2021’s value rally was spurred by optimism over ‘re-opening’ but came to an abrupt halt with the arrival of the Omicron variant. The value rotation in play since the start of 2022 should not only have more longevity, but is likely to be broader in scope. An environment of higher interest rates and inflation should favour new sectors such as financials, energy and materials rather than just the “COVID recovery” names. Dividend strategies should thrive in this climate, but investors should be wary of “bond proxies”.
Last year’s value rally lifted ‘deep value’ stocks particularly in the more challenged sectors such as travel, airlines and leisure. But many do not pay dividends because of weak cash flows and pressured balance sheets. This year, as markets become more volatile and less directional, the dividend factor could become important once again. Over time in Europe, dividends have provided investors with around 40% of their total returns.
Value versus growth
Value investing has been out of favour since the Financial Crisis of 2008 with low interest rates and the effects of quantitative easing driving high valuations for growth companies. However, as inflation and the prospect of higher interest rates weigh on investors’ decision-making, we may be at an inflection point. After a false-start earlier in 2021, value strategies have now outpaced growth strategies since November last year, with the technology sector – and particularly the more speculative stocks within it – taking a tumble.
Historically, the dominance of one investment style over the other can last for many years before a reversal occurs. The famous value rally that started in the mid-70’s lasted almost two decades before growth took over in a run that ended with the “dotcom” boom and bust. The most recent growth cycle started with the resolution of the Financial Crisis as central banks used unconventional monetary policies to depress interest rates and attempt to kick-start economic recovery.
The result has been extreme dispersion between the valuations of growth and value stocks, surpassing the levels seen at the peak of the late-90’s technology bubble. These valuation extremes have made the style performances susceptible to a reversal, and the change of central bank policy in the face of growing risks from inflation has provided the catalyst for this to take place.
A different flavour
At NN IP we believe this year’s value rotation is likely to have a different flavour. There have been two legs to the value rally. The first occurred after the success of the vaccination programmes as economies started to reopen. That particularly helped companies who had seen demand shut off, or had experienced severe disruption to supply chains. We think this year’s rotation is different – we’re seeing the consequences of inflation and the winners and losers from this environment are a different set of stocks.
Financials, for example, will benefit from higher interest rates. With low, or even negative rates, it places a lower bound on the spread between the interest rates banks can charge and receive for lending and borrowing, and this has seen their profit margins under pressure. As rates rise, so should banks’ profitability. Energy and materials stocks have also been clear beneficiaries of strong demand for their underlying commodities.
Together with the better performance from these sectors which traditionally pay higher dividends, dividend strategies should have other advantages in the current environment. For income-focused investors, there is a level of inflation protection built-in as dividends should rise with company earnings. And as markets become more volatile and less directional, the one element of total return for equities over which there is good visibility is the dividend payout. In a mature market like Europe, dividends comprise around 40% of total returns over the long run.
However, it is not enough to target high yielding stocks. “Bond proxies”, defined as companies in sectors characterised by steady but slow earnings growth and therefore stable dividends, may see their yield advantage eroded with inflation and higher interest rates. This may be holding back sectors such as healthcare, where drug pricing is fairly independent of economic trends with the risk that dividend growth lags increases in inflation. In other stocks, the highest dividend yields may be a sign of distress and are best avoided: an indication that the market thinks the company will be unable to sustain current levels of payout.
NN IP’s focus is on quality dividends paid by companies generating growing cash flows and with a track record of returning cash to shareholders, but also reinvesting for growth. Today, this also requires finding companies with strong pricing power that can pass on higher input costs to customers.
Within the consumer space, we’ve been increasing exposure to the luxury sector. Whereas food producers may be struggling to pass on higher input costs like energy and agricultural commodities, luxury goods companies appear to have few problems increasing the price of a designer handbag or high-end watch by another 10%.
This focus on quality also allows the fund to integrate environmental, social and governance metrics. ESG can be difficult for Value and Dividend funds which can be skewed towards “old economy” businesses. We target a lower CO2 intensity than our benchmarks. By owning better ESG-rated and lower polluting companies in our strategies we can even run an overweight in sectors like energy while maintaining a lower CO2 footprint than the broad index.