George Sertl gives a value manager’s view of the US equity market with a focus on key sectors
Investors have long sought active management as a way to capitalise on near-term inefficiencies to improve risk-adjusted returns. However, since the financial crisis, active managers have had a tough time beating their benchmarks. In the six years from 2009 to 2014, only about one in five US large-cap managers added value relative to the S&P 500.
To improve their chances of beating an index, portfolios have to look different from that index. Warren Buffett captured this sentiment perfectly in a 1991 Berkshire Hathaway shareholder letter, when he wrote: “If my universe of business possibilities was limited, say, to private companies in Omaha, I would try to buy into a few of the best operations at a sensible price. I certainly would not wish to own an equal part of every business in town.”
Due to our investment criteria as value investors, our portfolios generally have lower valuations, stronger balance sheets and higher returns on equity. Presently, our US large-cap portfolio is heavier than its benchmark in the technology sector, modestly overweight in the energy sector, and lighter in high-yielding utilities stocks and property real estate investment trusts (REITS).
When investors think of US technology stocks, what often comes to mind is the late 1990s technology bubble and the types of companies that came and went during that period, which were selling at sky-high valuations despite unproven business models.
Much has changed since then. We have seen fundamentals within the technology sector improve vastly. Better financial health, renewed focus on profitability, and cheaper valuations, have made a fertile area for a value-orientated investment process. When valuations were high in the late 1990s and early 2000s we had little technology exposure. We have moved from a meaningful underweight to a sizeable overweight in this sector now that the sector has become one of the cheapest on an enterprise value basis.
We think of technology as modern-day capital expenditures that are integral to the operations of most businesses. Much of this expense is not discretionary, and companies will continue to spend on productivity enhancements. We have found many companies within the US technology sector that have strong balance sheets, great free cash flow production and attractive returns on equity.
In our large-cap portfolio, we own several of the largest and most recognised global technology franchises, such as Apple, Cisco and Oracle.
Utilities and property REITs
Lofty valuations in the bond-proxy sectors have generally kept us away from US utilities and property REITs. These stocks are often used by investors as bond substitutes due to their high dividend yields, so they rarely become cheap enough to meet our thresholds on valuation. Investors seeking income may look at utilities and REITs relative to bonds and, from that perspective, they may look appealing.
Interest rate movements have a significant impact on how value is defined for utilities and REITs. In today’s low-interest-rate environment with high-quality fixed-income yielding low single digits and cash paying nearly zero, investors are understandably drawn to their yields. Although utilities and REITs look less expensive to us compared with fixed-income securities, they appear fairly valued to expensive versus other equities.
“We have found many companies within the US technology sector that have strong balance sheets, great free cash low production and attractive returns on equity”
The US energy sector is an area where there is still a lot of uncertainty. The energy sector has traditionally followed boom-and-bust cycles, typically driven by the capital spending cycle. We are now well into the bust phase. While energy companies cannot control commodity prices, they can control costs and capital spending. It appears that producers have accepted the new reality. The US rig count has already fallen by half since the middle of 2014.
The best way to characterise our thinking today is: eyes wide open. As a value investor, when you look at the big declines – which in energy have been quite substantial relative to the rest of the market – the natural inclination is to say it is an overreaction. But our analysis suggests there is also fundamental change under way. This may affect long-term average prices, over-the-cycle price volatility, swing producer status, and determine which fields get developed and which do not. It also seems likely to redefine the winners and losers in ways that are not yet clear.
Most energy stocks exposed to oil look cheap based on normalised oil prices, at least statistically. Until we feel like we understand the implications of a potentially new industry order, we will not be in a hurry to pile in. We remain of the view that these conditions will produce more losers than did the prior environment. Some balance sheets that were acceptable a year ago will not be today. This is more of a concern as you go down in market capitalisation. Our portfolios have above-benchmark weightings in the energy sector, but weights are not huge in an absolute sense.
The turmoil affecting energy markets has led to a number of new investment ideas that are outside the energy sector, yet still have exposure to oil and gas. For example, low oil prices have led to falling raw materials prices for Celanese, a chemicals company. Similarly, shares of Jacobs Engineering Group, an engineering and construction company, have been hurt by weaker demand from the oil and gas industry. Our view is that the selling in these stocks has been overdone and presents an attractive buying opportunity.
In general, our investment approach is geared toward investing in low-expectation situations, as is true today in the US oil and gas industry. These situations are often found in areas where high levels of fear and uncertainty exist. Our belief is that if a high level of pessimism is already baked into the stock, the risk/reward will be tilted in our favour.
George Sertl is a portfolio manager in the US value team at Artisan Partners