Equity investors today are undoubtedly giddy for structural growth and quality, with the price dispersion between growth and value stocks now at the widest levels since records began. However, rather than framing today's equity market through the lens of the traditional value versus growth debate, we prefer to examine why stocks on a high P/E have benefitted most from the recent decline in rates.
We often hear about this mad investor scramble for yield, but if this was truly the case, investors would be buying high dividend paying banks and other cyclical stocks. We contend equities are increasingly behaving like bonds, with a stark contrast between the valuations of long and short duration equities.
Growth stocks, by definition, are a claim on distant cash flows. This means this segment of the market does well when long-term interest rates fall, and the yield curve flattens. As the economic environment has deteriorated and rates have fallen - which has had a negative impact on cyclical and low P/E stocks - investor demand for high P/E stocks has accelerated.
The continual chase for duration is the single greatest risk in portfolios today, with many investors simply disregarding the underlying quality of many highly valued businesses.
Here, there are lessons to be learned from Japan. The growth-at-any-price investor has constantly argued the value style is dead because the world is likely to experience an economic environment previously witnessed in Japan. The Federal Reserve has stated it does not want the US economy to go the way of Japan, but we would argue the reason the equity risk premium stayed high in Japan for so long was because rates were kept very low. The worst Japanese companies never went broke.
I have invested in Japan for many years and while the cycle became a little less pronounced, there still was a cycle. In fact, over time, value actually outperformed growth in Japan - which is not the conventional wisdom.
Coming back to today, we are currently living through one of the most technologically disruptive and innovative periods in history, but the current borrowing landscape means that companies are not going under. Nevertheless, the success of Amazon and the other FAANGs is undoubtedly putting pressure on many incumbents - which have borrowed money and prioritised buying back stock rather than focusing on innovation.
What does this mean? We believe half of the US stock market is on the cusp of a very severe earnings recession. When capital markets become more discerning many businesses will not be able to stand the test of time.
We are underweight domestic part of the US market, particularly as the domestic-facing sectors of other global markets are vastly cheaper - as much as 30% in the case of Europe.
We see many attractively priced quality growth opportunities today, particularly in less-obvious areas of the market.
For example, industrials companies, such as German giant Siemens, are currently priced like other unloved cyclicals - despite being exposed to secular growth. The Siemens market narrative has long focused on its seeming inability to evolve - due to a lack of will and competing stakeholder interests. The need for change has long been apparent.
The core of Siemens is comprised of several truly world class businesses. Of the prior nine operating divisions, all but two are in the global top three - most of which are oligopolistic in nature. Siemens' leading divisions are its automated manufacturing business and healthcare business, which operate in secular markets with limited competition. These high-quality assets have long stood in stark contrast to the low valuation which has been, and still is ascribed to, the equity of the overall group.
While Siemens has historically been a complex company, the current management team is focused on simplifying the structure, recently announcing its intention to spin-off its conventional and renewable power businesses, which will realise the long-apparent latent value.
Our proprietary analysis clearly show Siemens' businesses would trade at higher multiples if separately listed. Developed world automation and healthcare companies continue to be valued at elevated levels. Buying Siemens today represents an inexpensive exposure to highly valued sectors, a discrepancy we believe will close as management executes on its plan. In a market prepared to pay a very high valuation multiple for structural growth, Siemens represents a remarkably cheap way of gaining such an exposure.
Jacob Mitchell, portfolio manager and CIO of Antipodes Partners