An Inefficient Market: Finding Mispriced Opportunities
By TRG Advisors on March 24, 2022
Winning by Not Losing
The goal for a portfolio manager is to generate long-term outperformance versus the benchmark. Alpha represents returns in excess of a portfolio’s risk-based (beta-adjusted) expected return. Beta represents a portfolio’s exposure to systematic market risk. During periods of elevated market volatility (or increased systematic risk), alpha sometimes produces excess returns in the form of “winning by not losing.” Our portfolio management strategy focuses heavily on quality and valuations because it positions our portfolios to optimize risk/reward characteristics in the current environment.
Year-to-date, the Russell 1000 Value Index has returned (1.0%), while the Russell 1000 Growth Index has returned (10.1%). While both indices are negative, this variation in performance illustrates the importance of diversifying risk and generating alpha: “winning by not losing.” We advocate for, and maintain, a barbell approach toward portfolio management, seeking to achieve success through diversification – ideally allowing investors to capture outperformance amid volatility and during a bounceback.
In contrast to year-to-date performance figures, over the past five days the Russell 1000 Value Index has returned +4.1% and the Russell 1000 Growth Index has returned +8.4%. Maintaining a barbell positions our portfolio to capture opportunities across sectors where securities are mispriced, avoiding downside risk and generating upside capture.
While the Volatility Index (VIX) has fallen below its 50-day moving average and equities have rallied over recent days, significant economic tail risk still exists. The yield curve continues to flatten with an increasingly hawkish Fed, widespread inflation and plenty of geopolitical uncertainty. The recent equity appreciation in the market may reflect heightened risk being sufficiently priced in and greater clarity on the Fed’s path forward or may be the beginning of a mean reversion across value/growth.
Cheap vs. Mispriced
Before diving into where opportunities may be present, it’s important to consider which stocks are cheap and likely to stay cheap versus which stocks are mispriced and attractive. We maintain an emphasis on quality because prices tend to follow profits, and profitable companies that can generate growth and free cash flow are more likely to outperform during slowdowns or periods of contraction. Companies without profits that are valued at extended multiples – based on sales or pure expectations – are at an increased risk when discount rates rise alongside higher risk-free market rates.
Case in point: Of the 158 companies within the Russell 1000 Index that have negative earnings over the past 12 months, 65% are underperforming the index and the average performance is (14.6%). Companies that are swept up in the market sell-off and incur multiple contractions, despite more limited exposure to overall long-term market risk, may present a buying opportunity at a discounted value. The distinction between what’s cheap and what’s mispriced is critical. In the current environment, we closely analyze balance sheet quality, pricing power, demand strength and management strategy for further indication that a company may be mispriced.
Mispriced Opportunities by Sector
We looked into earnings growth expectations and associated multiples contraction among the S&P 500 GICS sectors. As of March 18th (Friday), the top three sectors with the greatest expected EPS % growth in 2022 are energy, industrials and consumer discretionary. In 2021, these sectors maintained three of the top four spots in terms of aggregate EPS growth (the materials sector generated the #3 greatest EPS % growth in 2021). Following record-high levels of earnings growth in 2021, many analysts expect that these sectors in particular will continue that momentum in 2022.
From a valuation perspective, consumer discretionary has experienced the most significant P/E and P/B contractions. Industrials have experienced the second-most significant P/E contraction, while technology has experienced the third-most significant P/E contraction and second-most P/B contraction. It’s interesting to note that technology is also anticipated to have the fourth-greatest EPS % growth in the current year.
2022 EPS % growth for the index remains elevated, now at 9.2% – greater than seven of the last 10 years. Multiple contraction has been widespread. We’re looking for opportunities in names that are positioned to maintain profit growth, priced at attractive valuations and with quality characteristics.
One measure to indicate quality, profitability and growth opportunity is free cash flow (FCF). Real Estate maintains the greatest expected y/y % change in FCF yield, followed by consumer discretionary and technology.
Table 1: S&P 500 Expected Earnings Growth and Associated Statistics by Sector1
Themes Among Opportunities
Underneath each sector, we search for themes that either indicate stocks as cheap or mispriced. Consumer discretionary, for example, includes themes like strong pricing power from pent-up demand and reopening and tailwinds from improved supply chains. That said, it also includes a considerable group of non-earners and companies that no longer benefit from stay-at-home trends. Technology tends to include growth companies with extended valuations, and opportunities exist for high quality, demandinelastic technology names that have been caught-up with the lower quality sell-off in the sector. Lastly, industrials are expected to benefit from travel, reopening and infrastructure demand, while some are overly exposed to supply and labor cost headwinds and deteriorating margins.
By incorporating a barbell and top-down approach, investors can diversify risk while allocating to high conviction names that are mispriced in the market. We continue to look for mispriced companies within the sectors that maintain market leadership and are set to benefit from key themes in the current market that we believe will generate long-term outperformance.