March 2021 – Value Pays Cash

Finance

For several years now, growth stocks, led by the largest technology companies like Amazon, Facebook, Microsoft, and Google, have outperformed their slower-growing value counterparts. Fundamentally, the rapid growth in revenue and cash flows at the tech giants justified their outsized moves. Value companies struggled to grow, and their valuation-discounts relative to growth companies were not enough to attract capital. After the coronavirus stock market collapse of March 2020, the immense appreciation in growth and technology issues has been a gap too far. Value companies are now materially cheaper than growth companies, but more importantly, changes in consumer behavior and shortages of most commodities are also significantly boosting value-company cash flows.

 

Reopening Requires Stuff

Lock downs and working from home caused ecommerce and technology usage to burst beyond trend growth in 2020. Under the surface, something else changed – as consumers refrained from spending money on services and experiences like concerts, hotels, and restaurants, spending on goods exploded. Bicycles, swimming pools, RVs, and home improvements are in extremely high demand, and these things all require value-type companies to build.

1yr Copper Chart

Value Pays Cash

While investors rabidly bid technology issues higher on what may be a temporary blip in demand, value stocks have suffered lagging relative performance. Meanwhile, decreasing capital expenditures in areas like oil and mining have created future shortages which will lead to years of earnings growth at value companies. Finally, select value companies have great setups: low absolute valuations and long runways for earnings growth.

 

Rates Trapdoor

As mentioned in The Interest Rate Arsonist:

Rising rates are a mixed-bag for the U.S. economy. Investors may cheer “reflation” but for consumers that rely on debt for purchases of homes, cars, and college educations, rising rates are painful! As these purchases are the largest most consumers make, you can see how rising rates could be disastrous for consumer spending.

While it is certainly an opportune time to be stock-picking value stocks, investors must beware of rates and debt. Countless companies have been enticed by cheap money. When debt comprises a large percentage of the company’s enterprise value, increasing amounts of cash flow is diverted from the equity holders to the debt holders. This limits upside for stocks but creates advantages for fiscally responsible corporations.