It's no secret that value investing has been out of favor. The spotlight has been on megacap tech stocks. But cheap stocks in the ignored value corner of the stock market won't stay cheap forever.
That's the message from Billy Hwan, lead portfolio manager at Parnassus Value Equity (PARWX), a fund with deep roots in sustainability investing.
Hwan runs an opportunistic large-cap value fund. He's not just fishing for stocks with the lowest price-to-earnings ratios. Or the ones down the most. He buys quality stocks when they're beaten up. And he's willing to snap up a member or two of the Magnificent Seven tech stocks when they're temporarily on sale.
Parnassus Value Equity was an IBD Best Mutual Funds winner in 2023. So far this year, it's posted a total return of 2.1%, trailing the S&P 500's 4% gain, according to fund tracker Morningstar. Still, Hwan's fund ranks in the top 26% of funds in its peer group. What's even more impressive, the fund ranks in the top 1 percentile versus its peers in the past 5-, 10- and 15-year periods. That means it has outperformed 99% of its competitors going all the way back to 2009.
IBD caught up with Hwan to get his outlook for the broad market, value stocks, and ESG investing.
IBD: Describe your approach to value investing?
Billy Hwan: In a nutshell, we invest in higher-quality companies trading at discounted prices. As far as quality is concerned, we're looking for companies with relevancy, moats and good management. Those are the pillars of our investment process.
IBD: Expound on those three pillars.
Hwan: Relevancy is looking at a company and making sure that what they're selling or what they're offering to consumers is becoming increasingly relevant over time. The moat is a competitive advantage that helps them sustain above-average profit margins over an extended period. Management is very important, too. We put a lot of trust in the capital allocators. We want to make sure that management has shareholder interests at heart, that they're not making any destructive acquisitions, for example. And that they're doing the right thing for the business. For the value part, we look for price dislocations in the market.
IBD: So, you like to buy good stocks when they go on sale?
Hwan: We get excited when we see the price of a stock fall a lot, because that means something has happened. Usually there's some bad news, such as earnings misses or a product launch that failed. That's an opportunity for us to figure out if the market overreacted. Have they thrown the baby out with the bathwater? The market is efficient. So, most of the time, the market has it right. We're looking for that small minority of cases where the market is wrong, because we have a divergent view and feel we can invest over a longer period (and profit from the rebound). In terms of valuation, a stock should be trading at a discount relative to what we think are the future prospects of that company, and what we think the intrinsic value is.
IBD: You also look beyond traditional value (such as cheap) stocks, right?
Hwan: When people think of traditional value, they're thinking of statistical value, or just buying the bottom of the barrel — bottom fishing — the cheapest price to book (or price-to-earnings, P-E) stocks. A lot of (those type stocks in the Russell 1000 Value index that we track) are energy companies. (But) we don't invest in fossil fuel companies because we're also a sustainable fund.
IBD: The fund owns Microsoft and Alphabet, typically viewed as growth stocks. Explain.
Hwan: We don't veer into the highflying parts of the market as much, especially the stocks that are trading at 30 times price to sales. We think the risk reward is not as attractive. But we do own (some of) the Magnificent Seven names. But we will buy them when they have fallen in price. And we will constantly assess whether the upside is still worth the price that we're paying. We're just more price sensitive.
IBD: Well, Microsoft is certainly a relevant stock. When did you add it to the fund?
Hwan: Value and growth are labels that people find very convenient. But it's very fluid. I added Microsoft to the portfolio in 2021. It's a stock that we've followed for a long time. They have business exposures that we wouldn't be able to get in a traditional value fund: cloud computing, gaming, cybersecurity and now artificial intelligence (AI). The idea is you're looking for things that are going to be more relevant over time. And at the time we bought it, it was trading in the midteens (from a P-E perspective). It's hard to believe, but many of these stocks were trading at discounted valuations because people are not able to kind of imagine the future and see that the prospects of the companies are much greater than they are today.
IBD: How do you avoid buying cheap stocks that are cheap for a reason?
Hwan: I wish I could say we've avoided 100% of value traps. But, of course, that's impossible. What really supports our chances of success is (acknowledging) that investing is all about probabilities. It's important to do due diligence so you can see whether a company has begun gaining share or losing share. Or if they have pricing power. Or what their competitors are doing and who the disrupters are. The benefit to us is we have that quality bias. We also have a longer time horizon so we can (take advantage of lower prices when we think) it's just a one-year blip. Microsoft is a fantastic company that sometimes goes out of favor, like other value companies we own.
IBD: Are there any specific stocks or sectors you think offer value and upside now?
Hwan: That's the million-dollar question. The largest position in our portfolio is Verizon Communications. Talk about an out- of-favor company. It's underperformed for the last couple of years. But I really think going forward, it's a free cash flow story. You have this oligopoly structure with wireless providers and cable companies. Verizon spent an amazing amount of money on 5G upgrades. That's coming to a close. And because of increased capital discipline, and hopefully a stabilizing competitive environment, the company can provide cash support to their dividend, which is already over 6%. They can also pay down debt, which I think really juices the returns. They don't do stock buybacks now, but there's a possibility of buybacks going forward.
IBD: Sounds like Verizon could lose its laggard label.
Hwan: If you put it all together, you could have double-digit investment returns the next three years. The other thing that's happened is as interest rates have increased, dividend payers like Verizon have basically been like the baby thrown out with the bathwater. So, as that reverses and the direction of borrowing costs heads lower, you potentially have a multiyear tailwind.
IBD: How do the different sector weightings in the Russell 1000 Value index impact the fund's asset mix?
Hwan: Financials, for example, are a big part of the value benchmark we track (at around 20% of assets). But I'm bullish on financials, so it's a bigger part of our fund (about 28% of fund assets at the end of 2023).
IBD: What's the bull case for banks and other financials?
Hwan: Essentially, the economy is much stronger than people give it credit for. That's the other thing you're looking for: disconnects (to the market consensus). In October, there was panic about rising yields (after the 10-year Treasury topped 5%). But if you look at the economy's fundamentals, the labor market is strong. The housing market is strong. And earnings growth, which has been stabilizing, has upside potential. So, that speaks to the benefit of investing in financials which are basically macro plays (on the economy).
IBD: What bank stocks do you like?
Hwan: Our biggest financial bet is Bank of America. It's America's second-largest bank to JPMorgan Chase and has over $3 trillion in total assets. I think fears over a recession, about the credit cycle, about higher interest rates, making their (holdings of long-dated bonds) less valuable, we're overblown. I think BofA has opportunities to take out expenses and invest in technology. So, given its high single digit P-E (based on 2023 profits) and a nearly 3% dividend yield, it looks very attractive to us.
IBD: You have an 18% stake in tech, above the 10% index weight. What tech names do you like?
Hwan: Taiwan Semiconductor. It's the world's leading semiconductor foundry (or chip manufacturer). The bull case is simple. They are a major supplier of chips to Apple and Nvidia and a large share of their revenue comes from high-performance chips in the (fast-growing) AI market. On the smartphone side, there's a cyclical recovery. During the pandemic, everybody bought PCs and cellphones. And then there was this massive post-pandemic slump.
IBD: Is AI a growth engine?
Hwan: With AI, Taiwan Semiconductor is not really getting the credit that they should be getting because they manufacture for Nvidia, for Advanced Micro Devices, for all the cloud players, even for Intel. So, there's a cyclical component, and then there's also a secular growth story. The stock is also trading around the Russell 1000 Value market multiple of 17 times earnings, mainly because of geopolitical friction between the U.S. and China. But one (positive) thing that Taiwan Semiconductor is doing is that they're diversifying. They're building fabs (manufacturing plants) in the U.S., Europe and Japan, so it will completely mitigate geographic exposure (risk).
IBD: What's your current market outlook?
Hwan: I see fewer and fewer reasons to be pessimistic. There are a slew of positive factors and a relatively favorable outlook for 2024. It really comes down to two things: the labor market and economic growth. Overall, the labor market remains quite healthy, with an unemployment rate of 3.7%. (It's the 24th straight month the jobless rate has been below 4%, according to the Labor Department.) And don't forget, we have a Fed that's focused not only on inflation, but on the labor market and labor market stability. Full employment is the second part of their mandate.
IBD: There's still debate over whether the Fed can engineer a soft landing, no?
Hwan: I think they've done a remarkable job. I think in the benefit of hindsight, we'll find out that this was an extraordinary feat pulled off by the Fed if we have a soft landing, even if we have no landing. And for economic growth, going into this year, the consensus growth for GDP was 1.2%. That's very low. It would be the lowest expectations in the last six or seven years. Already, we're seeing upward revisions to that. Of course, GDP doesn't translate directly into how stocks do, but the setup is pretty positive.
IBD: Do you expect the "other 493" stocks in the S&P 500 to play catch-up to the Magnificent Seven?
Hwan: My first instinct is yes, but the real answer is yes and no. Yes, because we are at historically unprecedented levels of market concentration. And a lot of times that doesn't end very well as people just buy blindly, ignoring valuation. The market will broaden out eventually because investing is about risk and reward, and about probabilities and the price you pay. You've already seen a little bit of broadening since the fourth quarter of 2023. There will be more broadening as long as the economy stays strong.
Investors will wake up to the facts and ask, "Why would I buy Nvidia, which trades at more than 30 times price to sales, when I get to buy Taiwan Semiconductor for a single-digit price to sales and a below-market P-E?" It's kind of a no brainer. Investors will still make that calculation and remain greedy to find the upside.
IBD: In your fourth quarter report, you said CBRE was a new buy. Do you still like it?
Hwan: Yeah, I still really liked CBRE Group, which is a commercial real estate broker. CBRE is in a very debt intensive business. But CBRE has multiple businesses. But the main one is transaction-based, which has suffered because a higher cost of financing means lower transaction volumes. And then there's their outsourcing business, where they provide maintenance, services and support to landlords. So, it's just a really great business. It's an interest rate play (as rates move lower). We initiated a position when the spike in Treasury yields brought the entire sector to historically low valuations. It's an asset-light business with attractive recurring revenue streams, a strong balance sheet, and it's not dependent on debt financing.
IBD: Any other clean value plays you like?
Hwan: Brookfield Renewable Partners is another interest rate play (and sustainability stock) that was selling at bargain basement valuations because interest rates had really shot up at the end of October. (Brookfield operates one of the world's largest publicly traded platforms for renewable power and decarbonization solutions.) Like CBRE, it is inversely correlated to the cost of financing.
IBD: You often refer to your style as clean value. Can you elaborate?
Hwan: Unlike many value funds that have exposures to carbon intensive industries, we are very cognizant of minimizing our carbon footprint. Relative to our benchmark index, we are 80% less carbon intensive. That's a dramatic difference. There's a lot of investors who like the idea of owning value now because higher interest rates argue for maybe value outperformance after a long stretch of underperformance. But (we also cater to value investors who) don't want to (own) the worst carbon emitters, which are typically energy companies.
IBD: ESG investing has come under attack; do you still think a focus on sustainability adds value?
Hwan: Yeah, I think it does, but it really depends on how you do it. What's different about our process is that we don't just accept what other people say are the ESG leaders and invest in those companies. We do our homework and dig several layers deeper. Are they really an ESG leader? Why or why not? What is the carbon footprint? How has the company behaved over time? You really have to kick the tires. We also look at the company holistically. There's a lot of skepticism that's required to make sure that ESG adds value and helps you kind of see the company for what it really is. ESG gives you that risk management tool.
IBD: Do you see more reward than risk now?
Hwan: You know, usually I'm not that bullish because I'm usually very even keeled. But when you keep looking at the data, (which I interpret as bullish), eventually you have to change your mind. But that said, there's always things that are going to happen that we didn't anticipate. So, a recession is still possible, and if that happens it's bad for everything. Even our stocks will go down and we might go down even more than the market. A recession could happen because of a flare up in geopolitical conflicts. That's something most finance people are not good at modeling. So, we've probably underpriced the risk that world conflict expands, and that'll have knock-on effects on energy prices. And (higher oil prices) will impact our fund (from a return standpoint) because we avoid fossil fuels. So that's something that keeps me up at night.
IBD: What's your message to frustrated value investors?
Hwan: The case for value is essentially a mean reversion argument. Value has been out of favor for so long. And then there's the idea that higher interest rates for longer means that money actually has value again. For the past 15 to 20 years when money was free, that benefited growth stocks and other long-duration assets. Interest rates went up, but then they came down a bit. And if they stay at this level, that's like a normal environment. And that benefits large, established companies in our fund with a long record of profitability who know how to maintain their costs and compete in a competitive environment.
IBD: How might the presidential election impact markets?
Hwan: I think the best thing for markets is a repeat of the last election because we know the candidates, we know their positions, we know their characters. And you know, there shouldn't be any huge surprises. I think the market could still do well under either scenario, and I don't think there's a huge amount of downside regardless of the outcome.
