Fear of recession has depressed valuations of many economically sensitive businesses. Contrary to
popular belief, this may be an opportune time to invest, with the added benefit that many of these
businesses have improved their financial strength and operating flexibility.
The first quarter of 2019 marked another period
when growth beat value, with most outperformers
falling into the paradigms of high-flying growth or
so-called safety stocks that offer higher dividends,
low volatility and stable earnings. Meanwhile, many
of the valuations of traditionally cyclical businesses
already appear to be discounting a recession. This
has pushed valuation dispersions between the
cheapest and most expensive stocks to their widest
point since the dot-com internet bubble that ended
Valuation dispersion widest since 2005
Past performance is not a guarantee of future results. Data provided through 03/31/2019.
Source: Sanford C. Bernstein & Co. Dispersion based on price/book, equally-weighted data.
Includes largest 1,600 stocks by market capitalization in developed world.
While we can never predict when such a trend will
reverse, the historical pattern has been for cyclical
shares to become heavily discounted amid fears of a
recession, and then outperform once the prospects of
a recession become clearer. In our view, valuations in
financials, energy, autos and housing-related stocks
are currently heavily discounted. While the reasons
for their weakness vary by industry, we believe each
offers a meaningful investment opportunity.
Is it too early?
In considering the viability of investing in these
businesses today prior to a downturn, we evaluated
returns relative to the market when bought within 24
months of a recession and then held for three years.
Because the global financial crisis (GFC) was such an
outlier, we wanted to differentiate its results from what
has typically happened around a recession.
Leading into the GFC, it is no surprise that
financials did not deliver a positive return over the
ensuing three years. However, buy-and-hold
investors in consumer discretionary stocks were
rewarded for purchasing virtually any time within six
to eight months of the crisis.
In more mundane recessions, like the four prior to
the GFC, patient investors were rewarded for owning
undervalued cyclical stocks.
The following two charts show just how strong the
outperformance for financials and consumer
discretionary stocks were over the three years
surrounding these recessions. In various stages of
repair, we also believe that many of these companies
are better prepared than in the past for a downturn —
even as their valuations imply that the opposite is true.
Forward 36-month relative returns
Prior to recessions 1975 — 2001 vs. global financial crisis
U.S large-cap financials
U.S. Large-Cap consumer discretionary
Past performance is not a guarantee of future results. Source: National Bureau of Economic Research,
Empirical Research Partners. Equally-weighted cumulative returns of sector versus capitalizationweighted
returns of the largest 750 U.S. stocks by market capitalization.
Financials: Progress yet to be fully rewarded
We believe the distrust created during the GFC has not
been fully resolved in investors’ minds, so financials
remain heavily discounted as demonstrated in the chart
below. Their current valuation relative to the broad
market places these stocks in the 97th percentile of
the past 45 years, meaning they have only been cheaper
3% of the time. However, given their profitability,
capital strength and liquidity, we believe the discount
U.S. Large-Cap financials relative to the market
Past performance is not a guarantee of future results. Source: National Bureau of Economic Research,
Empirical Research Partners. Data provided from 01/01/1974 – 03/31/2019. Largest 1,000 U.S. stocks ranked
by market capitalization. Ratios of price/book values relative to the equally-weighted broad market data as
We believe both U.S. and European banks have improved
their fundamentals and fortified their balance sheets by:
- increasing tier-1 core risk-based capital ratios to over
13%, from 7%–8% at the end of 2006
- raising liquidity ratios in the U.S. by 9%, almost
triple pre-crisis level; European banks have similarly
improved liquidity management
- scaling back risk-taking to reduce the likelihood
of a major institution upending the system
- implementing self-help that cut costs, improved
governance, focused on higher-return businesses
and installed next-generation technology to better
These combined actions make the banks much
better positioned to weather future credit events or
Higher liquidity improves resilience to volatility
Past performance is not a guarantee of future results. Source: Federal Deposit Insurance
Corporation (FDIC). Data provided from 03/31/2002 – 12/31/2018. Liquidity ratio shows liquid assets
(cash, Treasuries and municipals) / tangible assets.
From a credit perspective, we believe the overall
environment today remains benign, and non-performing
loans are below their historical range. The recent outsized
growth in leveraged loans alongside loosening lending
standards in this space has raised some concern.
With most loans being packaged and dispersed among
institutions and within financial products, the additional
risk will be borne across markets. The extent to which
investors bear this additional risk remains important and
may be accentuated in the event of a downturn.
Exposure to risky loans among banks remains
constrained, and we do not believe it warrants their
current valuation discounts. As a result of stronger risk
management and higher regulatory requirements, banks
today turn over their leveraged loan inventory as rapidly
as every 60 days, three times faster than before the GFC.
We continue to watch for new developments but believe
that any problems surrounding these loans will be limited
in scope, and the risk of systemic contagion is low.
Investors also penalize the sector as interest rates remain
persistently low. The reality is that financials have
demonstrated an ability to adapt by raising revenue and
restoring earnings. Even with the combination of low
interest rates and increased regulatory capital
requirements, U.S. banks have restored profitability with
return on tangible equity of 15%. European banks face
more severe interest rate headwinds than those in the
U.S. Banks in Europe also have more restructuring ahead
to restore profitability; most expect to resume doubledigit
returns on equity over time.
Energy: coming off the bottom
Energy stocks are also at depressed valuations because
of concerns centered on the uncertain path for energy
prices. On a price-to-book (P/B) basis, they are trading
in the 98th percentile of the range relative to the market
over the last 44 years. In other words, they have been
cheaper on a relative basis in just 12 months out of the
last 528. And each time was on the heels of a rapid oil
Companies in the sector have taken significant steps to
endure this kind of volatility — cutting operating costs
and capital spending to restore profits and cash flow.
Meanwhile, the downturn in exploration and
development accelerated the decline in global oil reserves.
Falling at a rate not seen in the last four decades (See
chart below), the pace of the fall seems unsustainable.
Even with developments in the alternative energy and
transportation industries, world oil demand is expected to
grow over the next two decades, according to the U.S.
Energy Information Administration. The combination of
rising demand and depletion will more than offset any
reductions from technological advances, and ultimately
we believe it will require companies to invest in developing
Oil reserve depletion indicates more capital spending is needed
Past performance is not a guarantee of future results. Source: Rystad Energy
Oilfield service companies would be central to that
development but have been particularly vulnerable of late.
The previous chart shows that upstream capital
expenditures fell by 44% from their 2014 peak. After
having endured sharp declines in revenues (-49%) and
margins (-63%), these companies have shown progress.
With only a slight improvement in revenues, these
companies doubled their margins to 10.4% by 2018 (from
5.1% in 2014) by focusing on cost cutting and supply
chain efficiencies. In many cases, they have also shown
disciplined capital management by aggressively trimming
debt. We believe the more austere approach of these
companies should allow them to come through this period
as leaner, more efficient operations. With these companies
trading near historical lows relative to the market,
investors are essentially getting a free option on increased
energy capital spending whenever the recovery occurs.
Household durables and autos are also undervalued
Within the consumer discretionary sector, household
durables and automobiles have faced a perfect storm.
Their natural tendency for a late-stage selloff may have
been intensified by headwinds such as trade-related cost
increases that are specific to the current cycle. Building
product manufacturers and homebuilders have
underperformed on slower growth in housing starts and
the impact of rising rates on affordability. Costs
surrounding materials and transportation have risen
substantially since the beginning of 2018, and labor has
Amid the volatility and rising fears of a recession in 2018,
household durables fell by 29% and autos by 34%. After
taking a severe battering in the last recession, investors
seem to want to steer clear of anything housing or
automotive related. While there has been some recovery
within housing this year, U.S. large-cap auto and housingrelated
stocks continue to trade at a significant discount to
the broad market on a P/B basis.
Attractive valuations remain
The market’s continued preference for growth and safety
has recently left many of the traditionally cyclical
businesses out in the cold. While financials, energy and
autos have each been discounted for its own specific
reasons, each has been judicious in deploying capital,
realigning its business models and maximizing
operational efficiencies. Meanwhile, valuations in these
segments are all attractive. We believe these businesses are
better prepared than in the past for a downturn, and
history would suggest this is a good time to invest for the
Past performance is no guarantee of future results. The opinions expressed are those of the Fund’s managers and are not meant as investment advice or to predict or project the future performance of any
investment product. The opinions are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of
information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s
specific objectives, financial needs, risk tolerance and time horizon.
Risk factors: The value of the Fund’s shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit
Insurance Corporation or any other government agency. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences
in accounting standards and foreign regulations. These risks are magnified in emerging markets. The value of a security believed by the Fund’s manager to be undervalued may never reach what the manager believes
to be its full value, or such security’s value may decrease. These and other risks are more fully described in the fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.