Value Stocks: Cracking The Quality Code

By James MacGregor, CFA | Cem Inal | Erik Turenchalk, CFA

Today’s value stocks offer a magnificent mix of quality, forward-looking profitable firms.

Investors often perceive value stocks as “old-economy” companies with boring businesses, compared to fast-paced, growth-oriented equities. Trailing performance hasn’t helped value’s reputation either. For nearly 10 years, growth stocks have persistently outpaced value stocks, driven by ultra-low interest rates and, more recently, a handful of high-flying technology names.

Value’s relative weakness reflects investor angst that earnings of cheaper companies won’t hold up if the economy softens. With uncertainty at heart, many investors have preferred the earnings profiles of mega-cap growth stocks that have dominated market returns. In reality, however, value equities are much different today and offer advantages that may be one of the market’s best-kept secrets.

Value Companies Have Improved Profitability

In fact, we believe value investors have access to a broad spectrum of high-quality earnings streams today. In recent years, profitability-as measured by return on equity-has sharply recovered among companies in the Russell 3000 Value Index (Display). As a result, the wide profitability gap between value companies and their Russell 3000 Growth peers that prevailed for much of the prior decade is now largely gone.

Quality Gap Between Value and Growth Stocks Has Narrowed

Meanwhile, US value stocks also trade at a deep discount to growth stocks, based on a metric that combines price-to-sales, price-to-cash flow and price-to-forward-earnings ratios (Display). This valuation spread is near its widest in decades, and we believe it is poised to narrow, which would bode well for broad value equity returns.

Valuation Discount Is at Historically Attractive Levels

Lots to Choose from, but Choose Carefully

While the profitability and valuation spreads may be flashing green for value, investors must be selective. After all, stocks can be cheap for good reasons that can lead to bad outcomes. So equal attention should be paid to business fundamentals, as high-quality companies with strong earnings potential tend to be rewarded over time as they attract more investors.

Of course, some value stocks are cyclically exposed and will fall in and out of favor as economic conditions shift. However, with broader market returns driven by such a narrow set of mega-cap growth companies, value opportunities have widened to include many choices that are less sensitive to macroeconomic moves. Indeed, we’ve found that the value universe is now flush with quality companies of all sizes and in all industries and sectors, many with solid earnings trajectories underpinned by company-specific drivers, niche-industry trends and structural changes in the US economy.

Quality as a Value Driver

Many attractively valued stocks with strong balance sheets and robust profitability have fallen from favor. But firms with improving business quality to support earnings growth offer compelling recovery potential, in our view.

Consider the home-improvement segment of the consumer discretionary sector, which is growing at a healthy clip. Lowe’s is a home-improvement retail chain that has increased market share in recent years. Company management has executed several initiatives to bolster its position; these include a sharper focus on home-improvement professionals, such as contractors, and an improved ordering and delivery model for appliances. As a result, Lowe’s has posted strong revenue and cash-flow growth.

In the building-supplies industry, Builders FirstSource has acquired and restructured its way to bolster competitive advantages. The company’s shift to high-end products has strengthened its foothold among homebuilders who value its labor-savings qualities and consistency.

Value Can Tap Dramatic Economic Changes

Some value companies enjoy a supportive industry structure. Trends such as supply chain protection and reshoring, energy transition and cybersecurity are gathering pace. Select firms have attractively valued shares that don’t reflect their potential to access these themes, in our view.

Companies that facilitate efforts to bring US supply chains closer to home should benefit from the reshoring wave. For instance, ArcBest provides “less than truckload” sized transport solutions, combining goods from multiple customers into fewer cost-effective loads. Demand for its services should increase as US reshoring accelerates, while new entrants to the market face considerable moats in the form of local pushback over potential noise and congestion. ArcBest has also long invested capital in a robust national network of facilities, which should enjoy high utilization.

Blue Bird is likely to benefit from energy security and transition. The manufacturer of electric-powered school buses is already backlogged in supplying the growing wave of district transitions to low-emission fleets. Likewise, Eaton produces electrical equipment used in repairing and enhancing electrical grids, which are undergoing a massive transition to a renewables-based generation.

No More Compromising Quality… or Excitement

In his seminal book on behavioral economics, the late Daniel Kahneman quipped that it’s easier to strive for perfection when you’re never bored. We think this observation applies to value investing now more than ever. This isn’t a typical value downcycle. Nor is this your grandfather’s value pond-traditionally stocked with lower-quality companies that forced investors to make tough compromises in the quest for good value.

More value companies today are thriving and stack up strong against their growth peers in terms of end-market dominance, competitive positions and profitability. Investors who crack the quality code by identifying companies with improving fundamentals can capture attractive recovery potential from value stocks, as their changing characteristics are gradually unlocked by the market.

The authors would like to thank Snezhana Otto, Senior Research Analyst-Value Equities at AB, and Dennis Stakhov-Senior Quantitative Research Analyst-US Value Equities, for their research contributions to this blog.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.

References to specific securities discussed are for illustrative purposes only and are not to be considered recommendations by AllianceBernstein L.P.

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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.