Value Stocks Could Be Cheap for a Reason

Many investors are—sensibly—considering rebalancing their portfolios away from the large-cap tech and growth stocks that have driven market performance. The search is on for strategies that may potentially lead the next leg of a rally. Value stocks are one example, as they tend to trade at lower prices relative to their fundamentals. While value stocks are indeed less expensive, they may represent a “value trap”—cheap for a reason. As a group, the companies in the S&P 500 Dividend Aristocrats Index offer a compelling alternative of historically attractive valuation, higher quality—as measured by credit ratings, price/earnings (P/E) ratios and return on assets (ROA)—resiliency, better total return and higher historical dividend growth.

Definitions: Price/earnings (P/E) ratio shows how much investors are paying for a dollar of a company’s earnings. Return on assets (ROA) indicates how efficiently a company utilizes its assets, by determining how profitable a company is relative to its total assets.

Large-Cap Tech and Growth Stocks: Some Considerations

What’s not to love about large-cap tech and growth stocks? The tech sector accounts for nearly 40% of the market-cap weighted S&P 500 Growth Index. If you include Facebook, Google and Amazon, that figure rises to more than 55%.

Shouldn’t these companies be driving the market? The pandemic alignment is clear: Working from home, e-commerce, cloud computing and other transformative business changes have helped buoy technology-related companies. Low interest rates help, too. In fact, low interest rates disproportionately help growth stocks by increasing the value of big cash flows out into the future. The fear of missing out—or more formally, “momentum”—has also supported tech stocks. If fundamentals are important to you, note that, as opposed to 20 years ago, most of these high-flying tech companies are highly profitable. So what’s the problem?

Figure 1:

Pacific Gas & Electric Co. transformers and power lines stand in Nevada City, California, June 12, 2019.



Photo:

David Paul Morris/Bloomberg News

Donald Trump promises to “keep America great” in a second term. But he won’t do it if his trade policies get in the way of a sorely needed upgrade of the U.S. electrical grid.

Investment in electricity for the 21st century will be a heavy lift for utilities. But it will become heavier if a Commerce Department investigation finds imports of transformers and related components to be a national-security threat and imposes tariffs. The price for the transformers required to modernize the grid is in the range of $8 billion—today. Deliberately raising that cost sounds insane. But then this is an election year.

In 2018 the Trump Administration used Section 232 of the Trade Expansion Act to declare imported steel a security threat and impose a 25% tariff. We warned the tariff wouldn’t make American steel producers more efficient but would hurt other industries. This is what happened in the transformer industry.

Transformers use a special electrical steel that in the U.S. is made by one company,

Cleveland-Cliffs

’ subsidiary AK Steel. Because U.S.-made “grain-oriented electrical steel” prices are high relative to the world market, many American transformer producers, prior to the 2018 steel tariffs, imported some of the raw material they need. The 25% steel tariff raised prices in the U.S. further, forcing many companies to move component manufacturing out of the country.

Without proof of unfair trade practices, national security is again the excuse of protectionists. Yet the steel in transformers comes from allies including Canada, South Korea, Japan and Brazil. Much of transformer and component production now comes from Canada or Mexico. Unless we’re expecting a sneak attack, the case for a national-security risk is