Dear Clients and Friends,
As we embark on the new year, it’s reassuring to see that the value run that started a little over two years ago continued through 2022. Over the past year, value stocks have outpaced their growth counterparts across various markets, as shown in the table below.
Recent Value Run
1-Year Value vs. Growth Index Performance
The value run is one answer to the question that some investors had during the previous decade, “is value investing dead?” We dedicated a lot of ink on our past quarterly letters defending the value investment approach, cautioning investors not to abandon value and consider always maintaining an appropriate allocation to the style. We believe the fundamental concept of value investing has always—and will always—remain relevant, regardless of the value/growth cycles.
The Brandes organization was founded in 1974 with the express purpose of applying a value investing approach to global financial markets. While the way we implement that approach has evolved over the intervening 49 years, the core principles never change. A value investing approach seeks to take a business-like approach in establishing a long-term fundamental value of a company. We purchase securities when we believe they are sufficiently undervalued by the market due to temporary challenges or market overreactions. Since there are no guarantees when it comes to investing in the stock market, seeking to purchase a company at a discount creates a powerful concept called “margin of safety” (the discount of a security’s market price to its estimated intrinsic value). The concept of margin of safety was coined by Benjamin Graham, considered the father of value investing. In his seminal book, The Intelligent Investor, Graham wrote “[T]he function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future. If the margin is a large one, then it is enough to assume that future earnings will not fall far below those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time.”
While value investing can cycle in and out of favor, its efficacy over the long term merits attention, in our opinion. When you compare the Fama/French US market value and growth parts of the total market between 1927 and 2021, on average, value has outperformed its growth counterpart by 4.1% each year.1
It's a fact that for much of the previous decade, growth stocks handily beat value stocks. But just as trees don’t grow to the sky, the conditions that are favorable to one style don’t persist forever. However, when one style dominates for an extended period of time, some investors are prone to certain behavioral biases. For example, extrapolation bias refers to a tendency to expect the current environment to continue. This is often mentioned when a gambler enjoying a run of good luck (albeit entirely random) extrapolates his recent success and doubles down, confusing the string of good luck with random events. In the context of value investing, many in the investment world exhibited extrapolation bias. In some of our previous letter, we wondered where had all the value managers gone? The chart below shows that value-focused funds now make up only a sliver of large-cap global equity assets under management (AUM).
Where Have All the Value Managers Gone?
Allocated by Style (Value vs. Growth)
This chart shows that a significant majority of the AUM in the Morningstar Global Equity Large Cap category have portfolios more tilted to companies with growth characteristics (71%) than to value characteristics (8%).
It was created by evaluating the open-end and exchange-traded funds in the Global Equity Large Cap Category with at least $100 million in AUM. Each portfolio was classified based on exposure to the value style (as defined by Morningstar), with greater than 35% exposure defined as “more value focused”, 25%-35% core/blend-focused, and less than 25% “more growth focused”.
The dark green line denotes the % of AUM (Y-axis) across the value exposure spectrum (x-axis), moving from the most “value” (left side of the x-axis) to least value (right side of the y-axis).
Of course, not all investors abandoned value investing entirely, yet many struggled to remain invested with the value style over the past decade. As legendary investor the late Sir John A. Templeton once remarked about the four most dangerous words in the world of investing: “this time is different”, such a mindset began to take hold. This time it’s different or falling prey to confirmation bias such as we’re in a ‘new normal’ to explain recent stock price movements can cause investors to give up on an otherwise sensible asset allocation approach.
Over the past several years, the most common question we received from investors was “what are the catalysts for value investing to make a resurgence.” We provided examples of catalysts but were quick to caution investors that we had no way of knowing whether or when an event would happen to cause these catalysts to take hold. Instead, we often urged investors to have an appropriate allocation to value for when some of these catalysts would take hold. While we knew it was very likely that eventually interest rates would rise and the rate of inflation would increase (and create a potentially more favorable environment for value investing), we did not know when this would happen or what would be the exact cause.
While we feel vindicated by the resurgence of the value investing style and the recent outperformance of most Brandes strategies (see table, Brandes Strategies with Excess Return vs. Benchmark), we continue to caution investors to remain diversified with their investments.
Brandes Strategies with Excess Return vs. Benchmark
Our client letters over the past several years have focused on defending the entire value investing style and we have tried to make top-down arguments in support of the style. However, as a fundamental investor, we build portfolios from the bottom up, one company at a time. We value companies with a business-like mindset taking into account the material issues impacting the business. Having insight into how we think about business valuations is key to understanding Brandes and our value investing approach. To illustrate this, we have profiled below two companies currently held in a number of our strategies.
Fiserv Inc (NASDAQ FISV) – currently held in the following strategies: Global Equity, U.S. Value Equity, Enhanced Income
Fiserv is a leading provider of financial technology services for merchants worldwide, including governments and companies, as well as financial institutions such as banks and credit unions. After its 2019 merger with First Data, a leading payment processing company, Fiserv holds a strong market position in each of its three key business segments, which comprise of:
We first purchased Fiserv as its price declined in 2021. The company’s share price continued to retreat in early 2022 due to several factors, including increasing competition in the merchant acceptance space and the overhang from KKR’s sale of its ownership stake (private equity firm KKR held a major portion of First Data). We added to our position in Fiserv amid the share-price decline as we believed it traded at an attractive valuation relative to its favorable economics and long-term secular tailwinds. As banks increasingly outsource their payment transactions (including debit- and credit-card processing) and consumers progressively shift from cash to card payment, Fiserv could—in our opinion—benefit from these trends. We also believe the company has the potential to improve its operating margin and free cash flows as it continues its integration with First Data, and to strengthen its earnings per share growth once it resumes share buyback program. Prior to the First Data merger, Fiserv had used its strong free cash flow generation to repurchase 30% of its shares outstanding over an eight- year period.
While competition will likely remain intense given the long-term secular tailwinds of the industry, we believe that Fiserv’s strong relationships with large banks and merchants, as well as with smaller businesses through its Clover product offering, put the company in a strong competitive position. At its current valuation, Fiserv represents an attractive risk/reward tradeoff to us.
Sanofi SA (SNY) – currently held in the following strategies: Global Equity, International Equity, European Equity, U.S. Value Equity, Global Opportunities Value, Global Balanced, Enhanced Income
Sanofi is one of the world’s largest pharmaceutical firms, with a well-diversified business portfolio that includes pharmaceuticals, generics, vaccines, and consumer care products. The company is also diversified geographically: the U.S. and Europe represent approximately 40% and 25% of total revenues, respectively, while emerging markets and Asia make up the rest. Sanofi has top positions in drugs aimed to combat rare genetic diseases, and in a broad range of vaccines and consumer products.
We have held Sanofi in various portfolios for well over a decade. At the time of our initial purchase, Sanofi, along with many of its pharmaceutical peers, was struggling with several challenges, including patent expirations for its large products, increased competition, and poor research and development (R&D) productivity. We believed these issues led the market to be overly pessimistic about Sanofi’s long-term prospects.
While revenues were impacted by patent expirations, Sanofi managed the difficult period through cost reductions, asset restructuring, and strategic capital deployment. At the same time, Sanofi continued to strengthen its pipeline through investing a meaningful portion of its revenues in R&D, licensing, and bolt-on acquisitions. During this past decade of transformation, the company has been able to consistently generate healthy free cash flow, continuously increase its dividends, and optimize its business portfolio through divestments and acquisitions. Furthermore, the launch and subsequent success of asthma/atopic dermatitis medication Dupixent (co-developed with Regeneron) has helped the company revert to revenue growth.
Recently, investor concern about the uncertainty related to the litigation focused on heartburn medicine Zantac led Sanofi’s share price to decline meaningfully, driving its market cap to drop by over $20bn in a week’s time in August 2022. While the market seems to assign close to a worst-case scenario, we believe the ultimate liability will likely be split among multiple companies and any subsequent charges may take some time to be paid out.
Despite this recent market negativity, we believe Sanofi merits a continued inclusion in our portfolios. We appreciate the company’s ongoing efforts to cut costs and strengthen its margins. The pipeline has been improving, revenues have been growing, and there is minimal patent expiration risk over the next few years. We also take comfort in the substantial value of Sanofi’s franchises in vaccines and consumer products, which the market may be underappreciating. Moreover, litigation risks have always been a consideration in our valuations for pharmaceutical firms, and we reflect this in our assumption of a higher cost of equity/higher discount rate for these businesses. We believe Sanofi has a strong balance sheet that should help protect the downside of potential damages related to the litigation. At its current valuation, Sanofi offers an appealing margin of safety to us.
We remain convinced that value investing has a place in most portfolios. Brandes has sought to be a faithful practitioner of the style for nearly five decades, and we do not think that it’s different this time; there may always be a new normal, but the core principles of value investing will always make sense to us. As we embark on this new year, we are mindful that we can’t predict what the world has in store for investors. That’s why the concept of margin of safety is so key to our approach. To quote our founder, Charles Brandes, paraphrasing his mentor, Benjamin Graham.
“Value investing is timeless. It’s as relevant today as it was 100 years ago. The principles haven’t changed and never will.” (Charles Brandes, Value Investing Today).
"In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, "This too will pass." Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety." (Benjamin Graham, Chapter 20: “Margin of Safety” as the Central Concept of Investment, The Intelligent Investor.)
Brandes Investment Partners