What Will Determine the Durability of Value Performance?
Granger: You both make good points about why investors should focus on manager approach rather than style index performance. However, the value index has outperformed the growth index by well over 1000 bps since the announcement of the vaccines in November 2020. Raj, you brought up a good point about the market’s recent rebound. Much of the rally has been driven by multiple expansion. Some like to characterize the last six months of value outperformance as largely being driven by the re-rating of either lower P/E names or previously underperforming stocks—especially in financials and energy
Raj, what factors should investors focus on moving forward? What will determine if the value rally continues?
Gandhi: In our view, the key variable is the sustainability of earnings growth and finding situations where the true earnings potential is not factored into consensus expectations. For example, in response to the pandemic, companies have instituted short-term measures to protect profits, including employee furlough schemes or pulling back on travel expenses. These types of cost cuts are temporary. We've spent a lot of time identifying which companies may benefit from long-lasting changes in behavior—enabling stronger and more sustainable growth.
Behavioral Changes Are Creating Opportunities
Take the IT services sector, for example. Before the pandemic, companies had already begun migrating infrastructure to the cloud and upgrade their communication infrastructure so they could reach customers through digital apps. The pandemic and experience of companies during the lockdown revealed significant shortfalls in IT infrastructure. As a result, we’ve seen an acceleration in IT spending on digital transformation projects.
Cap Gemini of France is a direct beneficiary of this increase in spending. Cap Gem has a global presence, with onshore consultants who interface with C-level executives. They have also built a large offshore design and implementation team in India, which enables delivery of these solutions at a competitive cost. The company is starting to see growth accelerate, as evidenced by a rise in their bookings. We believe this will lead to accelerating earnings growth and positive earnings revisions.
Another example is Cemex, the global cement company headquartered in Mexico. Many countries’ fiscal stimulus packages include programs to boost infrastructure investment as well as subsidies to stimulate spending on housing. We see this in markets where Cemex has operations, including Mexico, Europe and potentially the U.S.
President Joe Biden's infrastructure plan, if passed, could potentially add 5% to 8% to annual cement demand over the next five years when utilization rates are already running at high levels. We expect not only volume growth to accelerate but pricing to rebound, which could result in strong operating leverage and earnings acceleration.
Granger: From a value perspective, do you believe the recent value rally was a typical early cycle, short-lived beta re-rating, or is there durability in value’s outperformance?
Polit: After hearing Raj’s response, I’m reminded of a phrase Ronald Reagan used during the presidential debates against Jimmy Carter, “There you go again.” Raj never once mentioned price.
The work-from-home companies will start losing market momentum, the pandemic will subside, and the millennials will get back to work and spend less time on Reddit. We think markets will continue to acknowledge the value rotation and appreciate that price does matter. This price-focused value rotation has started and will only get stronger, in our view, given fundamentals and current prices. In the meantime, our goal is to take advantage of the disarray by buying businesses trading at attractive prices with downside protection.
We think one such nickel (not diamond) in the rough is Norilsk, a Russian mining company. In our view, the firm offers compelling value because of its attractive price, its strong balance sheet, and the fact that it is among the lowest-cost producers in each of its mining segments. Our research shows Norilsk offers an attractive growth profile over the next decade, as decarbonization initiatives throughout the world boost demand for nickel, palladium and copper. Supplies are already constrained and will struggle to keep up with demand growth due to the limited available resources and long lead times for mine development.
We believe the company’s strong balance sheet, cash flow generation and access to attractive and low-cost untapped resources also bode well for long-term growth.
That said, the key is that the current price is attractive.
Granger: Can you give us another example of a compelling opportunity that you’ve uncovered with your growth approach?
Gandhi: We like a company called Techtronic Industries. It is Hong Kong-based global leader in the power tools industry, competing head-to-head with Stanley Black and Decker. Techtronic owns the Milwaukee Tool and Ryobi brands, which you may have seen at your local home improvement store. Techtronic generates close to 70% of its revenue in the U.S.
We anticipated a long-term resurgence in power tool demand due to the work-from-home and nesting dynamic, as consumers diverted spending from travel to home improvement. This has played out—the company reported 44% revenue growth in the second half of last year.
Techtronic has also outspent its peers on R&D, resulting in the development of more innovative products. For example, Milwaukee’s MX FuelTM Equipment Systems are helping the company gain share in the fast-growing cordless tool market. These products offer longer battery life, more power, and greater torque. Despite the stock being up 133% over the last year, we believe the Street continues to underestimate the earnings power of this business.
Granger: How about on the value side? Can you give us an example of where your team is finding value now?
Polit: Raj may be surprised to hear that a dumpster diver like me found BMW attractive as the pandemic was surfacing and its price was appealing. BMW has leveraged its strong brand and technology and taken share from smaller automakers without the scale or resources to make the necessary investments to transition to electric vehicles or autonomous driving. Despite the strong share performance over the last year, the quality of the company and its product pipeline are still not fully reflected in the share price, in our view.
Gandhi: I’m glad to see you’re not simply buying old Pintos. We like Daimler, owner of the Mercedes brand. Mercedes has begun to benefit from an overall rebound in luxury car demand. It is also in the early phase of launching new models across its major markets.
For example, it recently launched a new generation of the S class, its most profitable car. We believe improving demand, coupled with the new model launches, will boost volume growth and lead to an improvement in margins.
As we look longer term, Mercedes has spent billions of dollars in developing a world-class electric drive train platform. We think the products coming off this platform should allow Mercedes to capitalize on the transition to EVs.
In fact, it revealed its first vehicle on this platform last month—the EQS, which will be in showrooms this fall. The EQS will compete head-to-head with the Tesla Model S, and it possesses some key superior features like a longer range and shorter charging times. For all these reasons, we believe Daimler appears positioned to see accelerating and sustainable earnings growth.
Polit: Well, Raj, we like Daimler, too. I agree with a lot of what you said about the company. It has made significant investments in R&D as well as in software development.
I also agree about the highly anticipated EQS competing with premium EVs. I would add that the trucks and buses division spinoff should be completed by year-end, which we think is positive.
An underappreciated asset is the financing division. Its extremely low credit losses reflect an inherently low-risk customer base. Its return on equity averaged 14% over the last four years despite a dip in 2020 due to COVID-19. And, even after a nice run-up, we still like the price.
Granger: Thanks, Raj and Al. Daimler is a great example of how we can look at a stock from different angles yet draw similar conclusions. You each make compelling arguments. The reality is the outperformance of growth and value goes through cycles that are difficult to predict, and investors may benefit by staying allocated to both.