Causeway Capital Comment: V –

Causeway focuses on evaluation. Clients who invest in our global and international equity strategies expect us to apply our disciplined value approach to equity markets through cycles, regardless of trends. Why then, just as sobriety has gripped the most expensive stocks, are these portfolios’ Causeway value risk factor exposures at such low levels?

We have not abandoned our value philosophy. Now would be an odd time to ‘drift style’, having adhered to our process for the past decade-plus in growth-obsessed markets. On the contrary, we appear to be underexposed to value as some of the most attractive global equity investments are under-rewarded companies that confuse metrics-based value analysis. We believe these beleaguered companies have some of the strongest recovery-inspired risk-adjusted returns of any value stock, far more than the companies at the peak of their profitability in this economic cycle.

Companies in recovery mode typically appear expensive on valuation ratios using earnings or cash flow in their denominators. Many companies that are going through more severe earnings setbacks have reduced or suspended the return of capital to shareholders, their paltry dividend yields falling short of another indicator of core value.

At the end of August 2022, seven of the ten most weighted (i.e. most convinced) holdings in the Causeway international value portfolios and six of the top ten in the Causeway global value portfolios had negative value scores in our risk model. Portfolio-wide, earnings returns for nearly 50% of Causeway’s global and international value stocks are currently below normalized levels. Too expensive for mechanical value strategies and too established to attract go-go growth investors, style investors of all stripes may overlook these under-earners, despite, in our view, their promising upside potential.

Undercompensation typically occurs most often in cyclical industries. As gross domestic product growth slows or even reverses, profits decline for the most economically sensitive companies. At the bottom of the economic cycle, valuation multiples often appear high relative to history and to markets in general. Portfolio manager Jonathan Eng, who leads Causeway’s fundamental research in the industrials and energy sectors, is familiar with this phenomenon. “A cyclical stock may appear most expensive at its best entry point. As a value investor, you need to understand the timing of a company’s earnings cycle. As the economic cycle peaks and earnings peak, many over-earning companies have low valuation multiples (both absolute and relative to their history).

A cyclical stock in a booming economy can appear like a lagoon in a hot desert. But it is a mirage. For example, some of the major constituents of value indices today are oil and gas majors. Unsurprisingly, the profits of these companies are inextricably linked to oil and gas prices. Commodity price spikes will make these stocks appear particularly undervalued. Passive investors looking to track value indices can hold large exposures to these stocks precisely when earnings are peaking and valuation multiples are rising, ending up in hot sand. Portfolio manager Conor Muldoon, head of fundamental commodities research at Causeway, says, “Value benchmarks don’t typically use normalized earnings. Using these longer-term earnings averages, a business can appear much more expensive. With cyclicals, it’s really about taking a contrarian approach.

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