Last year was a punishing market — unless you were a value investor. In 2022, the total return (Canadian dollars) of the S&P 500 Value Index was 1.67% versus –24.27% for its growth counterpart and –12.16% for the S&P 500.
Stephen Jenkins, co-chief investment officer and portfolio manager with Sionna Investment Managers Inc. in Toronto, expects value’s outperformance to continue.
“There appears to be a real regime change,” Jenkins said. “Rates increasing, inflation being higher and perhaps more sticky is changing the game.”
As rates rise and multiples compress, “buying businesses well below what we deem they’re worth, [and] providing that margin of safety, puts an investor … in a better position,” he said.
In a blog post last year, Jenkins compared the current situation to the ’70s, when the Nifty Fifty — popular, overvalued U.S. growth stocks like Coca-Cola and McDonald’s — were hit with rising inflation and interest rates. “Many of the basic-economy stocks did not participate in the market’s Nifty Fifty runup and were thus offering very attractive valuations post the 1973/74 market collapse,” he wrote.
Sectors that included most of the Nifty Fifty stocks were among the worst performing during the rest of the decade. The lesson: “Even high-quality businesses can be poor investments if purchased at extended valuations or not sold as valuations become stretched,” Jenkins wrote.
Sionna identifies businesses that will grow over time and buys when they’re undervalued. A business may have been “dealing with some transitory issues that we can see through the next two or three quarters,” Jenkins said.
Some of the cheapest opportunities are in Canada and other developed markets outside the U.S., such as the U.K. and Japan. For example, the firm invested in Canadian Tire Corp. Ltd. at lows last year amid market concerns about unsustainable pandemic-related earnings and inflationary pressures.
The stock trades at about 10x earnings and pays about a 4% dividend. “You’re not being asked to pay much for growth in the future,” Jenkins said. “We think the earnings power in the coming years will be north of $20 a share, and that multiple should be going higher than the current 10x.”
The Canadian retailer has “done a great job … on their financial side, rewards and digital offerings,” Jenkins said. Canadian Tire now also sells more of its own brands, which increases margins.
An investment pick outside Canada is U.K.-based multinational energy company Shell PLC, which cut its dividend early in the pandemic. “We saw through that,” Jenkins said. “We saw that cash flows would rebuild again, which they have.”
Cash flows, generated in part from Shell’s legacy business, are being returned to shareholders and funding renewables, he said. Shell is also the world’s leader in liquefied natural gas, which will “continue to play an important transition role as we move to greener fuels and economies.”
Shell is trading at a forward price-to-earnings multiple of 6.3x, and the distribution yield to shareholders should average about 10% in coming years, he said. “We think [Shell] has more room to … reward shareholders and transition the business to renewables.”
Broadening the value definition
The conventional definition of value investing — stocks that trade at low earnings or book multiples — is “an oversimplification” at best and “self-limiting” at worst, said Randy Steuart, portfolio manager with Ewing Morris & Co. Investment Partners Ltd. in Toronto. He manages the Ewing Morris Flexible Fixed Income Fund, which focuses on high yield.
“To me, value-driven investing refers to purchasing a stock or a bond at a discount to the value I expect to receive in the future from the investment, be it a stream of cash flow or a return of the capital itself,” he said in an email.
He noted that in 2021, the high-yield bond market “could hardly justify its own name,” yielding 3.5% at one point. “Fast forward to today and you’re back to getting paid, thanks largely to the move in interest rates.”
One concern, however, is a contraction in commercial lending due to stress in the banking system. Steuart also referenced the lack of supply in the high-yield market — new issuance, in particular, is down this year. While economic challenges may lie ahead, high-yield investors have priced in caution, he noted.
“I like to say that credit investors are the cardiologists of the capital market: they hear and see the warning signs first,” Steuart said. “At an 8.9% market yield [for the S&P U.S. High Yield Corporate Bond Index], you can make an argument that high yield is braced for some degree of pain already.” Yield-to-worst — the lowest likely return — for the index is 8.88%.
In the past year he’s seen opportunity in convertible bonds.
“Many tech companies issued bonds at nosebleed valuations in early 2021, and with stocks down and yields up, it means many of these converts are trading now in the range of 60 to 85 cents on the dollar and often in multibillion-dollar market cap situations,” he said.
Steuart controls risk in the fund by hedging the bond holdings: he shorts a lesser amount of the same company’s stock.
“We like this approach, as debt investors tend to be pessimists and equity investors tend to be optimists,” Steuart said.
An example is California-based Chegg Inc., an education tech company that provides services such as exam prep and writing support. “Bondholders at Chegg were and are rightly paranoid that ChatGPT and [artificial intelligence] is going to be a problem for the company, whereas equity investors seemed to be more complacent regarding this risk, judging by its lofty valuation,” Steuart said.
In its first quarter this year, Ewing Morris took a 20% equity hedge against its convertible bond position, and the equity hedge gains offset losses on the bond. “The stock was down 50% and the bonds were down 10%,” Steuart said. “On a net basis, it was like nothing happened. Risk was controlled.”
Chegg bonds now yield about 9% despite the balance sheet being net debt-free, he noted. “There’s a very strong case for the bonds to be ultimately matured at par, while the long-term value of the stock is far less clear,” he said.
There are a lot of cases where a business isn’t strong enough to generate equity value over time, but its debt is paid, he said. “We try to find these situations where we can conservatively harvest the yield of the bond, and even have a shot at making money on the layer of risk reduction: the equity hedge.”
The risk of a takeout acquisition when shorting a company’s stock is less concerning given the bond contract.
“If the company gets taken out in a cash deal, the bond, with its par put option, is highly likely to contribute more profit than the losses of the low-ratio stock short,” Steuart said. “In Chegg’s example, the bond would be up about 40% from current levels in a takeout. … That’s a pretty good outcome for a bond.”