For professional use only Not all is true value: the case for quality-value investing

• A rise in inflation could prompt a -awaited resurgence for value • looking to add a value tilt can benefit from a quality-value approach with a focus on sustainability • Stringent ESG integration and an adaptive approach can help value investors navigate turbulence and beat the market

www.nnip.com Not all value is true value: the case for quality-value investing

Inflation-related has reached fever pitch in recent weeks. Signs of rising consumer prices are leading equity investors to abandon the growth stocks that have outperformed for more than a decade, and to look instead to the long-unloved value sectors that would benefit from rising inflation. How can investors interested in incorporating a value tilt in their portfolios best take advantage of this opportunity? We explain why we believe a quality-value approach, with a focus on long-term stability, adaptiveness and ESG integration, is the way to go.

Value sectors have by and large underperformed since the continue delivering hefty fiscal support. In particular, 10-year Great Financial Crisis. There are several reasons for this. bond yields – a common market indicator that inflation might be Central banks have taken to using unconventional tools that about to increase – have been steadily climbing over the past distorted the curve, such as quantitative easing, which few months (see Figure 1). has led many investors to pay significant premiums for growth stocks. All-time-low interest rates and the absence of inflation- ary pressures have exacerbated this trend. Speculation about Figure 1: 10-year bond yields the “death of value” gathered steam during the height of the 3 Covid-19 crisis as growth sectors such as big tech massively 2 outperformed, bolstered by the acceleration of long-term trends 1 such as working from home and the rise of digital consumerism. 0

Today, with the vaccine roll-out in full swing and governments -1 pulling out all the stops to deliver fiscal stimulus, hopes of a -2 Jan-20 Mar-20 May-20 Jul-20 Sep-20 Nov-20 Jan-21 Mar-21 value revival are on the rise again. Recent data and central bank US 10YR Yield EU 10YR Yield commentary also suggest a potential sustained rise in inflation, Source: Bloomberg, NN Partners particularly if governments follow through on their promises to

Not all value is true value: the case for quality-value investing 2 Figure 2: History of growth-value cycles

MSCI World Value Net/MSCI World Growth Net 3.0

2000-2007 Value Cycle (80% outperformance) 2.5

1975-1994 Value Cycle 2.0 (90% outperformance)

1.5

1994-2000 Growth Cycle (30% underperformance) 2007-2020 Growth Cycle 1.0 (60% underperformance)

0.5 1974 1976 1978 1980 1981 1983 1985 1987 1988 1990 1992 1994 1995 1997 1999 2001 2002 2004 2006 2008 2009 2011 2013 2015 2016 2018 2020

Source: NN Investment Partners

The positive vaccine data last November and the recovery Why inflation favours value stocks hopes since then have already noticeably boosted the perfor- There are two main reasons why inflation appears to favour mance of value sectors, but this has gone only a small way value stocks. The first is the traditional narrative of supply towards making up for their long period of underperformance. and demand: inflation occurs when demand exceeds As Figure 2 shows, growth-value cycles historically last for supply. At that point, growth is freely available, so demand several years. If we are indeed at the beginning of a value cycle, for growth stocks decreases. At the same time, demand there is a great deal of catching-up still to come. is high for the traditional business sectors that typically comprise value stocks. In this environment, investors seeking to add a value tilt to their portfolios may well be wondering which flavour of value will The second explanation comes from financial theory. Most best achieve their investment objectives and deliver sustained of a growth ’s value comes from the company’s termi- long-term returns. This article explains our approach to value nal value. When valuing companies using a discounted cash investing and why we believe quality-value is the way to go. flow (DCF) model, all its future cash flows are added up It shows how we identify high-quality companies and how we over time and discounted back to today’s value. The value manage risks and overcome our own biases. It also details of these cash flows depends largely on how inflation and how our commitment to integrating environmental, social and interest rates are projected to evolve. If interest rates and governance (ESG) factors and staying adaptable has helped our inflation are set to stagnate or decrease, that pushes up European Dividend strategies to deliver results over more than a the value of these future cash flows and the present value decade of value underperformance1. of growth stocks. Conversely, if inflation and interest rates are expected to rise, the future cash flows are worth less, Our approach to value investing creating a more supportive environment for value stocks. At its core, value investing is about going against the crowd. In this case, the “crowd” refers to growth-focused investors, who seek out companies positioned for expansion, perhaps because they are investing heavily in R&D or because they have a prod- uct in their pipeline that could propel them past the competition. Such companies often have share prices that appear excessive when viewed through the lens of price-to-book or price-to-earn- ings ratios. Investors flock to these companies because they are attracted to the potential high returns, despite the apparent risk; these therefore require significant confidence in future expectations.

1 Our European Dividend strategies come in two flavours: NN (L) European High Dividend targets the pan-European universe, while NN (L) Euro High Dividend focuses on Eurozone equities.

NN Investment Partners 3 The key to value investing, however, lies in contrarianism: We invest only in dividend-paying companies, which are gener- seeking out under-loved stocks with an intrinsic value that ally among the higher-quality companies in the value universe. isn’t reflected in their share price. Value investors who do their We believe that a stable dividend is indicative of capital disci- fundamental homework on a company should theoretically pline and strong governance: both traits that compa- expect a certain of safety relative to the purchase price. nies for long-term success. We look closely at dividend growth The expected return should be reasonable but not stellar. and yield, historically the primary sources of total equity return. Taking the European equity market as an example, investors As well as metrics like price-to-book and price-to-earnings can expect a real return of around 4%-5% per annum before ratios, are traditionally a focus area for value inves- adjusting for inflation. and dividend growth tors, particularly those investing for long-term stability. Dividend contribute around two-thirds of this, which underlines their payments are typically more stable than underlying earnings, as importance. companies will often go to great lengths to avoid the embar- rassment of a dividend cut. As a result, dividend-paying stocks Dividend sustainability is just as important as dividend yield – if typically exhibit lower , which offers downside protec- not more so. An overly high dividend yield can indicate a share tion in falling markets (see Figure 3). Further, risk-averse inves- price that is under pressure, suggesting the market is anticipat- tors often prefer to accept a regular small income stream now, ing a dividend cut. To properly assess dividend sustainability, while awaiting a capital gain, instead of gambling on the chance we look even more closely at factors such as balance sheet of a larger capital gain in the future. strength, free cash flow and return on equity, further increasing our emphasis on quality-value.

Figure 3: Sustainable dividends improve risk- As well as our dividend focus, our commitment to ESG integra- adjusted returns tion and adaptability are core components of our European 5% Dividend strategies. We credit much of our resilience during the 3.85% 4% 3.80% past 12 years to these key pillars of our approach, which enable 3% Hit Ratio us to stay true to style without sacrificing performance during 2% 62% turbulent times. The below sections explain why we believe 1% stringent integration of ESG factors and an adaptive approach 0% can make all the difference in a value investing portfolio, and -1% how they support us in avoiding value traps and countering our

-2% Hit Ratio own biases.

-3% 46%

-4% -3.76% ESG integration: strengthening risk-adjusted returns -4.22% -5% Environmental, social and governance analysis is a crucial NN (L) Euro High Dividend - B MSCI EMU (NR) component of our quality-value approach to value investing, Monthly gross return data for NN (L) Euro High Dividend as it helps us identify companies that are truly positioned for (April 1999 (inception) to end December 2020) versus MSCI the long term. Stringent ESG assessment helps us understand EMU (NR) Index. Source: NN IP Performance Measurement. the material risks to1 which individual companies are exposed Benchmark: MSCI EMU (NR). and how they manage this exposure. In turn, we can gain deep insights into a company’s potential long-term economic Returns are presented after all transaction costs, but before Ongoing success, and limit the risk of investing in value traps, thereby Charges (consisting of Management Fee + Fixed Service Fee + Tax strengthening the risk/return characteristics of our portfolios. d’abonnement). Returns include the reinvestment of income. Fund was launched in April 1999. Past performance is no guarantee of future results For us, ESG integration isn’t a simplified bolt-on process. We and the possibility of loss does exist. The Ongoing Charges vary per take a bottom-up approach that incorporates ESG considera- share class – please refer to the share classes’ Key Information tions into the valuation framework for each company, directly Document. Hit ratios refer to the number of outperformance months divided impacting our stock rating and price target. In some cases by total positive return months (46%) and number of outperformance this is relatively straightforward. When modelling companies months divided by total negative return months (62%). Hence, our strategy involved in relatively carbon-intensive businesses, we estimate shows lower volatility and benefits from a cushioning effect in falling the increasing costs of emission compliance in operational and markets. capital expenditure assumptions, including those relating to future carbon credit or permit pricing. This isn’t always a nega- tive cost. Companies that are ESG “leaders” can reasonably be Within our own strategies with a value tilt – Euro High Dividend expected to expand their market shares as a result of the push and European High Dividend – we take a nuanced approach towards emissions reduction. This could give them a competi- and do not simply select equities with the lowest price-to-book tive edge in providing solutions to customers who also need to value, as a pure value investor might do. We focus on quality- meet higher ESG standards. value: seeking out high-quality companies within the value universe. We look for companies with strong balance sheets Throughout this process, we rigorously assess the ways in which that can generate sufficient returns to cover the cost of capital all three ‘E’, ‘S’, and ‘G’ factors might impact a firm’s financial and also return cash to shareholders. performance, and we capture this in our valuation models. We benefit from this in two key ways.

Not all value is true value: the case for quality-value investing 4 First, our stringent approach to ESG integration helps us avoid Figure 4: NN (L) Euro High Dividend annualized perfor- unintended risk on a company level. A traditional approach that mance versus the benchmark3 relies only on financial analysis might miss risks accruing from a poor track record in labour relations, environmental standards, 14 or misalignment between minority and controlling sharehold- 12 ers. Careful and consistent ESG integration ensures that the valuation model and target price for the stock reflect all of 10 these risks. 8

Second, a value approach can push investors towards a bias 6 for “cheap” sectors. This opens the door to so-called value traps: companies that are cheap for good reason and that will 4 continue to underperform the market, owing to long-term chal- 2 lenges or potential disruption stemming from ESG risks. 0 1 year 3 years 5 years Since inception The energy sector is a clear example. For some time, oil and gas stocks have appeared attractive as measured by multiples Portfolio return Benchmark return Relative return or fundamentals, but these do not tell the whole story. Oil and Source: NN IP Performance Measurement. Benchmark: MSCI gas firms will face significant costs from energy transition and EMU (NR). the required investment in renewables that is consistent with global and European climate targets. By conducting a thorough Returns are presented after all transaction costs, but before Ongoing ESG analysis of the sector, we can estimate these costs at a Charges (consisting of Management Fee + Fixed Service Fee + Tax company level and compare them with the company’s stated d’abonnement). Returns include the reinvestment of income. Fund was goals and targets, which is generally where market consensus is launched in April 1999. Past performance is no guarantee of future results based. Analysing these costs using a valuation model demon- and the possibility of loss does exist. The Ongoing Charges vary per strates that market prices do not necessarily reflect “fair value” share class – please refer to the share classes’ Key Investor Information for these businesses. Nor does a more conventional valuation Document. based on earnings multiples, dividend yields or a traditional approach to discounted cash flows. One key example of our adaptable approach is how we have By consistently and stringently integrating ESG factors into learned to counter our own behavioural biases. As value our investment process and actively reducing exposure to investors we are no strangers to the concept of exploiting the companies with high levels of ESG risk, we can offer a better behavioural biases of others, but we are also prone to biases of risk/return ratio than most of our value/dividend peers. Our our own: expectations of , overconfidence (the norms-based approach for exclusion, engagement and voting, investor is right, the market is wrong), loss aversion, to name a combined with the qualitative assessment of relevant ESG risks few. We assessed more than 10 years of portfolio trading history and their potential financial impact, reduces drawdown risk to identify the behavioural biases of our portfolio managers, for our European Dividend strategies. We further monitor ESG who have been managing the portfolios for many years – in the risks at portfolio level using NN IP’s proprietary ESG Lens, which case of lead PM Nicolas Simar, for over two decades. provides another layer of risk management that limits unin- tended ESG risks2. One of our findings was that we have generated positive returns by buying low-volatility stocks with negative price momen- Adaptability: the key to resilience tum. In other words, the fund managers are skilled at spotting Even during extremely long periods when the style cycle turned good-quality companies that have underperformed to such a against our strategies, we have stayed true to the quality-value degree that their valuations are now highly compelling and may style our funds are known for. We are committed to provid- mean-revert. That’s quite a useful attribute for a value inves- ing investors with the exposure they have chosen to allocate tor! However, we also found that we lost money buying higher- to, rather than deviating too far to chase performance. Still, volatility stocks that were showing positive price . this does not mean that we have simply endured long-lasting In other words, when higher- names start to steam ahead, headwinds without making any alterations to our approach. On we were too often tempted to jump aboard (exhibiting “herd- the contrary, we take an adaptive approach and incorporate ing” behaviour) just before the move ran out of momentum. new tools in the investment process that can help us weather Having become aware of this bias, we can ensure that we take challenging periods. The results speak for themselves. Figure a second look before buying stocks that match this profile, and 4 shows the relative outperformance of our NN (L) Euro High either forgo the trade altogether or take a smaller position to Dividend fund, even in the face of the value headwinds of reduce the risk. recent years.

2 To learn more about the ESG Lens and how we apply it, see the ESG Lens document on our RI policies page. 3 NN (L) Euro High Dividend (P Cap, EUR), gross of fees. Data as of 28 February 2021.

NN Investment Partners 5 Figure 5: Our investment process

Eurozone / European listed universe approx. 4000 names Liquidity Screen Exclusion based on Market Cap. & average daily turnover 400-500 names

Step I Dividend Screen Median dividend yield threshold per sector Dividend Factor 200-250 names

Step II – Identification of potential Initial Selection stocks 150-200 names

Step II Fundamental Analysis – Deep dive analysis, including Deep Dive ESG risk assessment 50-75 names Step III & IV Portfolio Construction & Fixed model weights & contrarian rebalancing Risk Control Avoid unintended macro risks 30-60 names

Source: NN Investment Partners

By incorporating adaptive elements like these into our invest- ment process, we can strengthen risk-adjusted returns while staying true to style. This approach has served us well during Case study: Aperam the downturns and headwinds of the past 12 years, and if a The stock passes the first, more systematic, stages of our genuine sector rotation does materialize, it will also enable us to process quite easily, being sufficiently liquid and having take full advantage of the opportunities that arise. a dividend yield that exceeds the sector median. It may seem counter-intuitive that a steel company aligns with our How we put our quality-value approach into action ESG-integrated methodology, but our analysis shows that Identifying companies that meet our rigorous standards is no Aperam is a leading environmental innovator in its sector. It easy task. We use a combination of a quantitative dividend is the only global stainless-steel producer to use charcoal screen and fundamental research to find the right balance sourced from its own plantations in its furnaces. When between yield and valuation. Our active approach helps us combined with a high percentage of recycled scrap steel, separate dividend cuts from steady compounders, thereby this means that Aperam has the smallest CO2 footprint in avoiding unintended macro risks. Figure 5 shows the intricacy of the stainless industry, 50% smaller than its peers’. our multi-step process. Acquiring carbon certificates will be a major input cost for Our investment process is best illustrated via a case study of European steel producers in the future; Aperam’s lower one of our holdings: Aperam, a steel company in the materi- emissions will be reflected in lower certificate costs for the als sector.4 company. Our financial valuation model incorporates both the costs of acquiring the certificates and the increased Our in-depth selection process takes a great deal of time and capex needs to further modernize production and reduce effort, but it provides us with confidence that we are investing emissions. These additional costs reduce our estimated in truly high-quality companies within the value universe. This is value for the company, but by a much smaller degree than borne out by the results. Our quality-value approach has served for its competitors. This provides us with the necessary us well in both up and down markets, allowing us to counter confidence that we have considered the key ESG factors the trend of underperformance for value stocks over the past that will affect the company’s future, and that we are decade-plus. And if a long-lasting sector rotation does arise, the investing in a company that is at the leading edge of envi- high-quality companies in our portfolios are positioned to take ronmental progress in steel production. full advantage of it. - Matthew Huston, Senior Investment Analyst

4 For illustration purposes only. Company name, explanation and arguments are given as an example and do not represent any recommendation to buy, hold or sell the stock. The may be/have been removed from portfolio at any time without any pre-notice.

Not all value is true value: the case for quality-value investing 6 Authors

Nicolas Simar Robert Davis Head of Senior Portfolio Manager

Disclaimer This communication is intended for MiFID professional investors only. This communication has been prepared solely for the purpose of infor- mation and does not constitute an offer, in particular a prospectus or any invitation to treat, buy or sell any security or to participate in any or the provision of investment services or investment research. While particular attention has been paid to the contents of this communication, no guarantee, warranty or representation, express or implied, is given to the accuracy, correctness or completeness thereof. Any information given in this communication may be subject to change or update without notice. Neither NN Investment Partners B.V., NN Investment Partners Holdings N.V. nor any other company or unit belonging to the NN Group, nor any of its directors or employees can be held directly or indirectly liable or responsible with respect to this communication. Use of the information contained in this communica- tion is at your own risk. This communication and information contained herein must not be copied, reproduced, distributed or passed to any person other than the recipient without NN Investment Partners B.V.’s prior written consent. NN (L) Euro High Dividend and NN (L) European High Dividend are sub-funds of NN (L)*, established in Luxembourg. NN (L)* is duly authorised by the Commission de Surveillance du Secteur Financier (CSSF) in Luxembourg. Both the fund and sub-fund are registered with the CSSF. The prospectus and the Key Investor Information Document (KIID) (if applicable) and other legally required documents relating to the fund are available on www.nnip.com. Investment sustains risk. Please note that the value of any investment may rise or fall and that past performance is not indicative of future results and should in no event be deemed as such. This communication is not directed at and must not be acted upon by US Persons as defined in Rule 902 of Regulation S of the United States Securities Act of 1933, and is not intended and may not be used to solicit sales of investments or subscription of securities in countries where this is prohibited by the relevant authorities or legislation. Any claims arising out of or in connection with the terms and conditions of this disclaimer are governed by Dutch law.