In Focus interview: US valuations and spotting pockets of opportunity
US valuations and investment strategy are both on the agenda in this month’s In Focus interview.
Duilio Ramallo, Lead Portfolio Manager on the Robeco US Premium Equities fund, talks to Ian Aylward, Head of Manager Selection at Barclays, about where he sees pockets of opportunity.
IA: Duilio, could you start off by explaining how you go about investing in the US equity market?
DR: In the team, we assess stocks almost entirely from a bottom-up perspective. What I mean by this is that we evaluate companies on an individual basis, as opposed to being driven by the macroeconomic environment (top-down). In doing this, we focus on three characteristics; business fundamentals, business momentum and valuation.
Business fundamentals look at the health of a company, their ability to generate and grow revenue, make positive returns on capital and do so without taking on too much leverage.
Business momentum asks the question of whether sales or margins are improving, whether the company is organically growing. Finally the value of the share price is measured using various metrics and ensures that we don’t overpay for these companies.
IA: Do you manage to find companies that beat the market across all three characteristics?
DR: It does happen, but it’s rare that we’re able to identify a company that has strong fundamentals, with positive business momentum, that is also trading at a discount.
What we’re trying to do is build a portfolio that, on average, beats the market across these characteristics. If we can do that, then we believe we can beat the market return over the long-run too.
IA: ...and this applies in both the buying and selling of stocks?
DR: Yes, while we typically focus on our buying discipline to explain our investment philosophy, our sell discipline is just as important.
Most commonly we find reason to sell based on valuation. We will hold companies until we feel that the stock is looking overvalued. This is an important discipline that stops us from giving up market gains by holding a stock that no longer reflects our investment criteria.
IA: OK, so given that valuation plays such a large role in your assessment of stocks, do you find large areas of the market are out of bounds, so to speak?
DR: Yes but value investing doesn’t necessarily mean only investing in very cheap stocks. Value is relative to the quality of company that you’re buying, which can be measured as a company’s price relative to its earnings, company book value, or the cash flow that it generates.
For example, we have considered Google, or Alphabet to fall within our remit. It is a stock that we have owned on and off since 2014 and while it was much more inexpensive several years ago, we have continued to hold the stock through its strong performance in recent years despite a higher than market multiple.
That being said, Alphabet has exhibited exceptional fundamentals and strong business momentum and therefore would be an example of a stock where we think the company was still inexpensive to the cash flow it generated.
IA: That’s interesting; but given recent performance I don’t imagine much of the tech sector fulfils your value criteria?
DR: There are a number of tech stocks that fall outside of our universe of investable stocks. Netflix, Amazon, and Adobe are great examples of very expensive valuations, all with price-to-earnings ratio multiples of over 50 times.
However, we’re still finding plenty of tech stocks that we’re keen to hold; Cisco Systems, Microsoft, HP, DXC Technology and Oracle are some of our largest holdings in the space. In fact, the Fund’s allocation to tech is more than double that of the value benchmark. Also interestingly, the average price-to-earnings ratio of the tech stocks that we own in the Fund is under 13 times, much lower than the industry average.
That being said, we evaluate companies on a stock-by-stock basis and so sector allocation tends to be a by-product of this bottom-up stock selection.
IA: Where are you finding other pockets of opportunity?
DR: Financials look interesting; they represent the Funds largest sector allocation, a 7% overweight relative to the value benchmark. This is a part of the market that looks broadly undervalued, with banks likely to be one of the main benefactors from the rate hike cycle.
Being an all cap fund, we have the flexibility to allocate to mid caps where we see opportunities, which has served us well in recent years. We can also dip into international markets, with recent investments in Sony, Ambev [ a Brazilian beer company], and Baidu [a Chinese internet search engine].
IA: How are US equity valuations looking generally, if you’re turning to international markets for value opportunities?
DR: I’d say there are pockets in the market like Amazon, Visa, Mastercard, where we believe valuations do look high. However , if you strip out an elite group of 15-20 very highly valued stocks, the broader market really doesn’t look too unreasonable.
Robeco is an international asset manager of Dutch heritage offering an extensive range of active and quant based investment solutions, with group assets totaling £250bn. Duilio Ramallo has managed the Fund since 2005, and has 23 years of investment experience managing US equities.