From Airlines to Communications
Strong fundamentals and attractively valued stocks can be found in a range of industries, unlike after the global financial crisis, when opportunity was heavily concentrated in deep-value financial stocks. For example, valuations of US airline stocks are currently very compelling amid concerns that passenger numbers may drop if the economy slows. Yet after years of consolidation, domestic load factors have risen steadily from about 74% in 2004 to 85% in 2017, meaning planes are flying with many fewer empty seats than in the past. Select airlines, such as Alaska Air Group, have also lowered costs and enjoy dominant positions in niche routes, which should help the company do well, even in tougher times.
In many cases, cheap stocks don’t reflect strong underlying fundamentals. Shares of Comcast, the communications group, have faced pressure as investors frowned upon its takeover of UK satellite TV provider Sky for an enterprise value of $49 billion last September. Concerns are also growing about the sustainability of TV subscribers. Yet Comcast continues to show good earnings growth and free cash flow, driven by tight spending controls and its improving broadband business, which continues to gain new subscribers.
What Could Prompt a Rebound?
Still, for value stocks as a group to deliver better results for investors, market sentiment needs to change. We believe that the current environment is actually a classic value opportunity. Many investors have an exaggerated fear that a recession will depress earnings dramatically for value stocks, which has pushed valuations down to extremely low levels. Some cheap companies are clearly vulnerable to a slowdown. But for select companies that are properly positioned, the worst earnings nightmare is unlikely to come true, and these stocks could ultimately deliver much better performance than expected, in our view.
Active Positioning Is Essential
Even if a value rebound materializes, the road to recovery won’t be smooth. Volatility is likely to persist. And companies of all stripes are facing multiple risks.
That’s why investors need to be selective. Passive value portfolios based on simple valuation metrics don’t scrutinize individual companies. To identify undervalued companies that can withstand external pressures, investors need to look closely at balance sheets, cost structures, management teams and, most importantly, cash flows as indicators of company health. Multi-dimensional valuation metrics—earnings, sales and cash flows—are essential to understanding the true value of a business. And identifying clear catalysts for a company to rebound can help reduce the danger of falling into “value traps.”
Reports of the death of value investing are greatly exaggerated, in our view. Nobody can say when the cycle will shift in favor of value stocks again, but we believe that today’s pent-up return potential could lead to extremely attractive results for patient investors. By being mindful of the current risks in the market and using multiple lenses to gauge valuations, we think investors can gain the confidence to reallocate to disciplined value portfolios based on traditional contrarian stockpicking.
