Where There Is Room to Run
“Fortune favors the bold” says an ancient Latin proverb. The progeny of Rome now offers investors an opportunity to buy profitable, cash-generative businesses at historic discounts.
In recent weeks, markets have gyrated based on news related to coronavirus and its effect on the global economy. Two weeks ago, we wrote about the relatively modest volatility in Japanese equities due to the country’s full employment and near absence of default of risk. Today, we cover how the pandemic’s risks have been priced into other developed markets in Europe and the United States.
The figure below tracks the year-to-date performance of $100 invested into the MSCI Large Growth Index and the MSCI Small Value Index at the end of 2019. This analysis is applied separately for Europe and the US, but the broad conclusions are the same: the darlings of the market—large growth stocks—now trade as if coronavirus never happened, whereas small value stocks are now priced at an even steeper discount relative to the end of 2019.
Figure 1: Year-to-Date MSCI Index Performance (June 2020)
Source: MSCI. Data as of June 19, 2020.
To put today’s valuations into historical perspective, we sorted all European and US stocks into five valuation segments. The first segment (deep value) represents the cheapest 20% of stocks in the market. And the fifth segment, consisting of companies more expensive than 80% of the market, represents the most loved growth stocks. Based on this segmentation of the market into five price buckets, we compared the valuation of each segment today against its average valuation over the past 20 years.
In both Europe and the US, the cheapest stocks in the market now trade at significant discounts relative to their long-term averages. The cheapest segment of European stocks—where Verdad selects the vast majority of its European portfolio companies—now trades at 5.2x EV/EBITDA; a 13% discount relative to this segment’s average valuation of 5.9x over the past 20 years. The cheapest segment of US stocks trades at 5.7x EV/EBITDA today; a 17% discount relative to this segment’s average valuation of 6.9x over the past 20 years.
On the other hand, the most expensive stocks now trade at a premium relative to their historical averages in both Europe and the US.
Figure 2: Current Valuations by Market Segment vs. Historical Averages (June 2020)
Sources: Capital IQ and Verdad research. Segments 2, 3, and 4 are the 40th, 50th, and 60th percentiles respectively.
The market today is a tale of two cities. Growth stocks are trading at very rich valuations as their prices have shrugged off any economic effects of coronavirus, whereas value stocks are trading at deeply discounted valuations that reflect significant fear about the pandemic’s economic impact.
Europe is a more extreme case with cheaper valuations than the US in four out of the five market segments shown above. So why are European stocks systematically cheaper than US equities? It does not appear to be because of higher default risk; European stocks have a lower debt-to-income ratio of 1.8x Net Debt/EBITDA versus 2.4x Net Debt/EBITDA for US stocks. The answer seems to be related to expectations of future economic growth. As evidenced by the projections below, economists expect a relatively sharper contraction of GDP in Europe compared to the US over the next two years. Relative to 2019 levels, economic output in Europe is expected to be 2% lower at the end of 2021, versus 1.6% lower in the US.
Figure 3: GDP Forecasts Relative to 2019
Sources: Eurostat and Congressional Budget Office (May 2020).
These gloomy expectations are already reflected in the prices of value stocks today, but apparently not in the prices of growth stocks. That is why fear and pessimism create opportunities for value investors—particularly those who focus on buying profitable, cash-generative businesses. We have written extensively about how crises create opportunities, based on evidence from eight market crises since 1970. When we add European returns to our prior research on crisis investing in the US, we find similar results. In both the US and Europe, quantitative factors like value, profitability and investment return substantially more after the start of an economic crisis like the one we are currently experiencing in the US and Europe.
The figure below summarizes factor premiums before and after each of the eight market crises that have occurred since 1970. European data begins in 1990, so the Europe sample includes five crises. Over the two years after the start of a crisis, investors receive significantly higher compensation for holding stocks that are cheap, profitable, and conservative in their spending (i.e. cash flow generative).
Figure 4: US and Europe Factor Premiums Before and After Crises (1963—2017)
Source: Ken French data library. US data begins in 1963 and includes eight crises. European data begins in 1990 and includes five crises. All crises are defined as events when the high yield spread exceeds 6%.
Crises have a way of forcing people to acknowledge reality. Doing the things that should work over the long run—buying cheap companies that are profitable and generating cash—has historically been amply rewarded in the years following a market crisis. But capturing those return premiums requires a certain amount of boldness in leaning toward uncertainty as opposed to running away from it. We believe that today, Europe offers a historic opportunity for long-term investors to buy deeply discounted companies that exhibit healthy profits and solid cash generation.