berkshire missing out on the tech boom. Over the past five years, Berkshire’s total returns were 14% compared to the S&P 500’s 18%.
The Economist sees fundamental problems with value investing stemming from the structure of the new economy. With assets increasingly intangible rather than tangible, investors may find it more difficult to value companies using traditional methods. And with more young firms exploiting increasing returns to scale to grow exponentially, the maxim that “what goes up must come down” is being called into question.
“A different approach is required — not the flaky practice of the dotcom era but a serious method, grounded in logic and financial theory. However, the vaunted heritage of oldschool value investing has made it hard for a fresher approach to gain traction,” The Economist warned on Nov 12 last year.
In any case, it seems increasingly difficult for investors to find value in an expensive US market. Brian Arcese of Foord Asset Management notes that US stocks are already trading at around 24 times earnings compared to 17 times in Europe. With massive tech giants paying out low dividends like Facebook, Tesla and Alphabet seemingly on an inexorable rise, it seems that Wall Street is better suited to growth than value investing.
Pockets of value
But there are still pockets of value lingering in the US. Financial services firm Morningstar — a devoted disciple of value investing — sees value in large-cap US stocks with a wide economic moat. Chief US market strategist Dave Sekera says that this is an opportunity for investors to purchase high-quality large cap stock at a discount to their intrinsic value.
“Even after incorporating our recently increased expectation for a strong economic resurgence in 2021 and for that momentum to carry into 2022, we think the broad US equity market is 3% overvalued,” says Sekera in the firm’s US Equity Market Outlook for 2Q2021. Eight in 12 overvalued mega-caps including Apple, Tesla and Visa traded down in 1Q, with higher fair values for almost all of them.
Happily, for investors who fear that they have missed the tech boat, Morningstar sees several top tech firms as being attractive investments. Amazon, Alphabet, Adobe and Microsoft are among those identified as having “wide-moat” positions in the large-cap growth category, highlighting that the division between growth and value is perhaps slightly porous. These firms are trading at a price-to-fair value (P/FV) ratio of around 0.76 to 0.90.
The energy sector in particular has also been highlighted by Morningstar as being “the most undervalued sector by far”. Energy stocks have surged 34.71% quarter-to-date since the sector was described as “significantly undervalued” in 1Q2021. Still, its P/FV ratio remains low at 0.82, with Equitrans Midstream, Schlumberger and Core Laboratories among Morningstar’s picks.
Monier of Lombard Odier projects that economic recovery will boost oil demand. Yet, he sees oil prices stabilising at around US$60–70, since Biden’s re-engagement with the Iran Nuclear Deal will bring more Iranian oil into energy markets, he argues. But Cailin Birch, global economist at EIU, sees negotiations being long-drawn and complicated by upcoming Iranian presidential elections, meaning that Iran’s role in oil markets is unlikely to change significantly.
Other large-cap value picks identified by the firm include Wells Fargo, Lockheed Martin, Pfizer and Gilead Sciences. Nevertheless, Morningstar admits that it is more difficult to find value in the US market now, rating only 14% of stocks as four- or fivestar compared to 18% at the end of 2020. But where they can be found, such stocks have room to appreciate on the back of increased infrastructure spending and greater exposure to economic recovery.
Is it a bubble?
After a long period of exuberance, the market narrative is starting to turn towards the possibility of a bubble. Value stocks with strong fundamentals now appear a safer bet than growth stocks with less underlying strength.
“This reminds me of 2000 all over again,” said financial guru Suze Orman on CNBC on April 7. The stock market has been roaring despite a weak economy, she warns, noting that it would be advisable for investors to set up an emergency fund that could cover a full year of expenses. She sees a potential market pullback as a good opportunity to buy stocks at a bargain.
Institutions are more sceptical. “Today’s price appreciation is actually well below those of past bubbles,” says Jonathan Linden, senior equity strategist, and Stephanie Roth, senior markets economist, at JP Morgan Private Bank, on March 15. While elevated, valuations look more reasonable on a free cash flow basis and relative to bonds. Market sentiment, they say, looks “far from irrational” while management teams have been prudent about capital allocation.
Arcese of Foord notes that while some securities are showing signs of being “bubbly”, a market-wide bubble remains unlikely. “It is reasonable for the market to have a 10–15% correction,” he tells The Edge Singapore. A popped bubble scenario would typically be characterised by more drastic 30–40% corrections.
Chaar and Monier do not see the frothy market as a barrier to investing in risk assets either. “We believe that earnings per share (EPS) growth will act as a strong tailwind for stocks. EPS estimates have been increased and we expect this trend to continue,” they say. The fact that 73% of US firms that have currently released results indicated above consensus performance creates good support for US stocks.
“I think it’s a question of where the money can go,” says Madera of LSEG, noting some uncertainty about where interest rates are heading. “For the next 12 months, there is probably going to be closed-hand combat between markets and central banks. Markets want [interest rates] to go up while central banks are adamant about the logic of keeping them low,” she adds, noting that there is little chance of a bubble so long as there is no clear direction on where rates will go.
But the grandees of Berkshire are not taking their chances. “Yes, I think it must end badly, but I don’t know when,” said Buffett’s “righthand man” Charlie Munger in February. He had been asked if the present market resembles the 1990s dotcom bubble. Munger warns that the“crazy speculation” in SPACs (special purpose acquisition companies) — which he describes as firms that are neither yet found nor picked out — are an omen of an “irritating bubble”.
Winning on Wall Street
Linden and Roth think that investors could consider adding exposure to areas with more room to recover. These include cyclical sectors like financials, industrials and materials. Buying stocks that are trading inexpensively relative to the market, they say, remains a sound investment decision even as they do not think a bubble is yet imminent.
Stefan Hofer of LGT Bank Asia urges investors to favour equities over fixed income. “Within equities, the materials and consumer discretionary sectors stand out; the former for its inflation-hedging characteristics and the latter due to the renaissance in consumer spending,” he says. Michael J Kelly, global head of Multi-Asset at PineBridge, is also bullish on digitalisation and decarbonisation, as well as the inflation-hedging properties of real assets.
The biggest losers, says Nathan Sheets, of PGIM Fixed Income, are likely to be assets exposed to a tight regulatory environment. These include carbon-based energy, the tech sector and healthcare, particularly in health insurance and pharmaceuticals.
“For fixed income investors, the journey will be more difficult. Yields are low and spreads tight, offering fewer compelling alternatives. Inflation-protected securities are already in demand, but could continue to attract inflows,” warns Dover of Franklin Templeton. Mary Nicola, portfolio manager, global multi-asset at PineBridge, sees little Fed action to alter rates since real rates remain negative and mortgage rates low in the context of a highly liquid market.
But with her prediction of an earlier rate hike, Bostjancic, of Oxford Economics, sees bond yields rising further. She projects 10-year Treasury yields to rise 2% by end-2021 and as high as 2.45% by end-2022. The 10- year to 2-year Treasury yield spread has risen to 143 points — the widest since end-2016. This could see US fixed income becoming more attractive vis-a-vis currently robust emerging markets debt, which is perceived to be more risky.
The greenback is seen to be weak in the short term on the back of cyclical recovery, says Nicola, even with the support of a rise in yields. With robust reopenings coming through, the US dollar is seen to lose momentum going ahead. Yet in the long-run, Nicola sees US growth outpacing the US dollar, preventing a long-term decline and leading to US dollar strength against other developed markets’ currencies.
