Chasing tomorrow's winners

The fastest rate-tightening cycle in a generation has reinvigorated a perennial debate in investment management: in a bumpier economy is it best to tilt to value stocks?

A white paper by value fund manager Orbis says global indexes are so tilted to growth stocks – US tech giants in particular

– that most investors are ‘‘dangerously concentrated in last decade’s winners’’.

‘‘Investors remain concentrated, with the bulk of their active assets in growth-style funds, and their passive assets concentrated in giant US technology shares,’’ it says.

Eric Marais, who conducts investment research for Orbis, says greater exposure to value stocks, or those considered to trade below their fundamental value, is required to navigate the future.

‘‘We’ve come off this phenomenal period for equity returns, and we think it’s very unlikely that the next decade will look as good as the last decade,’’ he says.

Value investors buy companies that trade below their perceived intrinsic value in the belief that the market is mispricing the stock. The profit comes when the shares return to their ‘‘true’’ value. Growth investors aim to profit from companies that expand at above-average rates compared with their industry or the market.

Conventional wisdom says rising interest rates help value stocks and hurt growth stocks. Of course, value investors have been anticipating a rebirth for years.

‘‘You know that Samuel Beckett play, Waiting for Godot? It’s like that,’’ says David Tuckwell of ETF provider Global X. In the play, the two main characters engage in a long conversation awaiting Godot, who never arrives.

‘‘The rise of interest rates was meant to be the big bang moment when discount rates rose and growth stocks, or their valuations, were revised down,’’ Tuckwell says.

‘‘But even in the past year with interest rates higher, we’ve seen growth stocks outperform,’’ adding that the advantage of going, or staying passive, is that it’s extremely difficult to beat the market.

Orbis analysis shows nearly 70 per cent of the assets in Australia’s 10 biggest retail global equity funds are in passive strategies, which are heavily tilted to the US, the tech sector and mega cap stocks including the so-called Magnificent Seven.

‘‘That would be alarming enough,’’ the report says, ‘‘but investors have also actively allocated to styles best suited to the day. If we look just at the 10 biggest active retail global equity funds in Australia, 66 per cent of active assets are in growth strategies – those that generally pay higher prices for companies expected to grow more quickly. Only 10 per cent of assets are in value strategies.’’

And each of the areas – the US, tech sector and mega cap tech companies – are overvalued, the paper argues, noting that share-markets have only been more expensive 16 per cent of the time since the 1970s.

‘‘The US market trades at 22 times earnings, versus 14 times for shares elsewhere,’’ the paper says.

‘‘Giant stocks trade at 20 times earnings, while the median global stocks trades at 17 times. Tech shares are valued at 30 times expected earnings, while other industries are valued at just 16 times in aggregate.’’

Marais gives the example of computer chip designer Nvidia versus fellow chipmaker Micron. He says that while investors are ‘‘incredibly excited’’ about Nvidia, its cousin Micron has been undervalued.

‘‘We think longer term, the three to five-year view, you’re paying about 10x normalised earnings from Micron, which is really cheap. We’re finding lots of opportunities like that.’’

Marais also likes Korean banks and US nuclear power company Constellation Energy.

‘‘If you polled a room full of investors and asked how many of them owned a US tech stock, you’d probably see a lot of hands go up,’’ Marais says. ‘‘But if you did the same with Korean banks, you’re more likely to face a blank stare than a hand in the air. That is a good starting point.

Nuclear, although controversial, is is one of the few cost-competitive options that are carbon-free and reliable, he says.

The head of Australian Value Equities at Maple-Brown Abbott, Dougal Maple-Brown, says the ‘‘decade of misery’’ for value managers has drawn to an end.

He’s looking at opportunities among insurers, banks and commodities.

‘‘Going forward, in a higher interest environment, clearly growth stocks have de-rated,’’ he says.

‘‘We don’t think they’ve de-rated enough,’’ Maple Brown says. ‘‘CSL peaked at probably close to 50X forward earnings in an absolute moment of madness ... they’ve clearly come back,’’ he adds, although he still considers CSL expensive.

And while Maple-Brown is cautious about pushing general insurers as they’ve already ‘‘rallied hard’’, he thinks insurance is one of the few sectors in the stockmarket that is positively correlated to higher interest rates.

‘‘Why is that? If you think of your own home and motor policy in your own personal life, you pay NRMA or GIO thousands of dollars up front, they sit on that pile of money and pay out the claim in due course.’’

When those insurers are sitting on that money, and interest rates are near zero, they make ‘‘diddly squat’’, he says. But in a higher interest rate environment, they’re making significantly more.

‘‘The most levered there is QBE, so it’s done the best,’’ Maple-Brown says. ‘‘As long as interest rates stay around this level, they will continue to do okay.’’

But, he adds, if interest rates stay higher for longer because of consistently higher inflation, insurers like QBE, which tends to do longer-term insurance, will suffer.

While not ‘‘wildly excited’’ by banks, Maple-Brown says that compared with other growth stocks, he’d rather hold banks.

‘‘We think the forecasts for the banks are pretty sensible and then secondly, the bank valuations aren’t going to push the envelope,’’ he says. ‘‘You can still buy ANZ and Westpac roughly at book value, NAB is a bit higher and CBA is very expensive still.’’

James Tsinidis, portfolio manager at Munro Partners, says higher rates impact most asset classes, and while they tend to hit growth stocks earlier (because they are typically valued with a view towards future cashflow or earnings), over the medium- to long-term, companies’ earnings growth is what ultimately drives its stock price.

‘‘We can use an example such as Master-card to illustrate this,’’ he says.

‘‘Over the last 10 years, Mastercard’s earnings per share has grown at approximately 16 per cent a year, and its stock price has also appreciated approximately 18 per cent a year.

‘‘This is because Mastercard’s earnings was backed by a structural growth tailwind, which is the shift from physical to digital cash.

‘‘As this structural change has played out

– and continues to play out – over that period of 10 years, any shorter-term movement in interest rates has had little impact on the long-term stock return.’’

Tsinidis says this highlights the importance of identifying structural changes, and the companies set to benefit from them.

He believes 2024 will be good for growth equities and sees opportunities in artificial intelligence.

‘‘Our investment strategy has focused on investing in the ‘shovels in the boom’ which we believe are the large hyperscale cloud providers, such as Microsoft Azure, Amazon AWS and Alphabet GCP, and the semiconductor companies needed to provide the compute infrastructure,’’ Tsinidis says.

‘‘We believe the next evolution of investing in AI will be to focus on the software companies that can grow their earnings materially by adding AI to their product suite.’’

Tuckwell says that rather than shifting from one style of stock or investing to another, he believes investors need to observe the ‘‘age-old lessons’’ of investing: keep costs low, stay diversified, stay disciplined and invest in a way that maximises chances of success.

That, in his opinion, is through index funds. However, Tuckwell agrees that including an exposure to Australian stocks is broadly a sensible idea when it comes to diversification, and lowering costs.

‘‘It’s widely understood that investing in Australian shares as an Australian resident comes with franking credits, and for a lot of people, that’s a pretty compelling reason for a lot of people to focus your portfolio – to some extent – on our local shores.’’^SI