Mid-cap value, the quiet outperformer: Alcoa versus Starwood Hotels
Unlike large caps, mid caps see value outperforming growth post-crisis
The below graph reflects the outperformance of mid-cap value shares relative to mid-cap growth shares since the 2008 crisis, with a more pronounced 10% outperformance since 2013. While value tends to outperform growth in the long run anyway, it’s important to note that, over the past year, investors in the mid cap space, unlike the large cap space, have placed greater relative value on many mid cap value shares that may have taken an undue drubbing in the 2008 crisis, and they’re once again receiving enhanced revaluation. This article considers mid cap value versus growth shares in the context of softening consumption data.
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For a detailed analysis of the U.S. macroeconomic environment supporting this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
Alcoa can’t wait (but definitely has to)
Morningstar holds Alcoa (AA) at number 13 in its top holdings as 0.97% of its portfolio. With a $12.68 billion market cap, a -9.92% profit margin, a 19.97 forward 2015 price-earnings ratio, a 1.0% dividend yield, and a modest 1.21 price-to-book value ratio, Alcoa is very much mid-cap value material. International competition has definitely hit Alcoa’s margins post-2007, though it’s possible that Alcoa has made progress in turning around.
During the past year, Alcoa’s shares have risen nearly 40%, while mid cap growth high-flyer Starwood Hotels (HOT) has risen closer to 25%. From March 2000, Alcoa is still down nearly 70%, while Starwood is up nearly 60%. It would seem that investors may be playing a rotation into value shares such as Alcoa versus recovered growth shares such as Starwood.
Alcoa has a long way to go in terms of recovering to its pre-crisis levels. However, if consumption data continues to soften, it’s possible that Alcoa may hold up better than Starwood and other more richly valued growth shares in weakening equity markets.
Starwood Hotels & Resorts Worldwide: Fully booked
The Morningstar mid cap growth index holds Starwood Hotels & Resorts as number six in its holdings, at 1.08% of the portfolio. With a market cap of $15.09 billion, a forward price-earnings ratio 2015 of 24.21, a price-to-book ratio of 4.47, a profit margin of 18.15%, and a five-year average dividend yield of 1.20%, Starwood is clearly a much more richly valued growth company compared to Alcoa. With a 17.37% return on equity versus Alcoa’s -14.95% return on equity for 2013, it’s easy to see why Starwood has been such a strong performing stock, and why Alcoa has been a laggard. While past performance is one issue, it’s possible that value laggards such as Alcoa may finally exhibit some revaluation as future expectations for improved earnings strengthen.
To see how the declining federal budget deficit supports equity markets, please see the next article in this series.
Equity outlook: Cautious on China’s rate collapse and Russia
Tensions in Ukraine have led to a 20% sudden drop in the Russian stock market. China’s Shanghai composite index is also down 20% from its 12-month peak. The VIX volatility index in the USA has risen from its 15% lows earlier in the year to near 17.0% currently. This is still a fairly low level of volatility in the U.S. markets, as VIX volatility is quite normally within the 12%-to-20% annual volatility range. However, it should be clear that the volatility in the U.S. markets is driven by the tensions in Ukraine and evidence of some deterioration and oversupply in China.
In China, recent announcements of the bankruptcies of Chaori Solar and a trust investment portfolio loan of $500 million to Shanxi Energy raised concerns that China’s shadow banking system is coming under increased pressure. With China’s ICBC bank letting Trust product investors take the losses on this 10.% coal company loan, it might appear the speculatively inclined Chinese investor on the mainland is getting a lesson in credit risk—just as Chinese investors in Hong Kong did in 2008, when they invested in Lehman Brothers–structured investment products. This should keep the speculative investment climate a bit cooler in China.
China’s short-term interest rates plummet
While the allowed defaults in China should cool speculative investing, the China Central Bank has also been careful with interest rates in order to rein in speculative lending. The summer of last year saw the seven-day benchmark lending rate spike over 10.0%, with a run to near 9.0% at the end of 2013. Currently, the seven-day repo rate is at 2.50%. With the specter of shadow banking default looming in China, the Central Bank, since the beginning of 2014, has ensured ultra-low interest rates. Cautious investors could see this as a somewhat extreme level of credit market facilitation on behalf of the China Central Bank, suggesting that the Central Bank may be quite nervous about potential credit market contagion.
Given China- and Russia-related uncertainties, investors may wish to consider limiting excessive exposure to broad equity markets, as reflected in the iShares Russell 2000 Index (IWM), State Street Global Advisors S&P 500 SPDR (SPY), Dow Jones SPDR (DIA), and iShares S&P 500 (IVV). Accordingly, investors may wish to consider shifting equity exposure to more defensive consumer staples–related shares, as reflected in the iShares Russell 1000 Value Index (IWD).
Equity outlook: Constructive
Despite problems in Ukraine and China, and despite modest consumption data in the USA, U.S. labor markets appear to be well into recovery—with the exception of the long-term unemployed. From this perspective, it would appear that the U.S. is probably the most attractive major investment market at the moment. While the fixed investment environment of the U.S. is still quite poor, corporate profits and household net worth have hit record levels. Hopefully, all of this wealth and liquidity can find their way into a new wave of profitable investment opportunities and significantly augment improvement in the current economic recovery.
For investors who see a virtuous cycle of employment, consumption, and investment in the works, the continued outperformance of growth stocks over value stocks could remain the prevailing trend, favoring the iShares Russell 1000 Growth Index (IWF) and growth-oriented companies such as Google (GOOG) or Apple (AAPL).