As professional money managers, we are constantly on the lookout for undervalued sectors of the market. This is no easy task today as unprecedented amounts of fiscal and monetary stimulus have caused prices to soar across a wide range of financial assets. Still, as the most recent GameStop folly revealed, investors’ emotional tendency toward fear and greed continues to influence market behavior and periodically cause prices to deviate from reasonably fair values.
Market sectors that have underperformed are always a good place to start when hunting for the mispriced. But the job of finding undervalued securities is more difficult than simply looking at last year’s (or decade’s) losers. Today’s competitive markets tend toward “efficiency,” which means that most securities are priced as they should be. In addition, typically the rationale for investing in a laggard is based on the idea that investors are misreading a company’s potential earnings power – potential that takes time to be realized. In his work, Morningstar analyst Alex Bryan found that favoring sectors and asset classes that have underperformed over the previous 4-5 years generally led to better results. The take-away here? Examining underperformers is one approach to finding undervalued securities but patience is required.
The areas below have experienced multi-year periods of underperformance. Their appreciation going forward will depend on the pace of the global economic recovery. While this remains uncertain, allocating a portion of a portfolio to some of these out-of-favor sectors could well add diversification and return benefits over the long term.
International Issues: International shares have underperformed their U.S. counterparts for most of the past 10 years (see chart below). The relative under-representation of technology shares in international markets and the strength of the U.S. dollar have both contributed to the weak results. An economic resurgence due to the waning pandemic would favor international markets, which tend to be dominated by cyclically sensitive and export-oriented companies. Continued U.S. dollar weakness, the result of robust accommodative monetary and fiscal policies here at home, would also support the shares.
Traditional Value Stocks: Value and Growth strategies go in and out of favor with Value showing the edge over long time periods. But Growth shares have dominated over much of the past decade and were particularly strong last year, besting Value stocks by over 35% — the most in any year on record. The pandemic fueled this remarkable divergence with technology and other service-related growth companies uniquely benefitting from lockdowns. Deeply discounted sectors worth considering include:
Energy: As a group, energy shares have lost money for most of the last 10 years. Part of this underperformance is due to the significant structural changes impacting the industry including the introduction of new U.S. supplies on world markets and the shift to cost competitive alternative energy sources. But fossil fuels still supply over 80% of the world’s energy needs. Resumed travel and commuting will likely support higher oil and gas and share prices in the near term.
Financials: These stocks generally perform well in the early stages of an economic recovery as higher net interest margins, strong loan growth, and lower credit losses all fuel stronger earnings gains. The shares have discounted some of the recovery already but remain reasonably valued when compared to historic levels.
Commodities: While not traditionally a “Value” sector, commodities which include metals and agricultural products, have been one of the market’s worst performing asset classes over the last 15 years. A broad-based economic recovery would be key to price recovery here. The asset class can also serve as a hedge against potential inflation — a distinct possibility given the size and scope of economic stimulus measures undertaken both here and abroad.
