After a year of smooth sailing in the markets, volatility is back. Strong economic data worldwide precedes inflation, triggering predictable reactions from central banks and credit markets. Expect to see interest rate increases from the Federal Reserve along with a reduction in stimulus in Europe, which will generate additional credit volatility in companies with high debt loads. Global inflationary changes impact countries at different stages of economic growth, adding currency volatility into the mix. All of which means markets will be choppy for the remainder of 2018.
Volatility is actually healthy for stock markets, especially after an extended bull run. It’s like letting some air out of overinflated tires so they don’t burst. The Dow Jones Industrial Average (DJIA) was up 25% in 2017, returning 28.11% factoring in dividend reinvestment. Compare this to its average annual return of 9.4%. Over the long term, markets eventually revert to their mean. Another relevant comparison is the performance of growth versus value stocks over the past decade, with returns on the former almost double the latter: 159% vs. 89%. Based on the theory of reversion to the mean, there is more upside potential to value stocks. Factoring in the comparative stability during choppy markets, and it’s easy to see why Yield Management Inc. is making a case for value investing for the duration of the year.
Growth Vs Value
First of all, let’s clarify the difference between growth and value stocks. Both are important elements of an investment portfolio. Growth stocks are shares in companies that are expected to grow at rates greater than the broad-based market. Investors are paying a premium on future earnings and looking for capital appreciation. Generally speaking, shares in growth stocks rise relatively higher during a bull market and have sharper drops when the market corrects and tend to be more volatile. The small-cap sector is dominated by growth stocks, where one must differentiate between startups with potential and scams.
Value stocks, by comparison, are shares of ownership in mature, stable companies. They trade at lower price/earnings and price/book ratios, and often pay a dividend. The mid-cap sector is ripe with attractively priced value opportunities that are overlooked simply due to their market cap being too small for the large institutional firms to follow. Value can be found when stocks over-correct in reaction to bad news, and also among industry leaders in market sectors that are out of favor. Investors should look for companies with strong fundamentals and management that are priced favorably in comparison with their peer group.
There’s No Free Lunch
Investors should be wary of three traps when seeking value stocks in the current economic climate:
- Yield: Shares paying high dividends are adversely affected by increases in interest rates. The U.S. Federal Reserve will bump interest rates this year; it is a case of when, not if, and the financial sector, in particular, will take a hit.
- Utilities: Companies in this sector are perennial favorites for value investors. Long-term existing shareholders should continue to hold, but there are two reasons to avoid buying into this sector at present. The first is the higher dividend yield, as already discussed. The second is a tendency for stocks in this sector to underperform in response to both inflation and the current political environment of deregulation.
- Cheap: Sometimes lower prices reflect lower intrinsic value. A successful investor reviews all the facts when bargain hunting in the market. Cheap prices can reflect a poor upcoming financial report, a scam or a pending lawsuit, for example.
Promising Areas For Value Stocks
The first line of defense against excessive market volatility is proper diversification, which includes not just a variety of individual holdings, but also ensuring that a portfolio includes investments in different sectors, markets, and currencies.
The European Telecommunications sector is an excellent source of value stocks right now. The sector has been out of favor and is priced low relative to overall markets. The fundamentals are improving now that multiyear 4G infrastructure expenses are starting to bear fruit with increasing cash flows. While it is very difficult to predict currency markets, the Euro is widely expected to appreciate against the USD over the coming year, adding further value to European stocks in this sector.
In the United States, the healthcare sector is a great place to find value investments. Large-cap healthcare stocks are a traditional defensive sector because they drop less during market corrections. Small cap biotechs are another matter. Currently, the sector is undervalued in comparison to the market as a whole, and many companies will benefit from recent federal tax cuts and incentives to repatriate cash.
As a whole, Japan is the best place for value investing today. The Nikkei is trading at a price/earnings ratio of 17 compared to the Dow Jones Industrial Average with its price/earnings ratio of 27. Shareholders gain additional protection against volatility due to the Yen’s status as a safe haven. The Japanese automotive sector provides good overall upside potential and is on the upswing after being out of favor. Honda, for example, trades on the NASDAQ and in Tokyo. The company is stable and mature and very well priced trading below book value and paying a dividend.
About Yield Management Inc.
Yield Management Inc. provides wealth management services for international private clients seeking exceptional service and above average long-term returns. The overall investment philosophy favors conservative growth, with each portfolio individually tailored. People interested in offshore investing and wanting to review their holdings should contact the office in Tokyo. Contact information is available at www.yieldmgmtinc.com.
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