What’s Behind the Historic Valuation Gap in Equities?
As sectors ranging from manufacturing to financials experience disruption, the valuation gap between growth and value stocks continues to widen. Director of Research Carmel Wellso explains why careful stock selection is important at this stage of the cycle.
- Companies in sectors ranging from manufacturing to financials are experiencing disruption in various forms.
- One effect of this disruption is an ever-widening valuation gap between higher-priced growth stocks and lower-priced value stocks.
- Careful stock selection is critical at this stage in the business cycle.
Carmel Wellso: So far, corporate earnings are doing pretty much what we were expecting them to do. We’ve seen healthy demand in many markets even for products around automation, around more the disruption areas of manufacturing, electric vehicles. We continue to see pretty healthy growth in those areas.
When I think about the United States, I think about multiple markets. It’s not just one market. And we’ve had a number of sectors where we’ve actually seen the valuations go down within certain categories. We’ve had value underperform growth. The differential in valuations is the largest it’s ever been in history, and that’s from small cap all the way through large cap. Because there are some companies that are in that old economy and have been disrupted, and while they may not have a decent free-cash-flow yield right now, longer term, they may not exist anymore. So they need to reinvent themselves, and we really need to be very conscious and do good stock picking at this stage in the cycle.
Globally, I’m not a fan of Europe. While the multiples are low, the composition of the index is much more focused on old economy and on companies that I think in the longer term will be disrupted or they’re going to go through very large and difficult mergers. We’ve even see one recently fall apart, the Deutsche Bank/Commerzbank. I think we’ll see more of those types of mergers that take two national champions and they may have to merge not because it’s a good idea, but because they need the strength of a larger company and the ability to cut costs in order to even meet the expectations of the market.
I think there’s a long-term trend in every sector that’s interesting. If you take the financials industry, it’s everything from moving to digital platforms, whether it’s payments, whether it’s managing insurance risk – it’s the improved management of data, which I think of as an information moat around the financial industry, especially the fintech space.
When we look at energy, I think an interesting thing there is that you’ve seen commodity prices divorced from stock prices in the same space, and that there’s an interesting idea there in that these companies are really becoming more disciplined in terms of their capital allocation. And we’ll probably have more mergers in that area that will lead to better economies of scale and more flexibility on how they extract energy.
In industrials, it’s the intersection between tech and industry that I think is the most interesting from everything from defense, which we see no sign of demand really starting to reduce. So I think that’s an interesting area, is defense. I’d also expect to see improved logistics, improved AI learning, machine learning to really be the future of the sector, as opposed to some of the old economy companies.
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