Narrow Market Highlights Opportunities in Value Stocks

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Peter Hardy

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Peter Hardy, senior client portfolio manager, value equities, American Century Investments.

A market selloff in 2022 due to inflationary pressures and higher interest rates. There was a risk on rally that started at the beginning of the year based on a more benign view of interest rate increases.

Because inflation data got better, the belief was that the Fed would get more accommodative in the second half of the year. To us, that seemed somewhat illogical given that the Fed had stated they weren’t lowering interest rates for the foreseeable future, and if they did, it meant something bad was happening, likely impacting equity markets. The rally somewhat subsided at the end of the first quarter after the bank failures of Silicon Valley, Bankcorp, Signature and First Republic. But with Nvidia’s announcement in late May on the earnings benefits and growth that they were seeing from AI, we saw a furtherance of this speculative rally, and it benefited the large tech names in the S&P 500.

The belief is that these companies are the big beneficiaries of AI. But sitting here today on June 20th, the NASDAQ is up over 30% and value stocks are basically flat. It’s been really the performance of seven securities, Apple, Microsoft, Nvidia, Amazon, Alphabet, Meta, and Tesla that have driven returns. And without those securities, the market is basically flat.

The risks that led to market declines in 2022 are still present. Higher levels of interest rates provide a headwind to future economic growth, and there’s generally a 12-month lag to those impacts. But we’ve already seen risks. You had a crisis in the U.K. gilt market related to the risk that pensions took to immunize their liabilities. You’ve seen the bank failures that I previously mentioned. China’s economic growth does not appear to be rebounding post Covid reopening, and there are looming issues in the U.S. in the commercial real estate market that are starting to appear.

So plenty of risks present, and we’re likely to see headwinds in additional issues as this plays out into the future. The bigger challenge for investors is whether or not to invest into this rally. We’re at the early stages of AI, much like the internet tech bubble in ’99. We know AI is going to be a major force for the next 20 years, but determining who the ultimate winners and losers are and how it generally gets monetized is a bit uncertain. Also, those benefits have already been extrapolated for the earnings of tech companies, which are not immune to a broader economic slowdown I should add. The internet is everything we thought it was going to be in’ 99, but the ultimate beneficiaries are different than the expected, and many internet companies that traded at high valuations are now out of business. So there could be the same play out in AI.

We think the opportunity that comes with these challenges and risks is utilizing the rally, the risk-on rally to take chips off the table and de-risk your equity portfolios. Come to one like ours that provides equity returns, but with lower volatility and downside protection.

Historically, narrow markets have not been a good sign for the overall broad market. Previous periods of narrowness in the market like we’re seeing now, have been followed by muted returns. We don’t make broad market calls. We pick high quality companies that have attractive dividends and valuations, but many of the names in our quality universe are fully valued. So valuations going into an economic slowdown would say the broader market should be impacted. With that in mind, what happens in periods of uncertainty is quality companies with stable earnings and cash flow and clean balance sheets outperform. Dividends are a more important source to total returns and lead to outperformance.

And value stocks tend to do well based on lower expectations. Using the tech bubble once again, as an example, the period from 2000 to 2006 was largely beneficial for quality and value stocks. So the ingredients to our portfolios, quality, dividends, and value, appear poised for outperformance.

What that means is that attractively valued names are now more attractively valued. Using big weights in our portfolios such as consumer staples, those stocks are largely flat this year, and one of the things that occurred that impacted their earnings over the last couple of years were inflationary cost increases causing their profit margins to compress, and these profit margins are now at historically low levels. Well, many of these consumer staple companies have increased prices that occurs with a lag, but prices have now increased to above cost, and their cost pressures have subsided. So as opposed to speculating about who’s going to win in AI and what the ultimate earnings are over the next 10 years, we have companies that have a pathway for earnings margin and valuation improvement. And I should add, that can occur regardless of what goes on in the economic cycle. So we’re more confident in the valuations relative to the market of many of the names we’re holding based on them being basically flat this year.

In addition to consumer staples, we have big weights in healthcare names. One name is Medtronic. It’s one of the highest quality names that there is. They make medical devices, basically hips and knees, have very high returns on capital with low levels of leverage. And Covid led to unusual circumstances within the healthcare sector. Many elective procedures were canceled and that impacted the earnings of these companies adversely. What we’ve seen is that utilization rates in healthcare are still below pre Covid levels, and we’re seeing in improvement in that utilization giving us a belief that people are going back to the hospital, in essence, to get their hips and knees replaced that they needed during Covid, but hadn’t done yet.

So the pathway to earnings and valuation improvement for Medtronic can occur also without regard for the economic cycle in that the utilization rates of healthcare are not dependent on the economic environment, but dependent on people just going back to the hospital.