A relative value investor

Safa Muhtaseb, portfolio manager at Brandywine Asset Management explains the firm''s investment philosophy.

Muhtaseb is based at the firm's Wilmington, Delaware headquarters where he serves on the equities desk. Brandywine is a boutique that manages around $13 billion in global equities. The expanding firm is relocating to nearby Philadelphia next year.

What's your role in the equities team?

I'm a generalist portfolio manager for the global and international (ex-United States) equities strategies. I also cover stocks in healthcare, and in food, beverages and tobacco.

How would you summarize Brandywine's philosophy towards investing in equities?

We're a believer in the value discipline, and in relative value as opposed to deep value. Relative value means there is a discount to a stock's normal valuation, which we calculate over five to 10 years, looking at valuation models such as price to book, price to earnings and price to cash flow. We smooth the denominator, because we recognize that companies go through cycles, and we want to reduce the noise and get a sense of where a stock is traded. Then we compare this to its current valuation. If a company historically trades rich but is less so today, we're interested in that stock and understanding why its value is compressed.

Deep value just looks at the bottom quartile of earnings regardless of a company's situation. We've found that deep value invests in companies that are cheap for a reason, and which face significant barriers to recovery. Also, in the long run, markets are more likely to rise than fall, so deep value managers must take a pessimistic view and will experience far less participation in up markets.

Why value versus, say, momentum or growth?

Momentum is great so long as it's working. But it's impossible to predict when it stops working. Be definition, it stops working when it has stopped working. Price momentum takes you into non-fundamentals and it becomes just about the supply and demand for a particular security. Valuations of growth, momentum or mystique-type stocks reach irrational levels because of high expectations, and there's a good chance of disappointment.

How do equities compare today versus bonds?

We think equities are attractive. The MSCI All-world Index is trading at 14.5-15.0x 2005 estimates, and we expect earnings growth in the high single-digits or low double-digit range. Given inflation, interest rates and bond yields right now, that's quite attractive.

And fixed income?

We're not as bearish on bonds as the consensus. We don't see an interest-rate spike, in fact we think there's a chance that rates could go lower. Interest rates are determined by real rates and by inflation. We think that, net-net, we're still in a deflationary world because of China, India and other low-cost countries. This is not to suggest that there is no inflationary impact on these regions' demand for energy; sometimes it is tough to figure out which factor is dominant.

Consumption remains anaemic in Europe, while it is better but not healthy in Asia. It has been strong only in the United States, although for how long it can continue remains of considerable debate. America has record household debt, high property valuations and low interest rates which have allowed for refinancing-driven consumption. Job growth has been tepid. So at best this situation will only stabilize. We've gone through the profligacy of the 1990s when companies, if I may use the expression, went through an orgy of capital expenditure that has yet to be fully utilized. So inflation will remain tame.

Real rates, meanwhile, are a function of economic growth, which we see slowing to trend lines. Together with mild inflation, it's hard to see interest rates spiralling upward. Around the world, central banks are easing policy, stopping hikes or making their final interest rate rise.

We see exporting Asian countries with current account surpluses investing in US Treasuries. OPEC countries are also fuelling demand for US bonds, what with Brent crude at $60 a barrel. In the US, ageing Baby Boomers are shifting into capital-preservation mode. All of this continues to boost demand for bonds and keeps yields low.

What sectors do you like in equities?

We like healthcare because the market has fewer expectations for it, even though we think it has the ability to deliver earnings growth. And we like tech, where we see attractive valuations and the ability for companies to deliver growth. We're less keen on utilities, which have had a big run but now have inferior yields and a lower probability of dividend growth. We're neutral on energy: while we believe in high oil prices over the long run, and see earnings revisions have risen, we're tilting toward companies that are less dependent on underlying commodities, like Repsol in Spain.

What geographic areas are appealing to value investors?

From a valuation point of view, Europe is appealing. Investors tend to strap the macro malaise onto the micro level. Yes, there is high unemployment, poor GDP growth, and structural problems like high unemployment benefits and protectionism over products and labour. But at the company level, there are many restructuring stories. Companies are outsourcing and renegotiating labour contracts. Many of these companies are global and source their revenues from fast-growing emerging markets. We think the low ratings for many of these companies are unjustified.

And in Asia?

Like Europe, Japan has a tough macro story, which is cyclical and dependent upon exports. But the current valuations there versus their average prices since 1990 indicate an extreme discount. We see restructuring, and the financial services sector will go through more accounting changes next year that will require banks to sell their NPLs. There is less corporate protectionism, more cross-shareholdings being unwound, and management shakeouts at companies like Sony and Nissan.

Moreover, Japanese companies are benefiting from China's growth. Japanese companies lead the market for providing China with capital equipment, and they remain beneficiaries of China's FDI-driven growth. This trend is sustainable.

In the rest of Asia, many valuations are reasonably attractive. We see intraregional trade continue to rise. Most currencies are quite undervalued. The region's growing affluence means consumption is likely to increase. Emerging markets globally are healthier today than they were in 1994, when these stocks used to trade at a premium to the US market, whereas today they trade at a discount.

And in America?

If you just take a top-down view, this market has the least attraction for value investors. But the bottom-up view is different. There are undervalued or mis-priced securities. Many companies are generating cash and sitting on big piles of it. They have restructured and are more disciplined. We expect more consolidation and M&A. And market expectations for corporate earnings and margin expansion are beginning to come down.

The US stock market has been driven by macro factors, such as oil prices and the dollar. The sectors we like have been oil, utilities and, beginning this year, healthcare. We've avoided banks, which have been hurt by the flat yield curve. Utilities have become very rich, however, and are definitely in their final inning. Energy, on the other hand, could still surprise. Not every analyst believes in aggressively high and sustainable prices.

What about healthcare?

It has more room for upside. The market still has low expectations. For three years, the sector has underperformed, because of the rise of generic products and low R&D productivity. Positive factors such as increased government buying and rising healthcare costs are already baked in. We've had scandals like Vioxx. But what's not fully appreciated by the market is the pipeline at big pharmaceutical companies. Although research hasn't turned out any productive results in the past few years, we think the pipeline is bigger than people realize. The investing community today still has a "prove it to me" attitude toward the industry. Over the longer term, I think society will come to accept some product risks because they provide a greater benefit, plus there's the demographic and ageing background.

Where in healthcare do you find appealing stories? Big pharma, biotech, suppliers, hospitals?

The biggest misvaluations are in pharmaceuticals. We're also attracted to the device side. We don't spend much time on biotech firms, which have never been cheap relative to history or their peers. Investing in biotech companies requires a lot of scientific know-how, and even then these things can be hard to predict. This 'mystique' style of investing isn't part of our philosophy.

Share our publication on social media
Share our publication on social media