Mid-cap value stocks could be on their way to delivering for investors
At Boston Partners, our investment process is straightforward: We want to invest in stocks that have low valuation, attractive fundamentals, and positive momentum. We focus on low-valuation stocks because we want to know that we’re paying less than a company’s intrinsic value when we acquire it. We also believe that companies with strong fundamentals, which generally means high return on invested capital, tend to outperform companies with poor fundamentals. And we think stocks with positive business momentum, or improving trends and rising earnings, will outperform stocks with neutral to negative momentum. In our analysis, all three of these areas—valuation, fundamentals, and momentum—show above-average potential in favor of mid-cap value stocks today.
To be fair, the low-valuation signal is strong across the spectrum of value equity, including mid-cap, large-cap, and international stocks. This is evident in a simple comparison of forward price-to-earnings data for value versus growth.
P/Es across the value stock segments have clearly been compressed to historical lows—even in the wake of value’s general ascendancy over growth stock performance, which began roughly in the postpandemic period. This illustration broadly suggests to us that there are ample opportunities to invest in companies at levels lower than intrinsic value.
Alongside valuation, we consider fundamentals. Here, we’re thinking of several key attributes, particularly the resilience of a business to economic downturns, consistent-to-rising share buybacks, as well as high return on invested capital (ROIC) and free cash flow (FCF) conversion. While it’s something of a truism that value stocks grow more slowly than growth stocks, we see value companies as generally less reliant than growth companies are on capital markets to fund their growth. Given that the cost of capital is much higher today in light of the U.S. Federal Reserve’s (Fed’s) battle to tame inflation with tightening monetary policy, we think low-valuation stocks with strong cash flow generation may have an edge over their growth counterparts as well as peer value companies with less attractive fundamentals.
As we get deeper into the first quarter of 2023, we’re finding attractive relative fundamentals across sectors, but particularly in consumer discretionary, energy, and industrials. One of the signal differences we’re watching play out for companies now involves the variegated effects of fading supply chain disruptions. This phenomenon is good news for all companies that had suffered through the pandemic’s powerful distortions of global supply chain efficiencies, but we’ve been anticipating the positive impact that easing pressure could have in particular for midsize companies.
This is really at the heart of what we consider to be the value proposition within mid-cap value now. Pricing power of mid-cap value companies could demonstrate resiliency in the advent of a recession. Profit margins have been depressed in recent quarters from high input costs as well as high freight costs. With those pressures easing, we see a rather unique form of margin insulation taking shape; even if demand weakens for cyclical sectors, margins could still increase on year-over-year comparisons, implying relatively better fundamental performance from mid caps than you’d expect to see in a typical economic downturn. We’ve even observed this phenomenon begin to pan out in several areas, one of which is retail—not generally thought of as a recession-resilient sector.
These are the types of company we want to own now, particularly as key inflation components begin to roll over and in light of the fact that our near-term economic future is cloudy; the latter simply helps underscore mid-cap value's unique relative resiliency to prospective trends of declining consumer demand.
Momentum is building—despite recession risks—for many mid-cap value companies
As of early February 2023, more than 80% of the mid-cap companies we invest in are displaying positive earnings momentum now or we expect them to do the same in the coming quarters. That’s a high level of relative positive momentum, and even more so to see this condition emerge alongside a decade-plus valuation low for value stocks and what we consider broadly attractive fundamentals. It’s also testimony, we think, to diligent fundamental analysis, including our focus on industry trends for revenue growth and individual companies’ ability to take market share from competitors even if economic uncertainty rises.
The momentum we see as evident in companies should translate, we think, into a renewed investor focus on mid-cap stocks. We’re on what consensus seems to be calling the eve of a potential recession, so we think it makes sense to consider tilting a core portfolio toward higher-quality value equity, higher-quality corporate debt exposures, and a position of enhanced diversification.
Mid-cap value stocks are under-covered and under-owned
It’s long been the case that mid-cap stocks aren't as widely followed by sell-side research analysts as their large-cap counterparts. Larger-cap companies have historically attracted more analysts, and the trading volume of the largest companies in large- and mid-cap indexes reveals a decided tilt toward large-cap stocks. Most investors, it turns out, are underexposed to mid-cap stocks.
It’s worth remembering that mid-cap companies are essentially mature but not elderly companies. They’ve successfully grown beyond the vulnerabilities of newer, smaller-cap companies, but they’re not large or enormous mega-cap ships that take extra energy to boost ROIC. Mid-cap companies commonly offer a rich opportunity for more stable growth than small caps, but they’re often poised for more rapid growth as well.
The value segment, moreover, includes defensive sectors that may offer some relative protection in a recession. Remember what happens in a recession: We often find souring sentiment, shrinking production and consumption, higher unemployment, and sometimes lower price levels hitting company bottom lines. And recessions spread across an entire economy. The key questions are how deeply does the malaise go and which sectors will be the most vulnerable given the specific qualities of the recession in question. And yet overall, higher-quality, defensive opportunities have tended to do better than more speculative names, shielded as they may be by continued consumption in things like staples, energy, and healthcare.
As longtime investors in mid-cap value stocks, we think the long-term case for investing in the asset class is about diversification. But in the short term, we see mid-cap valuations and profitability potential as offering a compelling cyclical argument for allocations to the asset class. This is why we think a pro-cyclical tilt will work for investors as we get further along in 2023. The market will continue to speculate about the timing of a Fed pivot, and geopolitical risks will continue to rise and fall. Regardless of the level of relative uncertainty, mid-cap value is worth considering as a key component in a well-diversified portfolio.
Price-to-earnings (P/E) is the ratio for valuing a company that measures its current share price relative to its per-share earnings. Price/book (P/B) is the ratio of a stock’s price to its book value per share. Free cash flow (FCF) yield is a measure of a company’s cash available for distribution to shareholders per share after capital expenditures and taxes, divided by its share price.
The views expressed in this material are the views of the authors and are subject to change without notice at any time based on market and other factors. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index, and is not indicative of any John Hancock fund. Past performance does not guarantee future results.
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