Predicting the future is hard. It follows therefore that a stock price, which reflects investors’ imprecise forecasts of future cash flows, often does not represent the true value of the underlying business. Forecasts can be overly enthusiastic or pessimistic depending on the circumstances. For example, strong past performance often begets high expectations…which in turn lead to lofty (over) valuations. On the other hand, many investors will respond to recent disappointments with pessimism or apathy, emotions that contribute to low (under) valuations.
Emotions not only influence valuations, but also perceptions of risk. Currently, an investment in a company that is a big index weight and carries a lofty valuation is viewed by many as “safe”. Meanwhile, a business/stock that has under-achieved is “risky”. The irony is that a low bar is more easily cleared, and a discounted valuation does a great deal to mitigate uncertainty and set investors up for future outperformance.
This is why value investing has worked over long periods of time. Price paid matters! This mindset has informed our firm’s investment approach for over forty years. However, as we sit here today market participants seem willing to pay any price for certain favored businesses and are indifferent towards almost anything else. This dynamic is reflected in value spreads, which continue to be wider than normal.
We believe value spreads will revert closer to their historical norm. If you own the market, i.e. the index, this is a risk. To us, this is a tremendous opportunity and makes it a good time to be a value investor. Looking beyond the Magnificent 7 and the AI Darlings, we have found compelling opportunities. We have identified good businesses in different geographies selling at a significant discount to their intrinsic value.
Take Siemens (SIE GR), the Germany-based industrial conglomerate. Most people know of the Company…they’ve been around for 176 years. But fewer seemingly understand it: the quality of their assets is underappreciated and the stock trades at a discount to peers and its intrinsic value. Most exciting is their software business, which makes design and engineering software. This business has certain characteristics – high customer retention, healthy secular tailwinds, rational industry structure – which make it quite valuable. Siemens also boasts leading businesses in healthcare equipment, factory automation and grid infrastructure, not to mention a rock-solid balance sheet. We expect good things from Siemens in the years to come.
Nippon Sanso (4091 JP), is a Japanese industrial gas company with improving governance, expanding margins and attractive reinvestment opportunities. The industrial gas oligopoly grows sales faster than GDP and enjoys durable competitive advantages. The market understands these quality attributes and typically pays premium valuations for these businesses. Not so the case with Nippon Sanso today, likely due to historical underperformance vs. peers. We think the gaps between Nippon Sanso and these peers – with respect to both operating execution and valuation – will narrow and the stock will outperform.
These are two examples of potential discounts available today. The opportunity set is quite broad. Our portfolio has big weights in financials, healthcare, industrials, energy and technology (yes, there are a few misunderstood stocks even in this sector).
Overall, our portfolio trades at a double-digit earnings yield: high payouts and some growth could result in an attractive annual return. We are not as confident that the same can be expected from the MSCI World Index at 21x forward earnings. It’s worth noting that the best value-led markets historically emerged after prolonged periods of growth outperformance (e.g., the dot-com bubble). Today, value stocks have experienced one of the worst periods of underperformance on record, with valuation multiples continuing to be steeply discounted. A shift in sentiment toward a value-led market would provide a strong tailwind for our investment approach.
