Transcript: Value stocks entering recovery at cheapest valuations in decades

For today’s soundbites, we discuss the value cycle with Lauren DeMore, assistant portfolio manager for Putnam Investments’ U.S. Large Cap Value Strategies. We talk about what sectors she likes for value and how she avoids value traps. We started by asking if she thinks the value cycle will last.

Lauren DeMore (LD): We think that this value rally is sustainable. Because there’s a ton of savings that has built up during the pandemic, and pent-up demand to spend it on the consumer side, as well as the need to restock inventory and resume capex [capital expenditures] on the business side, and you layer in a patient Fed, you have the ingredients for inflation and rising bond yields to continue. And the sectors that are most correlated with rising rates are the who’s who of the value benchmark. It’s banks, commodities, industrials. So, the macro or factor drivers are on the side of value.

Her long view of the financial sector, and why she likes Citigroup.

LD: The banks are the barometer for the economy, so you’d think they would participate in a market rally coming out of a recession. And while their earnings faced numerous headwinds last year with margin pressure and credit costs, a lot of those are easing, or even reversing. And they’re beating earnings expectations by a wide margin as they report. So, from a high level, we think the banks are poised to catch up. Citigroup is our largest bank holding and one of the largest holdings in the fund because it’s a juicier play on the bank’s thesis. Citi trades at a wider discount to banks than it has historically. And you also have all the same points that we have on the banks — positive earnings momentum, excess capital — but they’re amplified in that Citi gets a larger portion of its earnings from the consumer, which we expect to see recovering quicker in terms of loan growth. And then you also have changes in their portfolio of businesses. Their new CEO Jane Fraser announced that they were going to close down about a dozen of their consumer banking operations outside of the U.S., which were sub-scale and earning low returns. So, it sort of fits in the wheelhouse of what we like about banks right now, and there’s a turn-around story going on which, you know, value stocks really tend to like.

How Microsoft fits into the value equation.

LD: Microsoft is a good example of our relative value approach. Their Office 365 business is really a subscription or SAAS [software as a service] business. And when we look at pure plays like Adobe or Salesforce, they trade at 40 or 60 times. So, at 30 times, Microsoft’s business looks cheap versus peers, and it grows at about the same rate. The second major business within Microsoft is Azure, their cloud business. They’re a strong number two to Amazon’s AWS [Amazon Web Services]. And, again, it trades at a big discount to Amazon. And then Microsoft has a video game subscription platform which they aspire to turn into the Netflix of gaming. And so, while Microsoft trades at about the same multiple as other gaming companies like Activision or Electronic Arts, it trades at a big discount to Netflix. So, when we talk about relative value, what we often mean is relative to peers. Microsoft trades below peers on the sum-of-the-parts basis.

Who she likes in the energy sector.

LD: Our portfolio is weighted towards companies with a history of capital discipline which has resulted in low break-even oil prices, strong balance sheets, and, ultimately, attractive outlooks for returning capital to shareholders. Our largest big-holding name is ConocoPhillips. They’ve had unwavering capital discipline over five years now. And as a result, they can cover capex and the dividend at [US] $40 dollars WTI [West Texas Intermediate], and their position to grow the dividends as well, helped by an acquisition last year of Concho [Resources], which heats up their exposure in the Permian [Basin] and is accretive on cash flow and earnings perspective. We also own a sizable position in Valero [Energy]. It’s a U.S. refiner with top-tier assigning assets and the lowest dollar cost for refining. In addition, we own smaller positions in Total and BP. The Europeans have lagged not only the recovery in the oil price but also other energy stocks in other geographies. So, they seem, you know, poised to catch up in the energy stock rally.

And, finally, how she avoids falling into value traps.

LD: I think one of the hardest questions to answer is how to avoid value traps. It’s like the Holy Grail. I think the key is to remember that value or cheapness alone is not necessarily going to drive shares. What you really need to ask is, why are they cheap and when will that change? Don’t be too tempted by cheap if you can’t come up with a reason for it changing.

Well, those are today’s Soundbites, brought to you by Investment Executive, and powered by Canada Life. Our thanks again to Lauren DeMore, assistant portfolio manager for Putnam Investments’ U.S. Large Cap Value Strategies.

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