Value stocks in a world of growth stocks

Good morning. Yesterday’s letter pointed out that fund managers who haven’t caught on to the AI ​​hype are all but doomed to lag the market. The Financial Times reported yesterday that Terry Smith is one of the skeptical underperformers. “We have yet to be convinced that (Nvidia’s) prospects are as predictable as we would like,” he wrote to his investors. Smith’s fund is up 9 percent year-to-date, which should buy him some time. If you think Nvidia’s future results can be predicted anywhere near more than a quarter or two in advance, be sure to email me: [email protected].

Where is the value?

In our letter on Monday we talked about the latest report by (now former) JPMorgan strategist Marko Kolanovic, which was something like a heart pain a plea for reason in the face of a market that seems to be in the grip of speculation. But if we’re not going to buy Nvidia, what should we buy? Here’s what the report suggests:

Given the robust investor sentiment and increased positioning, we recommend diversifying away from momentum tail risk by increasing allocation to anti-momentum defensive value stocks (utilities, staples, healthcare, telecom, dividend aristocrats) and away from pro-cyclical exposures (industrials, consumer discretionary, financials and unprofitable small caps).

That may be easier said than done. “Defensive,” non-cyclical stocks are certainly available to buy. But “defensive value” stocks—that is, stocks that are defensive and can be bought at fair prices—may be a little trickier. As we wrote recently, the stocks that have risen the most this year after the AI ​​gang are the largest and most stable consumer goods companies. Walmart, Costco, Colgate-Palmolive and Procter & Gamble, for example, all trade at hefty premiums to market price.

But there are definitely bargains out there, at least relatively speaking. We’ve looked at the chart below before. It shows the price-to-earnings ratio of the Russell Value Index divided by the P/E ratio of the Russell Growth Index. It shows roughly how much cheaper cheap stocks are than growth stocks:

So where is the value in the market? I spoke about this with Kimball Brooker, a portfolio manager at First Eagle Investment Management. He believes many food companies have been unfairly dismissed because they believed the new weight-loss drugs would reduce overall calorie intake. He points out that even if a significant portion of the population took the drugs, those people would still have years to live in which they would continue to eat. The weight-loss hype, he believes, has even affected the prices and valuations of healthcare companies like Medtronic (which makes pacemakers).

And indeed, some of the big consumer staples stocks that trade at large discounts to the market and have performed poorly recently include Kraft Heinz, ConAgra, JM Smucker, Lamb Weston, General Mills, Kellanova, Hershey’s and Pepsi. The trick is to figure out which of them are in the shadow of Ozempic and which are affected by the changes in Americans’ eating habits.

Brooker also believes that some companies that did well during Covid and have struggled since then have become too cheap. He cites the example of Comcast, where broadband internet subscriber growth has slowed. But Comcast is still generating tons of cash, buying back stock and trading at nine times earnings.

Value stocks tend to perform best in an economic recovery. The logic behind this is that cheap stocks tend to be cheap because their earnings are cyclical. Value stocks therefore suffer recessions hard and then rebound strongly when the economy starts growing again. Right now, however, most people believe the economy is either moving sideways or cooling slightly.

Bob Robotti of Robotti & Co is undeterred. He believes the U.S. industrial economy – one of the areas the JPMorgan report urged investors to avoid – has been under recession-like pressure for some time and is now on a growth trajectory. “In industrials, China is the economy to watch,” he says. China’s recent difficulties have prompted industrial companies to cut prices for products in their export markets, particularly in Europe, putting pressure on American rivals. But that won’t last forever. Moreover, following the shale oil revolution, U.S. industrial and commodity companies have the advantage of a permanent cost advantage over their rivals in energy inputs. He likes energy, chemicals, fertilizers, steel and aluminum.

I did a quick scan of the companies in the S&P 500 whose revenue and earnings have grown at least the rate of inflation over the past five years, that analysts expect to do the same over the next two years, and that trade at a price-to-earnings ratio of 18 or less (that is, a 20 percent discount to the market). The result was a list of 58 companies that have averaged 16 percent annual earnings per share growth over the past half-decade. There are solid, fairly valued companies out there. The question is when more investors will want to buy them.

A good read

Where have the high-quality smaller companies gone?

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