First Quarter 2019 Commentary

Fear of recession has depressed valuations of many economically sensitive businesses. Contrary to popular belief, this may be an opportune time to invest, with the added benefit that many of these businesses have improved their financial strength and operating flexibility.

The first quarter marked another period of growth beating value, with most outperformers falling into the paradigms of high-flying growth or so-called safety stocks that offer higher dividends, low volatility, and stable earnings. Meanwhile, many of the valuations of traditionally cyclical businesses already appear to be discounting a recession. This has pushed valuation dispersions between the cheapest and most expensive stocks to their widest point since the internet bubble (Figure 1).

While we can never predict when such a trend will reverse, the historical pattern has been for cyclical shares to become heavily discounted amid fears of a recession, and then outperform once the prospects of a recession become clearer. Currently, valuations in financials, energy, autos, and housing-related stocks are heavily discounted. While the reasons for their weakness vary by industry, we believe each offers a meaningful investment opportunity.


In considering the viability of investing in these businesses today prior to a downturn, we evaluated returns relative to the market when bought within 24 months of a recession and then held for three years.Because the global financial crisis (GFC) was such an outlier, we wanted to differentiate its results from what has typically happened around a recession.

Leading into the GFC, it’s no surprise that financials did not deliver a positive return over the ensuing three years. However, buy-and-hold investors in consumer discretionary stocks were rewarded for purchasing virtually any time within six to eight months of the crisis.

In more mundane recessions, like the four prior to the GFC, patient investors were rewarded for owning

Figure 2: The Most Highly Valued Stocks Have Led the Market Higher

Source: National Bureau of Economic Research, Empirical Research Partners, Pzena analysis
1Equally-weighted cumulative returns of sector versus capitalization-weighted returns of the largest ~750 US stocks by market capitalization

Past performance is not indicative of future returns. Does not represent performance of any Pzena product or service.

undervalued cyclical stocks. Figures 2a and 2b show just how strong the outperformance for financials and consumer discretionary stocks were over the three years surrounding these recessions.

Now in various stages of repair, we also believe that many of these companies are better prepared than in the past for a downturn — even as their valuations imply that the opposite is true.


The distrust created during the GFC has not been fully resolved in investors’ minds, so financials remain heavily discounted (Figure 3). Their current valuation relative to the broad market places these stocks in the 97th percentile of the past 45 years, meaning they’ve only been cheaper 3% of the time. However, given their profitability, capital strength, and liquidity, we believe the discount is unwarranted.

Both US and European banks have improved their fundamentals and fortified their balance sheets by:

  • increasing tier-1 core risk-based capital ratios to over 13%, from 7%-8% at the end of 2006;
  • raising liquidity ratios: in the US by nine percentage points, almost triple precrisis levels (See Figure 4); European banks have similarly improved liquidity management.
  • scaling back risk-taking to reduce the likelihood of a major institution upending the system;
  • implementing self-help that cut costs, improved governance, focused on higher-return businesses, and installed next-generation technology to better serve clients.

These combined actions make the banks much better positioned to weather future credit events or market shocks.

From a credit perspective, the overall environment today remains benign, and non-performing loans are below their historical range. The recent outsized growth in leveraged loans alongside loosening lending standards in this space has raised some concern. With most loans being packaged and dispersed among institutions and within financial products, the additional risk will be born across markets. The extent to which investors bear this additional risk remains important and may be accentuated in the event of a downturn.

Exposure among the banks remains constrained, and we don’t believe it warrants their current valuation discounts. As a result of stronger risk management and higher regulatory requirements, banks today turn over their leveraged loan inventory as rapidly as every 60 days, three times faster than before the GFC. We continue to watch for new developments but believe that any problems surrounding these loans will be limited in scope, and the risk of systemic contagion is low.

Investors also penalize the sector as interest rates remain persistently low. The reality is that financials have demonstrated an ability to adapt by raising revenue and restoring earnings. Even with the combination of low interest rates and increased regulatory capital requirements, US banks have restored profitability with return on tangible equity of 15%.E1 European banks face more severe interest rate headwinds than those in the US. Banks in Europe also have more restructuring ahead to restore profitability; most expect to resume double-digit returns on equity over time.


Energy stocks are also at depressed valuations due to concerns centered around the uncertain path for energy prices. On a price-to-book (P/B) basis, they’re trading in the 98th percentile of the range relative to the market over the last 44 years. In other words, they’ve been cheaper on a relative basis in just 12 months out of the last 528. And each time was on the heels of a rapid oil price collapse.

Companies in the sector have taken significant steps to endure this kind of volatility — cutting

operating costs and capital spending to restore profits and cash flow. Meanwhile, the downturn in exploration and development accelerated the decline in global reserves. Falling at a rate not seen in the last four decades (Figure 5), the pace of the fall seems unsustainable. Even with developments in the alternative energy and transportation industries, world oil demand is expected to grow over the next two decades, according to the US Energy Information Administration. The combination of rising demand and depletion will more than offset any reductions from technological advances, and ultimately it will require companies to invest in developing additional reserves.

Oilfield service companies would be central to that development but have been particularly vulnerable of late. Figure 5 shows that upstream capital expenditures fell by 44% from their 2014 peak. After having endured sharp declines in revenues (-49%) and margins (-63%), these companies have shown progress. With only a slight improvement in revenues, these companies doubled their margins to 10.4% by 2018 (from 5.1% in 2014) by focusing on cost cutting and supply chain efficiencies. In many cases, they have also shown disciplined capital management by aggressively trimming debt. We believe the more austere approach of these companies should allow them to come through this period as leaner, more efficient operations. With these companies trading near historical lows relative to the market, investors are essentially getting a free option on increased energy capital spending whenever the recovery occurs.


Within the consumer discretionary sector, household durables and automobiles have faced a perfect storm. Their natural tendency for a late-stage selloff may have been intensified by headwinds such as trade-related cost increases, that are specific to the current cycle. Building product manufacturers and homebuilders have underperformed on slower growth in housing starts and the impact of rising rates on affordability. Costs surrounding materials and transportation have risen substantially since the beginning of 2018, and labor’s been tight.

Amid the volatility and rising fears of a recession in 2018, household durables fell by 29% and autos by 34%. After taking a severe battering in the last recession, investors seem to want to steer clear of anything housing or automotive related. While there’s been some recovery within housing this year, US large-cap auto and housing-related stocks continue to trade at a significant discount to the broad market on a price-to-book basis. This quarter’s Highlighted Holding on Ford Motor Company points to some of the challenges facing the auto industry and the actions Ford is taking to meet these challenges.


The market’s continued preference for growth and safety has recently left many of the traditionally cyclical businesses out in the cold. While financials, energy, and autos have each been discounted for its own specific reasons, each has been judicious in deploying capital, realigning its business models, and maximizing operational efficiencies.

Meanwhile, valuations in these segments are all attractive. We believe these businesses are better prepared than in the past for a downturn, and history would suggest this is a good time to invest for the patient shareholder.


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