A recurring theme at the conference was: Will value investing ever rebound? Is a reversion to the mean forthcoming or has the market fundamentally changed during the past decade?
Morningstar’s director of equity strategies Katie Reichart posed those questions–and many others–to two fund managers who’ve proved adept at valuing companies relative to their growth prospects: Giroux, who manages Gold-rated T. Rowe Price Capital Appreciation (PRWCX), and Hynes, who leads Gold-rated Vanguard Health Care (VGHCX).
“It has definitely changed over the past decade,” Giroux replied. Specifically, the market has experienced a secular change. Giroux argued that secular risk is now a bigger defining factor in the market, touching more industries and companies than ever before. To wit: T. Rowe Price estimated a few years ago that 27% of the S&P 500 was facing secular risk; that figure stands 31% today. So while it’s true that value investing had a mean-reverting element to it over past 80 years–companies would struggle, recover, and then revert to the mean–that’s less likely today.
Giroux pointed to retail as an example: Fewer people are going to the mall, there’s less brand loyalty, and the Internet has fundamentally changed how we shop. As a result, most retailers can’t revert to the mean. So while the traditional light and heavy cyclicals have continued to show mean reversion, other industries aren’t–hurting traditional value approaches. To make matters worse, said Giroux, management teams of companies facing secular risk are making poor capital-allocation decisions to reinvent their companies– Verizon (VZ) buying AOL or IBM (IBM) buying Red Hat. Instead, he argued, these companies should be returning this capital to shareholders rather than making “Hail Mary passes” for growth.
Hynes noted that healthcare has become more consolidated and less fragmented in the past decade, with the bigger players gaining even more scale and market share. Hynes also noted that drugmakers, in particular, have been experiencing a “supercycle” of innovation and an intense period of regulatory scrutiny, which has injected more uncertainty and misvaluation of revenue streams. When asked what uncertainty Amazon‘s (AMZN) entry into healthcare may bring, Hynes said that while she respects what Amazon has done in other industries, she thinks healthcare is very different because it’s regulated and more complex. As such, it may not be as easy for Amazon to dominate here as it has elsewhere. Hynes admitted that it’s unclear what Amazon’s presence would be, but one thing’s for certain: “It will take a good deal of time.”
Reichart asked Giroux and Hynes for specific examples of such secularly challenged companies. Giroux named one that his fund in fact owns– Keurig Dr Pepper (KDP). “Almost all consumer staples have some secular challenges attached to their business models,” he observed. But Giroux thinks Keurig Dr Pepper boasts strong cash flows and a good CEO. Nevertheless, the holding is a small one in T. Rowe Price Capital Appreciation–just 0.43% of assets as of the latest portfolio.
According to Hynes, drugmakers that have benefited greatly from biologics/specialty drugs on the market for more than 20 years are facing biosimilar competition that will create a gap in earnings for those that don’t have the pipeline to offset it. She’s seeing a lot of this already in Europe, where the presence of biosimilars has been more rapid than expected.
Reichart then asked the managers to explore how the presence of disruptors has forced them to change their approaches to valuation.
Hynes brought up Illumina (ILMN) as an example. The firm has a monopoly on its technologies; as a result, its long-term growth rates look more like those of a biotech company. More than before, it’s critical for investors to figure out what the market opportunity for a company looks like five to eight or nine years down the road.
Giroux noted that, yes, the traditional yardsticks for valuing companies may be less useful today. For instance, looking out into the future, Amazon looks cheaper than Walmart (WMT) on a cash flow basis.
“The middle is where the most attractive part of the market is,” he argued, meaning those growth-at-a-reasonable-price stocks. Specifically, Giroux likes companies with improving margins, 4% to 5% organic growth, and less cyclicality–that’s where today’s inefficiencies lie. Giroux likes buying companies that neither value nor growth investors want–and he’s willing to occasionally pay a slight premium for them.
Both managers agreed that the market has become shorter-term-focused; those investors looking at the long term are differentiated from the rest. Giroux said there’s no easier way to make money in the market today than to buy a company that you feel good about in the long term that’s suffering from undue market stress in the short term.
What companies qualify?
Hynes cited portfolio holding Biogen (BIIB), which was under pressure because of its failed Alzheimer’s drug. “We were disappointed in that outcome,” she admits. However, very little of the team’s valuation of the firm was based on the outcome of the trials for that drug. So despite the short-term hit that the stock has taken, it continues to hold the stock.
Giroux, meanwhile, used General Electric (GE) as his example. Noting that GE’s fall is, in fact, a “sad story,” Giroux noted that he didn’t own the stock until Larry Culp became CEO. “I stopped what I was doing for two weeks,” he noted, and spent all his time analyzing the company. What he found: Over a multiyear time frame, GE has, in Giroux’s opinion, some of the best industrial assets in aircraft, an average imaging business that will probably be sold, and a power business that holds promise. “The upside is probably greater than anything else we have in the portfolio,” he asserted. “This company was horribly run for two decades with horrible consequences. I think you’re going to see a rebirth, and I’m excited to be a part of it.” GE is among the portfolio’s top 20 stocks today.
Overall, Giroux isn’t finding a lot of value in the equity market today; instead, he’s finding “idiosyncratic opportunities.” For instance, he picked up loans on First Data (FDC) with a 5% yield that will be going away in six months after its acquisition by Fiserv (FISV). “We backed up the truck,” Giroux quipped.
The duo closed with more examples of change.
Healthcare is changing at a more accelerated rate at any other time in her career, Hynes said. She noted that with the costs of sequencing the human genome coming down and a better understanding of disease pathways, there will be more research and development dedicated to diseases that we’ve never treated before. That could bring dramatic change to 60% of the healthcare market, she estimated. She also expects a very robust healthcare market in China, and noted that demographics in the next decade will challenge governments with aging populations.
Giroux noted one sector that’s changing dramatically but has gone unnoticed is utilities. The cost of wind and solar energy and renewables has led to a shift in the business models of utilities. He expects to see accelerating earnings growth as more power is coming from renewable sources, and sees renewables as a very powerful 20-year tailwind for utilities. “It seems like a great long-term place to be,” he concluded.