11/14/2018

Distinct Valuation Driven Market Insights

Quarterly Market Review: 2018 Q3

A primary theme of all of the content in this report is based on increasing evidence related to an upcoming shift in investor preference towards value stocks.  Growth has been largely in favor since early 2015, with a brief respite around the US elections in 2016, and it’s important to note that the themes that tend to coincide with growth cycles seem to be momentum and large-cap driven.  Over the last twenty years, within the Russell 1000 universe of stocks, we have observed that growth cycles tend to be shorter than value cycles, and the current growth preference has extended for more than 18 months.  With rising interest rates, investor preference will likely shift towards equity investments that return cash flow back to shareholders on an accelerated time horizon.  This also signals an investor shift towards stocks that pay dividends, where we would suggest using valuation characteristics in addition to yield/income needs to protect against capital loss (compared to investing in a broad market dividend fund that likely has exposure to a number of expensive equities).

Alongside this style analysis, weighting schemes can have a significant impact on portfolio construction and relative performance against a benchmark.  Market-cap weighted benchmarks tend to outperform equal-weighted approaches in growth cycles, then underperform in value cycles (as well as long-term aggregates).  Due to this, we believe an important component of attribution analysis in benchmarking requires additional understanding of equal and market-cap weights, as well as the contribution to overall market performance from a handful of top contributors.  For example, in the US last quarter (based on Russell 3000 constituents) 29% of the 7% appreciation delivered in the market was due to price movements from AAPL, AMZN, MSFT, FB, and BRKB, while the market was only up roughly 3% on an equal-weighted basis.

This report will also review small cap themes in health care and technology stocks, review where equity risk premiums appear to be as of the end of Q3 based on relationships between market prices, forecasted cash flows, and increasing interest rates.

Russell 1000 Analysis: Value & Growth Regime Shifts

Growth stocks have paced US markets since early 2015, aside from a sharp value rally around the 2016 elections.

The tables below highlight AFG metric performance in the Russell 1000 Index, as well as additional style and size-focused metrics, to better understand investor preference within each regime shift based on style performance.

Over long-term time horizons, where AFG now has 20 years of live website data for Russell 1000 constituents, we can observe significant outperformance delivered from AFG’s multifactor metrics, as well as each of the accompanying inputs to the multifactor model while smaller cap stocks outperform and value/growth baskets perform relatively closely in aggregate.

Further exploring each value/growth cycle, it is clear that long-term performance themes for AFG metrics are generally echoed in each value regime, while growth cycles tend to reflect megacap-driven returns dominated by momentum metrics.

Growth cycles tend to be short-lived. As rising interest rates likely shifting investor preference towards investments that will deliver cash flows in accelerated time horizons, this analysis can help clients navigate this style cycle shift, which will likely be dominated by valuation, quality, value, and smaller cap stocks.  (AFG’s model is market-oriented, and we do not advocate significant portfolio transitions based on market timing themes, but it may be a reasonable time to consider locking in gains on expensive, momentum driven stocks and finding cheaper alternatives)

Importance of Valuation in Dividend Investing

It is hard to ignore the increasing commentary regarding the likelihood of a potential market correction, which could be triggered by a number of factors (quantitative tightening removes capital from equity markets, rising interest rates cause an asset class rebalance away from equities to fixed income, or increased tariff retaliation or inflation concerns cast doubt on long-term global growth assumptions).  Even without a correction, it is likely that rising interest rates will shift investor preference towards value stocks as the recent appetite for growth reverses.

In the correction scenario, investors may flock to dividends stocks in a flight to safety or quality, and in the rising interest rate scenario, investors may emphasize dividend payers to realize cash flows more quickly as nominal discount rates increase.  As investors prepare for this allocation shift, it is important to highlight that not all dividend paying stocks offer similar yield and capital appreciation characteristics.

Dividend stocks have been influenced by a number of competing narratives over the last several years.

  • Growth stocks have dominated since the start of 2015, while most dividend stocks would be assumed to align with Value stock traits.
  • A number of high dividend stocks have performed well, however, due to their attractive characteristics as an alternative to fixed income products in a low interest rate environment.
  • Consumer stocks appreciated in the response to lower oil prices in late 2014 due to increased consumer spending power.
  • Industrial stocks appreciated in late 2016 and 2017 due to expectations of increased infrastructure spending.
  • Megacap mature businesses have continued to appreciate with the broader market, aided by the increasing exposure towards passive strategies, even while some examples have been subject to deteriorating levels of corporate performance and intrinsic value estimates.

Due to these competing factors, it is clear that an excessive amount of mispricing is rampant across dividend paying stocks, even when we limit our focus to the list of Dividend Aristocrats.  When seeking income, AFG advocates a diversified high dividend strategy focused on income and capital appreciation instead of focusing on income-only goals across a broad universe of dividend payers.

US Sector & Industry Analysis – 2018 Q3

US Markets, based on Russell 3000 constituent market cap weights, appreciated steadily throughout the course of 2018 Q3 by more than 7%.  This market-weight appreciation outpaced equal-weighted performance in the quarter by 3.8%.  The table above highlights the top five contributors to the overall market performance, as well as each sector, alongside the contribution of the top five stocks to the total performance.

Stock performance for AAPL, AMZN, MSFT, FB, and BRKB accounted for roughly 29% of the overall market gain in Q3 on a market-cap weighted basis.  Top five contribution was largest in Consumer Discretionary, Consumer Staples, Energy, Financials, and Telecommunication, where the largest contributors to overall sector performance accounted for at least half of the overall returns in the sector.

The tables below highlight the top and bottom performing industries on a market-cap weighted basis.  Top performing industries appreciated by at least 12.5% in Q3, while worst performing industries declined by more than -7.5%.

Excessive Risk-Taking in Small Cap Health / Technology?

Over the course of this recent growth cycle, technology and health care stocks have appreciated significantly compared to most other sectors.  While larger cap technology and health care stocks have recently seen valuation levels fall below historic norms, they still appear to fall within a reasonable boundary that can justify a strategic allocation exposure in-line with the overall market’s sector weights.  Small cap health and technology, however, appear to reflect intrinsic value estimates relative to current market prices significantly below their long-term normal level.  It is likely that investors have bid up a number of early stage growth companies in each of these sectors (especially in Biotech, Pharma, Health Care Tech, Systems Software, and Application Software industries), and this could be due to a variety of reasons that may appear reasonable until the implications are viewed in aggregate.

  • A number of large cap US health and tech companies with large offshore cash balances will repatriate large cash balances under the new corporate tax law, and these early stage growth companies may appear to be attractive M&A targets for their intellectual capital.
  • Cheap debt financing has made it easier for early stage growth stocks to achieve significant growth goals in short-term time horizons.
  • Appreciation over a nearly decade long bull-market rally and an increase in passive investing has shifted the concept of risk towards “tracking error” instead of “required return based on uncertainty of future cash flows”, benefitting the riskiest stocks and investment styles.

Discount Rates and Equity Risk Premiums

AFG calculates market-derived discount rates (MDDR) across a number of countries in our international database to identify the appropriate assumptions regarding cost of capital and discount rates that the market is discounting into current market prices based on accompany cash flow forecasts.

The chart below highlights the industrial MDDR across US, German, Japan, and UK markets.  (“Industrials” refers to all sectors excluding Financials and Utilities, which have their own MDDR calculation)  While MDDR levels have been relatively stable in the US and range bound between 4 and 6% since 1990, we can see much more volatility in international markets.  International MDDR levels where much higher following 2008, but have migrated towards US levels over the last several years.

AFG can use nominal corporate debt rates, inflation expectations, and median leverage rates to de-lever MDDRs and solve for a nominal equity rate.  Risk-free rates (in the form of 10 year treasuries) can be subtracted from the nominal equity rate to then calculate the Equity Risk Premium at varying points in time.

The next two charts highlight trends in equity risk premiums based on AFG’s MDDR approach in the Industrials model and Financials model. 2018 levels reflect new lower corporate tax rates, higher treasury rates, and increased inflation expectations.

Equity risk premiums for industrials have stayed similar to 2017 levels as of October 5th, due to increasing nominal equity discount rates offset by increased inflation expectations.  Financial MDDRs have mildly increased from 2017 levels.

Recent Industrial and Financial equity risk premium levels appear in-line with long-term average and median levels.  Based on this, we would not view the current marketplace as either cheap or expensive.  It is worth noting, however, that equities have benefitted since the financial crisis recovery as an asset class that delivered attractive returns while fixed income struggled, and a rising interest rate environment could entice a number of investors to lock in equity gains and shift to fixed income alternatives, which would certainly impact equity markets regardless of signals provided by ERP levels.

Despite uncertainty regarding broad market movement, we believe valuation models that properly account for corporate performance, growth, competition, and risk will continue to identify attractive investment opportunities over long-term time horizons.

AFG 50 Quarterly Performance Update

AFG 50:  A 50 stock, sector-neutral portfolio selecting stocks from the S&P 500 and benchmarked against the S&P 500.  Buy and sell decisions are completely driven by comprehensive due diligence provided by AFG’s analyst team.

In 2018 Q3, strategy performance trends in the AFG 50 strategy included the following:

  • Stock selection on a sector basis was strongest in Materials, Financials and Consumer Staples and weakest in Industrials, Consumer Discretionary and Health Care.
  • Active sector weights did not impact relative performance in a meaningful way. Overall sector allocation effect impacts were 0.00%.
  • Stock selection on a size basis was strongest in Large (6B+) . Stock selection on a size basis did not deliver negative relative returns against any size tiers this period.
  • Active size weights reflected weighting towards Mid (2-6B) stocks away from  stocks. Overall size allocation effect impacts were -0.13%. Allocation effects were negative in Mid (2-6B).
  • Stock selection on a style basis was strongest in Growth and Value . Stock selection on a style basis did not deliver negative relative returns against any style categories this period.
  • Active style weights reflected weighting towards Value stocks away from Growth stocks. Overall style allocation effect impacts were -0.30%. Allocation effects were negative in Value.

AFG HD Quarterly Performance Update

AFG HD:  A 35 stock portfolio selecting high dividend yield stocks from the Russell 1000 and benchmarked against the Vanguard High Dividend.  Buy and sell decisions reflect dividend analysis and capital appreciation characteristics, offering diversification across all sectors but no sector-weight mandate to mirror the broader benchmark or high income peer group.

In 2018 Q3, strategy performance trends in the AFG HD strategy included the following:

  • Stock selection on a sector basis was strongest in Consumer Staples, Industrials and Health Care and weakest in Energy, Information Technology and Materials.
  • Active sector weights reflected weighting towards Consumer Discretionary, Real Estate and Health Care away from Consumer Staples, Energy and Information Technology. Overall sector allocation effect impacts were -0.32%. Allocation effects were positive in Health Care, Real Estate and Energy and negative in Consumer Discretionary, Information Technology and Financials.
  • Stock selection on a size basis was strongest in Large (6B+) . Stock selection on a size basis did not deliver negative relative returns against any size tiers this period.
  • Active size weights reflected weighting towards Mid (2-6B) stocks away from Large (6B+)  stocks. Overall size allocation effect impacts were -0.24%. Allocation effects were negative in Mid (2-6B).
  • Stock selection on a style basis was strongest in Value and Growth . Stock selection on a style basis did not deliver negative relative returns against any style categories this period.
  • Active style weights reflected weighting towards Value stocks away from Growth stocks. Overall style allocation effect impacts were -0.08%.


Applied Finance Group (AFG) certifies that the views expressed in this post accurately reflect the firm’s models.  The information in this post is based on material we believe to be accurate and reliable, however, the accuracy and completeness of the material and conclusions derived from said material in this presentation are not guaranteed.  The information in this presentation is not intended to be used as the primary basis of investment decisions, and Applied Finance Group makes no recommendation as to the suitability of such investments for any person.  Any opinions and projections expressed herein reflect our judgment at this date and are subject to change without notice. Due to individual investor requirements, this post should not be construed as advice meant to meet the investment needs of any investor.  This post is not an offer to buy or sell, or a solicitation of an offer to buy or sell any of the security mentioned in this presentation.

Applied Finance Group (AFG), its owners, employees and/or customers may have positions in the securities that are discussed in this presentation.

The information contained in this presentation is the property of Applied Finance Group (AFG). The information included in this presentation has been acquired from sources believed to be reliable, but AFG cannot and does not guarantee the accuracy or validity of such information. Past performance is no guarantee of future results. Investing involves risk including the loss of principal. For Professional Financial/Institutional Use Only — Not For Public Distribution.

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