Equity Outlook  |  Q3 2019

What happened to value?

Darren A. Jaroch, CFA, Portfolio Manager of Putnam Equity Income, Fund and Putnam International Value Fund

What happened to value?

As a value investor for over 20 years, I have a few observations about the asset class today. The past decade has often been painful for value investors. The approaches that worked best 10 years ago aren't likely to work as well today. But there are always opportunities for those who know where to look.

Why has value underperformed?

Looking at the past decade, the core of the problem has been the response by central banks to the global financial crisis. The market was flooded with liquidity, which encouraged investors to move higher on the risk curve, sending them out of value and into growth. As growth became a scarce commodity, investors were willing to pay up for it, even when multiples reached extreme highs.

Sector biases and the shortcomings of indexes

The value investing environment has changed dramatically, but some measurements of value, such as benchmark indexes, have not caught up. Most indexes are only rebalanced once a year, and index performance is affected greatly by sector concentration. The financials sector, for example, makes up a considerable portion of value indexes. This is largely because financials have historically had low price-to-book values.

Indexes place a heavy emphasis on price-to-book value, which we believe is less relevant today. Relying solely on price-to-book as a measure of value is a sure way to miss opportunities elsewhere. Intangible assets, which are often overlooked, can be more important in analyzing value. Looking back 10 or 20 years ago, value stocks were more easily classified by sector, and tangible assets such as factories, land, and equipment, were an important, and relatively static, measure of value.

"We differentiate between cheap and undervalued, and our strategy brings us to places beyond traditional value sectors."

Don't confuse cheapness with value

Cheap stocks are easy to identify. And in many cases, they are cheap for a reason. In our view, a passive benchmark is not the way to target value in the market. Our strategy is to differentiate between cheap and undervalued. To do this, we assess the equity universe daily — across both growth and value styles. We combine a six-factor quantitative model with classic fundamental research. Defining value in this way keeps us on top of the changing market and brings us to places beyond traditional value sectors.

Concentration in sectors is a significant driver of index performance

Fertile ground: Great finds in what's left behind

Over the past three years, so many stocks have been left behind by investors who were only attracted to a select group of high-multiple growth stocks. Until very recently, it was challenging to find value in those "left behind" names. While some of these businesses are permanently impaired, many others were unfairly punished in the 2018 fourth-quarter downturn. Today, for the first time in a while, we view the equity universe as fertile ground for attractive, undervalued companies.

Across this promising landscape, we look for relative value. This means identifying companies that are attractively valued relative to businesses within the same sector. The most attractively priced technology stock, for example, could be considerably more expensive than most utility stocks. That doesn't preclude it from being an attractive value opportunity, in our view. This is how our portfolio can differ from the benchmark and, ideally, outperform it.

"For the first time in a while, we view the equity universe as fertile ground for attractive, undervalued companies."

Relative value example: Cigna

Cigna's valuation is at its lowest level in almost a decade. And it is a great example of how we differentiate cheap versus undervalued. Shares of this managed care company have declined for a number of reasons. But we believe that short-term challenges have caused investors to underestimate the company's long-term potential.

In 2018, Cigna acquired Express Scripts, a pharmacy benefit management firm. While many investors believed that Cigna overpaid for it, our view is more positive. We believe the deal enhances Cigna's core business, improves the customer experience, and will generate significant additional free cash flow. Investors also shunned Cigna in response to proposals from presidential candidates for a single-payer or "Medicare for all" system in the United States. We believe such a system is not even a remote possibility. In fact, if Medicare expands, which is a more likely outcome in our view, the managed care industry as a whole would benefit.

As of 3/31/19, Cigna represented 1.30% of Putnam Equity Income Fund assets. It was not a holding in Putnam International Value Fund.

Relative value example: Microsoft

Microsoft, one of our top holdings, is an example of relative value. Why is this technology stock, a significant component of growth stock benchmarks, in our portfolio? The reason is relative value — it is attractively valued for what it offers. Microsoft excels in its three core businesses. Most of its peers focus on just one of those businesses, yet those peers trade at much higher multiples.

Microsoft's divisions include its classic Office 365 franchise, a software-as-a-service business that is now offered as a paid subscription. Its cloud-computing business, Azure, has delivered solid revenue growth and is a key competitor in this segment of the market. And Microsoft's video gaming business, best known for Xbox, offers an impressive lineup of gaming platforms.

As of 3/31/19, Microsoft represented 3.31% of Putnam Equity Income Fund assets, and it was not held in Putnam International Value Fund.

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