Second Quarter 2017 Newsletter Commentary


Second Quarter 2017 Newsletter Commentary

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Improving fundamentals coupled with wide valuation spreads make for an attractive environment for deep value stocks. Self-help measures have been an important contributor to an improved profit picture.

The strong value run of 2016 paused in the first half of 2017 as market leadership shifted to growth. A narrow range of tech stocks - the FAANGs in the U.S. and Alibaba and Tencent in China - lead the pack in those regions. This abrupt shift leaves one wondering whether the value cycle is over, or if the environment is conducive to a resumption of value outperformance.

Three criteria typically set up the opportunity for extended value outperformance:

  • Uncertainty, either broad-based or company-specific,which creates
  • Wide valuation spreads between companies punished forthese uncertainties and those favored by investors, then
  • A dissipation of uncertainties which leads to there-rating of value stocks.

There are many such cases of uncertainty today. Whether it be major U.S. banks that are just regaining the confidence of investors a decade after the global financial crisis, European industrials whose valuations have been punished by a painfully slow economic recovery, Japanese companies put in the penalty box for a generation of low shareholder returns, or emerging market businesses cheap for their own specific reasons, there is a long list of companies suffering from uncertainty. Valuation spreads between these companies and the much-loved growth darlings and bond proxies are still near 50-year highs (Figure 1).

Figure 1: Valuation Spreads Are Still Extreme
1Q vs 5Q Spreads by Region, expressed in Standard Deviationse

Note: Data as of June 30, 2017.
Source: Sanford C. Bernstein & Co., Pzena analysis.

Yet when we look around the world, we see reasons for optimism. U.S. banks just received their best report card since the financial crisis. European order books are filling, and profits are inflecting higher. Companies around the world have undertaken extensive self-help measures creating the opportunity for accelerated profit recovery with even modest top-line support. And green shoots are appearing in unexpected places – corporate actions are unlocking value in Korean chaebols, Chinese state owned enterprises have initiated dividends, and Japanese managements have renewed focus on corporate governance and shareholder returns. A clear-eyed view of the landscape shows a broad picture of opportunity.

Redemption for U.S. Banks

For the U.S. banks, the recent stress test results were an affirmation that, as the banks fixed themselves and the pace of regulatory headwinds slowed, investors would see rising earnings yields and cash payouts. The U.S. Federal Reserve's go-ahead for the large banks to return higher levels of capital than expected was quickly followed by announcements from the banks themselves that they would immediately begin to aggressively return capital and earnings to shareholders.

The median payout request for the next six quarters was 97% of earnings, up from 84% in the 2016 stress tests and an average payout of 79% from 1999 to 2006. Those banks that plan to return more than 100% of earnings, including Citigroup, JPMorgan, and Morgan Stanley, are signaling that their capital ratios are high enough after years of steady increases. The fact that there was not a single quantitative or qualitative failure in this year's stress test shows not just the safety in the banking system, but also how far the banks have come in understanding and satisfying the Fed's requirements.

The expected payouts over the next six quarters at several of the banks equate to annualized yields of more than 10% of market capitalization (Figure 2). The fact that investors have been paying up for 3% dividend yields from the bond proxies (consumer staples, utilities, and REITS) highlights the very different discount rate they are applying to the “safe” stocks versus controversial sectors and names. Looking ahead, we expect rising earnings on the basis of continued self-help and improving fundamentals, as well as potential favorable changes to the stress test process. Even after the sharp rise in stock prices for all the large banks from mid-2016, we believe valuations remain extremely compelling. As the banks re-establish investor confidence over time, we would expect the discount rate applied to narrow, helping improve valuations further.

Figure 2: U.S. Bank Payouts To Shareholders Rising Substantially
Illustrative Payout Yield As % of Current Market Cap for U.S. Universal Banks

2017 based on CCAR results. 2019E is illustrative assuming return of 100%
of excess capital by year-end 2019. Source: Capital IQ, Pzena analysis


Europe Emerging From The Doldrums

Europe has lagged the U.S. in its recovery; however, green shoots are starting to emerge. Business sentiment is up, order books are filling, and corporate profits have surprised to the upside with almost two-thirds of publicly held companies beating expectations in the first quarter of 2017 (Figure 3). Self-help measures (i.e., cost reduction and efficiency improvements) have been major contributors to this progress, setting up a situation where even modest top-line growth has had an inordinately positive impact on bottom-lines (Figure 4).

Figure 3: European Corporate Earnings Are Beating Expectations

Universe is STOXX Europe 600
Source: J.P. Morgan, Bloomberg

Figure 4: Cost Cutting In Europe Has Created Significant Upside Operating Leverage

U.K. and Continental Europe Operating Leverage: Ratio Between the
Year-over-Year Changes in Pre-Tax Income and Sales1
1990 Through June 2017

Source: Corporate Reports, Empirical Research Partners Analysis.
1 Capitalization-weighted data.

Self-Help And Improved Corporate Governance

In Japan, corporate governance reforms under Abenomics have ushered in a new era of responsiveness to shareholders. Greater representation of independent directors on corporate boards, a decline in management-friendly cross-shareholdings, and a recommendation by the leading proxy advisory firm ISS to vote "against" top executives that haven't hit a minimum return hurdle have contributed to a renewed focus on profitability and shareholder returns. As can be seen in Figure 5, Japanese companies have substantially increased their dividends and share buybacks.

Figure 5: Japanese Companies Are Increasing Payouts to Shareholders

Note: Tokyo Stock Exchange 1st listed companies as of each fiscal year end, excluding financials and Japan Post. Net amount of share buybacks (reported on cash flow statements). Buybacks forecasted for FY 3/17 and FY 3/18 by Mizuho Securities. Data as of May 9, 2017.

Source: Mizuho Securities Equity Research, based on Tokyo Stock Exchange data.


Emerging markets have been a story of improving corporate results in an uncertain environment. After falling for the last three years, return on equity (ROE) in China is expected to inflect higher for both private and state-owned enterprises (Figure 6), much of it due to expense reductions and other self-help initiatives, though the upturn should be more pronounced for companies which have taken more aggressive action. Notwithstanding official China GDP data, other statistics (e.g.; electricity consumption) would suggest China slowed significantly in 2015. It appears China has exited that phase and is pulling its weight again in the global economy.

Figure 6: China Return on Equity Inflecting Upward

Note: ROE is bottom-up aggregate with free-float adjustment based on current MSCI universe. State owned enterprises (SOE) and Private (PVT) decided manually after analyzing the current holding structure for all the stocks.
Source: MSCI, FactSet, CLSA

A Good Environment for Value

There are many factors contributing to the opportunities in value stocks today beyond favorable valuations and improving fundamentals. Companies have demonstrated an ability to adjust their cost structures and implement self-help measures to improve current returns and set themselves up for significant incremental earnings, as top-line growth re-emerges. There are also many idiosyncratic opportunities driven by factors outside of general economic conditions (the U.S. pharmaceutical supply chains come to mind). None of these drivers is dependent on the prospects for reduced regulation, infrastructure investments, and lower taxes in the U.S. which helped drive sentiment in late 2016, but are becoming more doubtful of late. We see government-led stimulus as additional upside but not a requirement for value stocks to resume leadership. Of course, there are still uncertainties that can derail continued recovery, but barring such extraordinary events, we believe there is ample evidence that conditions provide a favorable environment for the value investor.


Past performance is no guarantee of future results. The historical returns of the specific portfolio securities mentioned in this commentary are not necessarily indicative of their future performance or the performance of any of our current or future investment strategies. The investment return and principal value of an investment will fluctuate over time.

The specific portfolio securities discussed in this commentary were selected for inclusion based on their ability to help you understand our investment process. They do not represent all of the securities purchased, sold or recommended for our client accounts during any particular period, and it should not be assumed that investments in such securities were, or will be, profitable.