Digging Deep for Value in Volatility
Selloffs like those seen recently in US equities have provided a respite from soaring share prices for deep value investors, and they have been out in force, scouring the markets for quality stocks at bargain prices. Grace Hoefig, research analyst and portfolio manager for Franklin Equity Group®’s US Value Equity team, says that recent stock market dips have presented value opportunities in some market sectors, but, as through all market conditions, a little patience and a lot of research and flexibility are required to uncover them.
The US stock market has trended upward for five years, and stock prices of many companies have risen along with them, so investors who forage for deep value discounts have had a more difficult time finding bargains. The market’s recent spate of volatility has opened a window for deep value investors like us, who look for shares of what we perceive to be quality companies that have been neglected by the market and, consequently, are selling for what we consider to be substantial discounts.
Recently, we’ve found opportunities in the energy-related, materials and commodities sectors. Lower oil prices, a stronger US dollar and slower global growth, particularly in China, have created headwinds in these sectors. And, as typically happens when a sector moves out of favor, the market shuns the really good companies right along with the marginal ones. This can present fertile ground for us as value seekers. Many of these companies have attractive assets and solid balance sheets, in our view, but they are currently not earning their cost of capital for a variety of reasons.1Stock prices usually follow the trend in return on invested capital. So, a company may have a return that currently is low, but management may be taking the proper steps to help restore it.
For instance, the recent pullback has allowed us to add to our holding in Cloud Peak Energy Inc.,2 a coal mining company whose stock has fallen precipitously, along with much of the energy sector. Although Cloud Peak faces some long-term headwinds, it has what we think are favorable assets in the Powder River Basin, where the top-10 producing coal mines in the United States are located.3 The company also has what we consider to be solid free cash flow at fairly low levels of earnings.
Even though volatile conditions like we’ve seen recently have opened up increased potential opportunities, we are not typically focused on the overall level of a particular index, because no matter how positive or negative market conditions are, there are usually some sectors that are experiencing headwinds, and individual companies that are dealing with idiosyncratic issues that hurt their valuations.
We use a screening process to track down companies with strong balance sheets that also trade in the lowest 20% of the fund’s investable universe measured by price-to-book value. “Book value” is an accounting term for “net worth” and is calculated by subtracting liabilities from total assets. We believe a company’s price-to-book (P/B) ratio4 tends to be a less volatile metric than, say, its price-to-earnings (P/E) ratio,5 because P/B ratios allow us to see through industry trends and economic cycles straight to asset values. We screen a broad universe of stocks and focus on the bottom 20% of that universe, based on P/B ratios. In other words, we’re looking at the cheapest, most out-of-favor part of the market, where we believe the most attractive opportunities can be found.
At the heart of deep value is buying “good assets” at a substantial discount to what we think they are worth. “Good assets,” by our definition, are assets that in a normalized environment should generate enough cash flow to: support a company’s capital expenditures to maintain the integrity of its assets; self-fund growth opportunities so it doesn’t have to leverage its balance sheet; and, afterward, have cash left over to return to shareholders. A company that fits that description and shows up on a low P/B screen is generally not operating in a normalized environment. To separate the true values from the value traps requires a thoughtful analysis about whether the headwinds affecting the company are temporary or structural. A value trap is a stock that gives the impression of being cheap because it has been trading at low multiples of book value, but after purchase, its price does not improve measurably.
Alcoa Inc.6 is a good example of how we implement our strategy for Franklin Balance Sheet Investment Fund. Just over a year ago aluminum stocks were greatly out of favor due to global overcapacity, a poor pricing environment and a lot of near-term earnings uncertainty. The stock was trading at a substantial discount-to-book value and in what we consider the sweet spot of our “screen.” What we saw was a company with an attractive base of assets, an improving balance sheet and, most importantly, a disciplined capital allocation strategy that was supported by nice free cash flow during the tough part of its business cycle.
Financials Force a Change
We maintain a consistent investment philosophy and are generally sticklers for our investment process, even when we refresh our it, as we did in 2014. We recognized that our opportunity set had been diminished since the 2008 financial crisis when financial companies became more than half of our screen on a P/B basis. Financials, which have underperformed for years, crowded out non-financial companies that could have been potential opportunities for us. We made some changes to our process to address the overrepresentation of financials in the fund, including separating our universe into financials and non-financials and running separate screens to avoid this crowding-out effect. We believe this approach enables us to once again get a good bite at a better-quality subset of companies outside financials.
Tweaking our process gave us an expanded opportunity set among value names, including Allegheny Technologies Inc. (ATI).7 ATI is a specialty metals company selling for what we considered a significantly discounted P/B multiple, with a solid base of assets and good prospects that would have been crowded out of our screen. With our modified method, which also gives us more headroom on a P/B basis, we were able to invest according to the level of conviction we have with this company.
Market trends may force us to modify our process at times, and, as we’ve seen recently, they may provide us with more opportunities, but we remain steadfast in our long-term strategy. We are comfortable investing around a lot of near-term economic or earnings uncertainty. What we can’t tolerate is balance sheet uncertainty. We focus on the market’s downtrodden companies, at least in terms of valuation, but we want to see a balance sheet that we believe can be strong enough to weather a protracted down cycle.
Grace Hoefig’s comments, opinions and analyses are for informational purposes only and should not be considered Individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.
This information is intended for US residents only.
What Are the Risks?
Franklin Balance Sheet Investment Fund
All investments involve risks, including possible loss of principal. Value securities may not increase in price as anticipated or may decline further in value. While smaller and midsize companies may offer substantial opportunities for capital growth, they also involve heightened risks and should be considered speculative. Historically, smaller- and midsize-company securities have been more volatile in price than larger-company securities, especially over the short term. The fund may invest up to 25% of its total assets in foreign securities, which may involve special risks, including currency fluctuations and economic and political uncertainty. These and other risks are detailed in the fund’s prospectus.
Investors should carefully consider a fund’s investment goals, risks, sales charges and expenses before investing. To obtain a summary prospectus and/or prospectus, which contains this and other information, talk to your financial advisor, call us at (800) DIAL BEN®/342-5236 or visit franklintempleton.com. Please carefully read a prospectus before you invest or send money.
© Franklin Templeton Investments