If interest rates are headed up because of rising inflation — the working theory behind the U.S. stock market’s recent panic attack — then it’s time to calm your nerves by tilting toward value stocks.
That’s the view of David Green, who helps manage the Hotchkis & Wiley Value Opportunities Fund HWAAX, +0.10% Sure, he’s got a bias. He manages a value fund. But hear him out, because he’s worth listening to.
A graduate of the University of California, Berkeley, Green started his investing career in the early 1990s at Prudential Investment. Then he moved on to Goldman Sachs Asset Management. His Hotchkis & Wiley fund beats its benchmark by 5 percentage points, annualized, over the past 10 years, according to Morningstar.
Beyond his investing cred, Green’s reasons for favoring value make a lot of sense.
‘Inherent risk in growth stocks’
They’re based on a simple lesson that business school students learn in first-year finance. That is, investors value companies by calculating the present value of future earnings. They do so by “discounting” those earnings back to the present using a risk-free interest rate based on government bond yields.
When that rate goes up, earnings in the distant future are suddenly worth a lot less now, because they get discounted back at a more aggressive rate. Since growth stocks like Facebook FB, -1.44% and Amazon.com AMZN, -0.89% have a bigger portion of their expected earnings in the future, their valuations get hit harder by rising Treasury yields, in this valuation model.
Value stocks, in contrast, often have more of their earnings weighted toward the near term. So they suffer less. Which means they should outperform if bond yields rise.
“If interest rates go up, the stocks that will be hit the hardest are growth stocks because they are longer-duration stocks,” says Green. “Duration” measures the proportion of bond payments that land in the more distant future, as a test of the interest-rate sensitivity of a bond’s price. But the concept can also be applied to stocks.
“This is an inherent risk in growth stocks that people are not appreciating,” says Green. “This is something that could ultimately unravel the growth bubble.”
Value stocks also look attractive now simply because they are so out of favor. The current valuation gap between Green’s stocks and the S&P 500 Index SPX, +0.04% is the widest it’s been since the tech bubble in the late 1990s. Once that party ended, value outperformed.
What to own
Green doesn’t turn his back on technology stocks, typically thought of as a growth sector. According to recent fund filings, his top 10 holdings included Hewlett Packard Enterprise HPE, +0.24% Microsoft MSFT, -0.71% and Oracle ORCL, +0.14% But these are the high-growth tech names of yesteryear. Now, as more mature tech companies, they have slower growth rates. So tech investors who chase hot growth may be overlooking them. That helps explain why these old-school tech names have been handed off to the value investors.
But for the real discounts, look to energy. Green and his team moved into this space in a timely manner last summer and fall just ahead of the big move up. They bought Whiting Petroleum WLL, -1.44% Marathon Oil MRO, -4.11% Hess HES, +0.26% Frank’s International FI, +0.49% and National Oilwell Varco NOV, +1.37% during August-November, according to Morningstar. His logic at the time was that oil inventories were steadily declining and eventually that would put upward pressure on oil prices. Then the stocks would follow. That is how it played out.
Now, despite the gains in energy stocks, Green continues to like the group because it still trades at a significant discount to its historical valuation. One reason is that investors don’t trust higher oil prices. They’re concerned that U.S. shale producers will again flood the market and drive oil prices down.
Like the oil experts in a recent column I wrote on energy, Green rejects this theory in part because solid global growth supports rising oil demand. “We still think energy is attractive,” says Green.
Green singles out rig equipment and oilfield services company National Oilwell Varco, from among his energy holdings, as a candidate for fresh money. The company’s shares have been held back by weak demand for offshore rigs, and relatively modest increases in demand for onshore rigs.
But Green thinks demand for National Oilwell Varco’s equipment and services will pick up because of growing oil demand. He thinks the company has the potential to earn $3-$5 per share, which would make the current stock price of around $35 a bargain.
“This is an example of an opportunity to buy a good company at a good price, because the overall market is depressed,” says Green.
A tainted bank
Next, Green likes Wells Fargo WFC, -0.12% which recently got hit by a Federal Reserve decision to prohibit the bank from growing its balance sheet until it “makes sufficient improvements” in risk management and compliance.
Mark Hulbert: Despised companies, such as Wells Fargo, often outperform the most admired
Green says the action doesn’t change his long-term bullish view on Wells Fargo. He thinks the bank will still be able to grow core loans to customers by reducing holdings in short-term investments and non-core assets. And while it would be better to be able to grow its loan book, “the impact on valuation should be largely offset by the fact that Wells will now have more capital to return to shareholders.”
Meanwhile, Wells Fargo has a huge deposit base and a great national branch network, including a big presence in high-growth regions on the West Coast and in the Southeast. Plus, Wells Fargo earnings may be temporarily suppressed for reasons that will fade. Costs have risen, because the bank increased oversight following the revelations of abusive behavior toward customers. But those costs should come down as the bank makes progress.
“As they work through these issues, there is upside in terms of higher earnings and higher multiples,” he says. But here’s the bottom line for a value investor like Green: “Because of the taint, investors are not appreciating how good their franchise is. When perception swings negatively, you can buy great franchises at good values.”
If position size is a measure of appreciation, then Green has lots of respect for Wells Fargo. It is his fund’s third-largest holding after Hewlett Packard Enterprise and American International Group AIG, +0.41% And it accounts for over 5% of his fund’s assets. That’s a significant overweight in a business that often caps position size at 2% to limit single-stock risk.
At the time of publication, Michael Brush had no positions in any stocks mentioned in this column. Brush has suggested WFC in his stock newsletter, Brush Up on Stocks, last April. Brush is a Manhattan-based financial writer who has covered business for the New York Times and The Economist group, and he attended Columbia Business School in the Knight-Bagehot program.