Value rally continues in first quarter

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Q1 2021 Putnam Large Cap Value Fund Q&A

• The fund outperformed the benchmark for the 1-, 3-, 5-, and 10-year periods ended March 31, 2021.
• Despite their recent outperformance, value stocks continue to trade at a significant discount to growth stocks.
• Over the next 12 months, we believe we should see assets flowing into the economy due to a burst of spending from both businesses and consumers.

How has the fund performed?

Darren: For the first quarter, the fund slightly underperformed its Russell 1000 Value benchmark. From a longer-term perspective, the fund outperformed the benchmark for the 1-, 3-, 5-, and 10-year periods ended March 31, 2021.

Value stocks have outperformed growth stocks for several months. What are the drivers of this market rotation?

Darren: A key development that sparked the value rally was the announcement last November of impressive efficacy results in Covid-19 vaccine trials. At the same time, valuation spreads in the market — the difference between the cheapest and most expensive stocks — had reached historic wide levels. This set the market up for the rotation into value stocks that has continued into 2021. The rally was boosted further by the rollout of three effective Covid-19 vaccines, optimism about the reopening of economies, and significant government stimulus, including a $2.3 trillion infrastructure plan announced at the close of the quarter.

Do you believe the value rally is sustainable?

Lauren: We believe we’re still in the early innings of the rally for a number of reasons. First, despite their outperformance since last September, value stocks continue to trade at a 40% discount to growth. This is a significantly wider gap than we’ve seen historically. Also, once these style rotations occur, the cycles tend to last for several years. Value has lagged growth for about a decade, so we believe value stocks are likely to fare well over the course of 2021.

Also worth noting are the very strong consumer balance sheets. That is, households across a range of income levels have built up significant savings. Throughout 2020, there were very few opportunities for consumers to spend money. Today, total savings equal approximately 65% of U.S. GDP, which is higher than the pre-pandemic level and significantly higher than it was following the global financial crisis. As vaccine distribution accelerates along with the pent-up demand for “normal” activities, we should see consumer spending accelerate as well.

Darren: For businesses, inventory levels are at historic lows across many industries, and companies that had been reluctant to pursue capital expenditure plans are now moving forward with them. Over the next 12 months, we believe we should see assets flowing into the economy due to a burst of spending from both businesses and consumers. This broadening macroeconomic growth is one of the most important ingredients for a sustained value rally.

Inflation expectations rose in the first quarter. What does this mean for value stocks?

Darren: We are seeing two other key ingredients for a prolonged value rally — modest inflation and modestly higher interest rates. During the first quarter, the yield on the 10-year Treasury note reached its highest level in more than a year. Industries that are most correlated to rising bond yields — banking, commodities, industrials — make up the bulk of the value benchmark. Stocks in these cyclically sensitive sectors tend to perform well with higher inflation. For many growth sectors, on the other hand, inflation can be a significant headwind. Spending and demand are starting to increase, and the Federal Reserve has indicated that it will keep its easy monetary policy in place despite rising inflation expectations. This environment is another reason we believe value can take a meaningful lead over growth.

With these changing conditions, how are you positioning the portfolio?

Lauren: Over the past 12 months, we have been able to take advantage of significant dislocations in the market. In the challenging markets of 2020, we focused on companies that we believed were being unfairly punished. As a result, we were able to add many fundamentally strong companies to the portfolio at attractive prices. In addition, we have been carefully monitoring holdings that have outperformed significantly, in areas like the technology sector. We are proceeding with caution toward any stocks with price-to-earnings multiples that we believe are too high, and we are selling or trimming those that we believe have become too expensive.

When stocks sold off sharply at the start of the pandemic, then later rallied through the remainder of 2020, and as the sector rotation continues today, our relative value approach has not changed. Our goal, as always, is to prepare the fund for a range of scenarios with a balanced structure for the portfolio. We plan to maintain a mix of cyclical and defensive holdings, investing in our best ideas with a focus on the fundamentals of the businesses.