A Covid Vaccine Is Coming. Here’s What It Means for the Stock Market.
A long winter for value investing could be ending.
Favorable news on Pfizer’s Covid-19 vaccine this past week ignited a global stock market rally on hopes that the world might start to normalize in 2021. It also spurred a rotation into value-oriented stocks from growth stocks that could persist for months and years.
Other recent reversals that might continue to play out are better showings by small stocks, compared with larger ones, and by international issues, relative to the S&P 500 index.
Stronger global economic growth would favor more economically sensitive U.S. value shares, relative to their growth counterparts, and benefit international markets, which are heavier in value groups such as banks, energy, and industrials.
Value stocks, which trade cheaply based on metrics such as price-to-earnings and price-to-book value ratios, usually have bested growth stocks coming out of recessions. And value has rarely been so cheap compared with growth based on these measures.
“We are on the cusp of a sustained rally in value,” write J.P. Morgan strategists, led by Davide Silvestrini and Marko Kolanovic. They express confidence that “this rotation has room to continue much further, given the material underperformance we have witnessed in recent years.”
The U.S. value sector’s underperformance has been historic. The iShares Russell 1000 Growth exchange-traded fund (ticker: IWF), which tracks the growth stocks in the Russell 1000 index (the top 1,000 U.S. companies, ranked by market value), is up 28% this year, against a 5% drop for the iShares Russell 1000 Value ETF (IWD). Since the end of 2016, the Russell 1000 Growth index has topped the Russell 1000 Value index by almost 100 percentage points.
Risks to the bullish scenario for value investing—not to mention the entire stock market—include unexpected vaccine setbacks and a weaker-than-anticipated recovery. With Covid cases spiking in the U.S. and Western Europe, the near-term economic outlook has worsened. That weighed on value and “reopening” stocks later in the week, and growth stocks again fared best. The worry is that this might be just another of value investing’s many false dawns of recent years.
But Jim Paulsen, chief investment strategist at the Leuthold Group, is as bullish on value stocks as he is on small stocks and international equities. He argues that the economy and earnings will run hot in 2021 because of the lagged effect of monetary and fiscal stimulus from this year, as well as the corporate cost-cutting that followed the onset of the pandemic in the spring. “We are going to blow away forecasts for economic growth in the coming year, which also means we are going to blow away Street expectations for earnings in the coming year,” Paulsen predicts.
Companies slashed costs in the wake of the pandemic, he notes. “Their goal was to survive, and they cut harder than ever before,” he says. “When demand comes back, profits will come back so much faster because companies cut so dramatically.”
Among industrial companies, Deere (DE) cut operating expenses by 15% in the third quarter from the level a year earlier. For Cummins ( CMI ), it was 10%, Ulta Beauty (ULTA), 30%, and Hilton Hotels Worldwide Holdings (HLT), almost 40%.
Investors looking to play a value revival can do so through dozens of mutual funds and ETFs. Some value funds, however, have strayed in recent years, sprinkling their holdings with growth stocks such as Alphabet (GOOGL) and even Netflix (NFLX).
Leading value stocks include JPMorgan Chase (JPM) and Goldman Sachs Group (GS). JPMorgan, like most of its peers, has operated at a profit during the pandemic, and its shares, at $114, trade for a reasonable 13 times projected 2021 earnings and yield 3.1%. Even after a recent rally, Goldman, at $219, trades just above tangible book value and for nine times forward earnings, after generating blockbuster operating profits of $18 a share in the past two quarters.
Berkshire Hathaway (BRK.B), the largest U.S. value stock by market capitalization, has popped recently, but its class A shares (BRK.A), at around $341,000, look inexpensive. They’re valued at around 1.2 times Barron’s estimate of year-end book value—against an average 1.4 times in recent years. Berkshire has trailed the S&P 500 by about 30 percentage points since the end of 2018—one of its worst periods of relative performance during CEO Warren Buffett’s 55 years at the helm. That could change in the coming year.
Berkshire would likely be a big beneficiary of a stronger economy because of its many industrial units, led by the Burlington Northern Santa Fe railroad. Investors also get equity exposure with a $245 billion portfolio led by Apple (AAPL), plus sleep-at-night comfort with $145 billion in cash.
“Berkshire is positioned to manage any renewed downturn and participate well in a continued reopening economic upturn,” says Larry Pitkowsky, manager of the GoodHaven fund, a Berkshire shareholder.
Also worth a look are drug stocks, which rarely have traded so cheaply in the past decade, relative to the S&P 500. Merck (MRK), at $81, fetches 13 times 2021 estimated earnings, with a safe 3% yield, and AbbVie (ABBV) and Bristol Myers Squibb (BMY) are even less expensive. Pfizer (PFE), which sparked the rally, got only a modest lift this past week, rising 5%, to $38.50. It trades for 14 times 2021 earnings, adjusted for the imminent spinoff of its generics business, and yields 4%.
Energy stocks popped by over 10% on the week, but remain deeply in the red this year. The sector now accounts for just 2% of the S&P 500, a record low. While oil prices are depressed on weak demand, one hopeful sign is that U.S. production has fallen about 15% this year, as companies rein in capital spending. The Energy Select Sector SPDR ETF (XLE), which holds the energy stocks in the S&P 500 and is dominated by Exxon Mobil (XOM) and Chevron (CVX), has fallen 45% in 2020, to $34, and yields 6%.
Morgan Stanley analyst Devin McDermott wrote recently that the group—energy and production companies and integrated producers—looks appealing, with a projected 10% free cash yield in 2021, double that of the S&P 500, assuming oil prices at $45 a barrel. That is close to the current $40 quote for West Texas Intermediate crude.
Small-cap stocks, which are more economically sensitive than large-cap issues, have trailed the S&P 500 in 2020 and over the past five years. Value has fared even worse, with the iShares Russell 2000 Value ETF (IWN) little changed over the past four years. This fund includes smaller banks and other financials, as well as industrial companies, that together make up more than 40% of the underlying index.
Overseas stocks are also high in financials and industrials, with a combined 30% weighting, and are low in technology at 9%, as reflected in the iShares Core MSCI EAFE ETF (IEFA). Technology is about 30% of the S&P 500 index, and that doesn’t include megacaps like Facebook, Alphabet, and Amazon.com, which aren’t classified as tech companies by S&P Dow Jones Indices.
The Japanese stock market is also heavy in economically sensitive companies, such as Toyota Motor (TM), that would get a lift in a global recovery. A broad play is the iShares MSCI Japan ETF (EWJ).
Toyota, whose U.S. shares trade around $140, fetches just 13 times predicted earnings for its fiscal year ending in March 2022 and has net cash equal to around 40% of its $200 billion market value.
“Not only will Japanese global cyclicals benefit, but rising U.S. bond yields should help banking stocks,” says John Vail, chief global strategist at Nikko Asset Management. “Japanese banks are very large lenders of U.S. dollars in global markets.”
Japanese banks are unloved, with the largest, Mitsubishi UFJ Financial Group (MUFG), valued at under $60 billion, against $345 billion for JPMorgan. Mitsubishi UFJ’s U.S. shares, at around $4.50, trade for under 40% of book value and yield 5%.
Emerging markets have had a poor decade, but the next one could be better because their valuations remain below developed markets, the quality of top companies is high, and the U.S. dollar could finally be poised to weaken. A low-fee play on the sector is the iShares Core MSCI Emerging Markets exchange-traded fund (IEMG).
Emerging market value stocks that look appealing include Samsung Electronics (005930.Korea) and Lukoil (LUKOY), Russia’s largest oil company. The sector trades for an average of 10 times forward earnings.
Gold, meanwhile, remains a good hedge against inflation and U.S. fiscal and monetary excesses, even though it got hit last week, falling 3%, to $1,885 an ounce.
“I’d have some money in gold, given what has happened to the U.S. budget deficit and the Federal Reserve’s balance sheet,” says Byron Wien, senior investment strategist at the Blackstone Group.
The largest gold ETF is the SPDR Gold Shares (GLD). The world’s two leading miners of the precious metal, Newmont (NEM) and Barrick Gold (GOLD), have strong management, stable annual production, and high profitability at gold’s current price.
In a recent report, Pzena Investment Management made the case for embattled value investing: “To us, value investing is far from dead. The arithmetic of purchasing assets that are significantly discounted to the present value of their cash flows can’t die.”
“However, endless multiple expansion, which has never been a sustainable source of excess return, can die,” Pzena wrote. “Value’s track record during and after recessions has been impressive and begs the obvious question: If you don’t like value now, when will you?”