Investment Research Finding Value in US Equities Nicholas Sordoni, CFA, Director, Portfolio Manager/Analyst Following strong performance in recent years, US equities may not be the most obvious asset class in searching for attractively valued securities, but as stock pickers, we continue to find compelling opportunities in a range of sectors. Our analysis of the market s performance, valuation, sector mix, profitability, balance sheets, and interest rates / inflation backdrop indicates that domestic equities are not extended relative to history, supporting our favorable bottom-up view. In particular, we are generally constructive on large banks, cable networks, and mature technology companies given compelling valuations. In each case, there are strong fundamentals, recovery opportunities, and/or attractive entry points following recent bouts of underperformance.
2 With the S&P 5 Index having returned nearly 5% over the last three years, US equities may not be the most obvious asset class in searching for attractively valued securities. However, as bottom-up stock pickers, we continue to find compelling opportunities in a range of sectors. Before we highlight particularly noteworthy areas of value in the market, we will first examine the overall backdrop for US equities as a reality check of our constructive bottom-up view. Market Backdrop While it is true that domestic stocks have generated strong returns over the past few years, a longer-term perspective suggests their performance does not appear stretched. A data series of more than 1 years shows that the trailing 1-year annualized total returns of the S&P 5 Index are actually still a bit below the historical average (Exhibit 1). While US equities are clearly well off their lows, their longer-term trailing performance does not argue against the potential for further gains going forward, in our view. Similarly, from a valuation perspective, market multiples do not seem stretched for US stocks. The price-to-earnings (P/E) ratio for the S&P 5 Index, on both a trailing and a forward basis, is roughly in line with historical averages (Exhibit 2). These mid-range multiples should not preclude solid long-term returns going forward. As reflected in Exhibit 3, our study of the S&P 5 Index going back 3 years suggests that the index s forward P/E is highly correlated with subsequent 1-year annualized returns, and based on that historical relationship, the current multiple implies, on average, 8.8% annualized returns over the next 1 years. 1 Further, we believe analyses based on historical comparisons actually underestimate the current fair value of US equities for several reasons. For example, the low interest rate environment suggests higher multiples for stocks, as demonstrated by the still-elevated equity risk premium in Exhibit 4. Moreover, low inflation as observed currently is also consistent with higher earnings multiples for equities. In addition, historically higher P/E sectors such as technology and health care, which benefit from strong financial productivity and secular growth characteristics, now comprise a higher proportion of the Exhibit 1 Despite Recent Gains, Ten-Year Trailing Returns Are below Average, 19 215 2 1-1 19 Average 1-Year Trailing Returns 1923 1946 1969 1992 215 Data are based on the S&P 5 Index. The performance quoted represents past performance. Past performance does not guarantee future results. This is not intended to represent any product or strategy managed by Lazard. One cannot invest directly in an index. Source: Robert Shiller, Yale University Exhibit 2 P/E Multiples Are Trading Near Long-Term Averages (P/E) 3 23 16 9 1985 1991 1997 23 29 Trailing Trailing Avg. Forward Forward Avg. Data are based on the S&P 5 Index. Forecasted or estimated results do not represent a promise or guarantee of future results and are subject to change. Source: Deutsche Bank, IBES Exhibit 3 Historical Relationship of Valuation and Future Returns Annualized 1-Year Forward Return 18 12 6 215 R 2 =.9 Latest Value, Aug 215 Aug 225 Implied Return -6 8 14 2 26 Forward P/E Data are based on the S&P 5 Index. The performance quoted represents past performance. Past performance does not guarantee future results. This is not intended to represent any product or strategy managed by Lazard. One cannot invest directly in an index. Forecasted or estimated results do not represent a promise or guarantee of future results and are subject to change. Source: Deutsche Bank, IBES Exhibit 4 Low Interest Rates Can Be Conducive to Higher Multiples (bps) 96 64 32-32 1987 Equity Risk Premium Average (ex-tech Bubble) 1993 Equity Optimism Tech Bubble 21 Financial Crisis 28 Euro Crisis, Fiscal Cliff/ Election Equity Fear 215 Equity risk premium is calculated as the spread between normalized EPS yield and normalized real risk-free rate. Normalized EPS yield is based on log-linear regression of S&P 5 operating EPS; normalized risk-free rate is the difference between the: 1) average of 3-year Treasury yield and 5-year rolling average of 1-year Treasury yield, and 2) 1-year TIPS spread and 5-year rolling average CPI inflation rate. Source: Bank of America Merrill Lynch
3 S&P 5 Index relative to historical averages, at the expense of lowermultiple sectors like materials (Exhibit 5). This dynamic suggests that the index warrants a higher weighted-average multiple relative to historical levels. Finally, increasingly healthy corporate balance sheets also support a premium multiple for domestic stocks (Exhibit 6). Comparing US equities to other geographies, rather than their history, also does little to diminish our constructive outlook. While US stocks trade at a modestly higher P/E multiple than other developed market equities, in our view this premium is warranted by a much more pronounced difference in financial productivity (Exhibit 7). We believe this variation in regional ROE profiles reflects significant differences in sector mix. Specifically, the United States currently has a higher exposure to more profitable sectors, like technology and health care, and lower exposure to more capital-intensive sectors, such as materials and financials, suggesting that its financial productivity superiority should persist. As of August 215 and based on the S&P 5 Index (for the United States) and MSCI index data (for Europe and Japan), technology and health care together represent 35.2% of sector weights in the United States, well above 17.5% in Europe and 18.2% in Japan. By contrast, weights for materials and financials combined are just 19.5% in the United States, versus 3.2% in Europe and 25.2% in Japan. We believe this structural advantage should support a materially higher overall P/E multiple for the United States relative to other developed markets. The one obvious pushback to our constructive view on US equities is that corporate margins are already high, suggesting limited room for improvement and potential mean reversion. However, a deeper analysis of the key drivers of margin improvement suggests that these gains are sustainable rather than overextended. As demonstrated in Exhibit 8 (page 4), three factors account for more than all of the improvement in net margins since 1995. First, average corporate tax rates have declined, largely driven by the secular trend of globalization. Second, favorable financing conditions have fueled lower interest expense, and because over 8% of the outstanding debt in the S&P 5 Index is fixed rate this benefit should be largely locked in for the foreseeable future. 2 Third, the technology sector s margins have improved significantly, and we view these gains as secular, led by structural shifts and internet-driven economies of scale, rather than cyclical. Considering these three key drivers, the overall margins of US companies do not seem especially extended. Looking beyond fundamental issues of margins and valuation, it is also worth noting that we currently do not see many of the indicators that might be suggestive of an imminent peak in the equity market and business cycle. For example, leverage is not elevated, credit conditions are still loose, inflation is well contained, the yield curve is not inverted, domestic equities have not benefited from strong fund flows, and sentiment indicators are generally not overly bullish. While the Fed s first rate hike of this cycle may be impending, this event has not been a marker of a market peak in most prior cycles. Exhibit 5 The Composition of the S&P 5 Index Has Changed in Favor of Higher P/E Sectors Sector Weight 36 24 12 1985 IT Average IT 1991 1997 23 Health Care Average Health Care 29 215 Materials Average Materials Exhibit 6 Strong Balance Sheets Can Justify Higher Valuations 1 75 5 25 Net Debt to Equity [LHS] Cash as a % of Total Assets [RHS] 2 23 26 29 212 215 As of 3 June 215 Data are based on the S&P 5 Index. Data exclude financials as is common practice in this type of analysis, as changes in their mix as a % of the S&P 5 Index can have a large impact. Source: FactSet, UBS Exhibit 7 Valuation and Financial Productivity for US and Other Developed Markets Equities NTM P/E NTM ROE Continental Europe 14.4 11.4 Japan 14.2 8.9 Asia ex-japan 14.1 1. Average 14.2 1.1 United States 16.1 14.8 US Premium Relative 13.1 46.5 to Average Forecasted or estimated results do not represent a promise or guarantee of future results and are subject to change. All data reflect rounding. Source: Lazard, MSCI, Standard & Poor s 13 11 9 7 5
4 Exhibit 8 Contribution to the Increase in S&P 5 Index Non-Financials Net Margin, 1995 214 7.7 1.5 -.4 1..6.7 + + + + = Exhibit 9 Recovery Potential in Banks Net Interest Margin 5.5 4.5 3.5 Net Interest Margin 2.5 1985 199 1995 2 25 21 215 1995 24 Net Margin Lower Effective Tax Rate Lower Interest Expense Tech Other Sectors 214 Net Margin As of 3 June 215 Source: US Federal Reserve As of 31 December 214 All data reflect rounding. Source: BofA Merrill Lynch US Equity & US Quant Strategy, FactSet Exhibit 1 US Cable Network Stocks Have Fallen Sharply Banks One area of the US market currently offering compelling value, in our view, is large banks. While the banks have certainly recovered from the depths of the financial crisis, both in terms of fundamentals and stock performance, a long-term perspective suggests they are by no means stretched. In fact, the stocks of the six largest US banks are up, on average, only 39% over the last 1 years, versus 11% for the S&P 5 Index. 3 Return 1 S&P 5 Index -1 Cable Networks -2-3 Oct 214 Dec 214 Feb 215 Apr 215 Jun 215 Aug 215 In terms of valuation, this group is trading at an average price-to-book multiple of just 1.28 times, below the 1-year average of 1.34 times. 4 We don t expect a return to pre-crisis valuations around 2. times book value as the returns generated by banks have declined substantially due to the meaningful decrease in leverage allowed by regulators and other changes mandated by Dodd Frank and Basel III. Even taking these factors into account, the stocks do not need to re-rate nearly that far to generate strong returns. On a P/E multiple basis, these large banks, on average, are trading at only 11.3 times next twelve months (NTM) earnings estimates, which we view as attractive on an absolute basis and, at a 3% discount, too low versus the market as well. 5 Not only are the banks trading at an attractive multiple of earnings, those earnings have further recovery potential, in our view. The banks net interest margins are currently hovering around 3-year lows, and we expect these margins to rebound meaningfully when we return to a more normal interest rate environment (Exhibit 9). As the yield curve becomes more favorable, we believe net interest income growth should be a tailwind for banks earnings growth. Longer term, we also see an additional margin tailwind as legal and regulatory costs roll off over time. Cable Networks Another attractively valued industry within US equities is the cable networks. As demonstrated in Exhibit 1, the seven largest US cable network companies, down 19.2% on average over the last year, have dramatically underperformed the broader market on concerns that the TV ecosystem is in the midst of total upheaval, with lower television viewership and increased dropping of traditional video bundle subscriptions offered by cable and satellite providers (i.e., cord cutting ). The performance quoted represents past performance. Past performance does not guarantee future results. This is not intended to represent any product or strategy managed by Lazard. One cannot invest directly in an index. Source: FactSet, Lazard Admittedly, the TV ecosystem is mature and the video (telco, cable, and satellite) subscriber numbers for the second quarter of 215 were indeed a bit soft. However, when considering that the second quarter has consistently been seasonally weak in recent years due to factors such as college disconnects, we do not see a dramatic change in cordcutting trends (Exhibit 11, page 5). Furthermore, we believe the second-quarter softness may have been exacerbated by elevated subscriber losses at AT&T and DirecTV as they neared their recently completed merger. Overall, while video subscriptions clearly have reached a plateau, we expect greater stability going forward than implied by the recent sell-off in cable network stocks. We would also note that, while traditional TV viewership is in modest decline, overall video consumption including newer platforms, such as connected TVs, over-the-top devices, and game consoles, continues to grow. 6 In our view, the valuation of cable networks seems to discount very little possibility that they will be able to monetize the consumption of their content over newer distribution media, as they have done successfully through previous platform evolutions. Non-traditional video consumption is currently not well captured by ratings measurements, but technological advances should drive more complete measurement and monetization over time.
5 Exhibit 11 Video Subscribers Trend (Millions) 12.5 11.5 1.5 99.5 Total Undajusted Video Suscribers Seasonally Adjusted Video Suscribers Exhibit 12 Valuation and Financial Productivity for Cable Networks Cable Networks S&P 5 Index NTM P/E 12.3 16.1 Trailing P/E 12.6 18.1 Trailing ROE 26.8 14.3 Forecasted or estimated results do not represent a promise or guarantee of future results and are subject to change. 98.5 29 211 213 As of 3 June 215 Source: Company reports, Lazard estimates, UBS estimates 215 Exhibit 13 Cable Networks Historical Valuation Premium Deteriorated into a Discount Ratio With the recent underperformance, the large cable networks are trading at only 12.3 times NTM earnings, a 23% discount to the market multiple despite returns on equity nearly twice as high, on average (Exhibit 12). Given the strong free cash flow generated by these highly financiallyproductive business models, we believe that the cable networks warrant higher P/E multiples, as video subscription and viewership concerns are overly discounted in current valuations. Indeed, the group s relative P/E multiple contraction, from a historical premium to the market to a significant discount, as illustrated in Exhibit 13, is striking. We believe this rapid de-rating reflects worries about video subscription and viewership trends that, at this point, are overblown. 1.4 1.2 1..8.6 Feb 213 Premium Discount Cable Networks (P/E)/S&P 5 Index (P/E) Aug 213 Feb 214 Aug 214 Average Feb 215 Aug 215 Mature Technology While investors may be enamored with hyper-growth internet companies like Facebook and its smaller brethren, they seem to be overlooking many of the mature (which we defined as non-internetbased and with over $5 billion in market cap) technology companies, another area where we re finding compelling value. The ten largest mature technology companies, down 8.6% on average, have significantly lagged the S&P 5 Index over the past year, creating an attractive opportunity, in our view (Exhibit 14). While these companies are no longer in hyper-growth mode, consensus expectations call for forward earnings per share (EPS) growth of 9.2%, on average, as fundamentals remain intact. 7 Indeed, a recent survey of CIOs indicated that the expected growth of their external IT budgets is stable at 4% 5%, (Exhibit 15, page 6). In fact, the 4.4% average expected growth in 214 215 is actually an acceleration relative to the average of 3.3% for 21 213. Exhibit 14 The Recent Underperformance of Mature Technology Companies Presents an Opportunity Return 9 S&P 5 Index -9-18 Oct 214 Dec 214 Feb 215 Apr 215 Largest US Mature Tech Companies Jun 215 Aug 215 The performance quoted represents past performance. Past performance does not guarantee future results. This is not intended to represent any product or strategy managed by Lazard. One cannot invest directly in an index. In our view, the outlook for continued stable revenue growth is supported by industry dynamics including global build-outs, data center consolidation, and recurring maintenance revenues, while operating leverage and cost management efforts should sustain margins. Due to the low asset intensity of these businesses, stable growth and margin prospects point to continued robust free cash flow generation and financial returns. The group s return on invested capital, despite being weighed down by significant excess cash balances (a high quality problem, in our view), averages 14.9%, well above capital costs. 8
6 With its recent underperformance, the group trades at only 12. times NTM earnings, well below the S&P 5 Index, despite superior financial productivity and balance sheet strength (Exhibit 16). This P/E multiple discount relative to the S&P 5 Index is unusually wide (Exhibit 17). Given stable fundamentals, high-return business models, and very low financial leverage, we believe this discounted valuation is compelling. Still, we believe stock selection is especially important in this industry, as technology shifts may eventually erode the financial productivity of some of these companies. In our view, a number of them are well entrenched and trade at valuations implying much more fundamental erosion than we expect, making them attractive investment opportunities. Conclusion On the back of a strong multi-year rally, many observers may dismiss US equities as overvalued. However, a closer look reveals that opportunities exist in specific areas of the market. In terms of broad market indicators, valuations do not look stretched relative to history and balance sheets are strong. When contrasted with other regions, we believe a higher P/E in US stocks may be warranted given the higher financial productivity relative to other developed markets. We note that the sector composition, as well as the current low rate/low inflation environment is also supportive of a higher overall valuation premium for the US market. As bottom-up stock pickers, we are generally constructive on large banks, cable networks, and mature technology companies given attractive valuations. In each case, there are strong fundamentals, recovery opportunities, and/or attractive entry points following recent bouts of underperformance. Exhibit 15 External IT Spending Growth Expectations 6 3-3 -6 Apr 29 Jan 211 Jul 212 Jan 214 Jun 215 '7 Budget '8 Budget '9 Budget '11 Budget '12 Budget '13 Budget '15 Budget 21 213 Avg. 214 215 Avg. '1 Budget '14 Budget As of June 215 Please note that materials that are referenced comprise excerpts from research reports and should not be relied on as investment advice. This material is only as current as the publication date of the underlying Morgan Stanley research. For important disclosures, stock price charts and equity rating histories regarding companies that are the subject of the underlying Morgan Stanley research, see www.morganstanley. com/researchdisclosures. Copyright 215 Morgan Stanley. Source: Morgan Stanley Exhibit 16 Attractive Fundamentals for Mature Technology Companies Mature Technology Companies S&P 5 Index NTM P/E 12. 16.1 FCF Yield 9.1 5.6 ROE 23.6 14.3 Net Debt/Total Capitalization.4 32.2 Forecasted or estimated results do not represent a promise or guarantee of future results and are subject to change. Exhibit 17 Premium/Discount for Mature Technology Companies Ratio 1.2 1. Premium Discount.8.6 Mature Technology (P/E)/S&P 5 Index (P/E) Average Feb 213 Aug 213 Feb 214 Aug 214 Feb 215 Aug 215
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