For professional use only Not all value is true value: the case for quality-value investing • A rise in inflation could prompt a long-awaited resurgence for value stocks • Investors looking to add a value tilt can benefit from a quality-value approach with a focus on dividend 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 speculation 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 yield 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 Investment 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 stock’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 investments 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 position compa- expect a certain margin 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, dividends are traditionally a focus area for value inves- adjusting for inflation. Dividend yield 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 volatility, 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.