Why Value Stocks are About to Outperform
The bulk of stock market gains since last October are due to large price increases from a handful of large-cap, tech-focused stocks.
But growth stocks like that have had their time in the sun.
Let’s look at why value stocks could outperform in the future…
According to Investopedia, growth stocks are shares of companies that have the potential to outperform the overall market over time because of their future potential. In an upmarket, investors seem willing to pay any price to participate in the growth, which can produce rapid share price appreciation.
Value stocks are shares of companies that are currently trading below what they are really worth, and will thus provide a superior return. Value stock investors use fundamental analysis to determine a “fair value” for individual stocks. These stocks typically pay dividends with attractive yields. Value stock investing requires patience; it works best when it seems that no one else is buying this type of stock.
Market wags, coined by a Bank of America analyst to describe analysts, are calling the top-performing, large-cap tech stocks the Magnificent Seven. The stocks are Apple Inc. (AAPL), Microsoft Corp. (MSFT), Amazon.com Inc. (AMZN), NVIDIA Corp. (NVDA), Alphabet Inc. (GOOGL), Meta Platforms Inc. (META), and Tesla Inc. (TSLA). Year to date, through September 5, these seven stocks posted an average return of 102%. The S&P 500 is up 17.7%.
The S&P 500 is a market-cap-weighted index. The seven listed stocks are very large and account for 27% of the index’s market cap. This is fuzzy math, but if you multiply 102% by 27%, you get 27.5%. That result tells me the remainder of the S&P 500 has, on average, posted a negative return for the year.
Another clue is that the SPDR Portfolio S&P 500 Value ETF (SPYV) is up 10.7% for the year. The top three holdings of this ETF are MSFT, AMZN, and META, so this fund also benefited from the Magnificent Seven effect.
Throwing out the large-cap stocks, the Vanguard Mid-Cap Value Index Fund ETF Shares (VOE) is up just 1.1% for the year.
What would cause a rotation out of the large-cap growth stocks into value stocks? I think professional money managers will lead the shift. They must harvest profits from those 100%-plus gains to balance their portfolios. Some will go into value stocks as money rotates out of the Magnificent Seven. Buying will increase stock prices, leading to more buying, and soon, we will have a value stock bandwagon.I don’t know when value stocks will start a meaningful move, but it has been two years since there was a meaningful really for undervalued stocks. To my subscribers, I recommend the InfraCap Equity Income Fund ETF (ICAP) to get a great current yield from a value-focused fund manager.
ASML Holding
- Market value: $263.4 billion
- Dividend yield: 1.2%
ASML Holding (ASML, $669.56) dominates the world of semiconductor manufacturing equipment and at the same time, it doesn’t. The company has a small share of the global semiconductor manufacturing equipment. However, it has the lion’s share of so-called EUV semiconductor manufacturing equipment, which uses 13.5 nanometer wavelengths to produce chips with as little as 3 nanometers between transistors. A nanometer is one-billionth of a meter.
Without the chips ASML equipment makes, Apple could not make iPhones. And with new demand anticipated for accelerator graphics processing chips to fuel AI applications, speculation is high that the company can maintain its monopoly stock status in an accelerating market.
With nearly $8 billion in EUV sales and global market estimates of $9 billion, ASML owns about 90% of the market.
Dominance is not the only ingredient required to maintain, well, dominance. Remember Sears? Facile management, marketing, financial strength and performance play a critical role.
In terms of performance, ASML’s results have been unimpeachable. For the five years ending 2022, the company grew revenues approximately 19% on average annually, from $9.8 billion to just over $23 billion. Over the same period, net income per share grew from $5.27 to $15.54, or about 24% annually.
All this was before the specter of AI. Analysts are now bullish, forecasting sales and earnings per share of $29.7 billion and $21.29, respectively, for 2023, both estimates above historical year-over-year growth rates.
But change is expensive, and prudent investors might evaluate whether or not ASML has the financial chops to weather the changes brought on by AI and electric vehicles and 5G and any other world-changing initials.
The short answer is yes, ASML is financially strong. Here are some of the signposts. The company is unlevered, with shareholder equity more than twice its long-term debt. The current portion of long-term debt, $560 million, is just a fraction of the $8 billion of cash on hand. Debt levels and liquidity are important because as the company maneuvers to capitalize on changes in the chip market, it’s not hamstrung by fixed interest payments, or loan covenants that could restrict its flexibility.
Cash from operations, about $8.5 billion, easily funds ASML’s capital expenditures of $1.4 billion. However, the company has a strong commitment to research and development – and investors should appreciate this. In 2022, it spent $3.2 billion on R&D, up more than $1 billion from 2020. Moreover, the company disclosed that it anticipates ramping up R&D to almost $5 billion by 2025.
While capital expenditures and R&D are comfortably covered by cash flow from operations, things do get tight. Specifically, add to these uses of cash $2.7 billion in dividends and $7.3 billion in stock buybacks in 2022. And this is again why the company’s modest borrowing matters. ASML has access to debt capital for continued R&D, capital spending, share repurchases and dividend payments should market conditions or its financial performance deteriorate.
While all of this is going on, the semiconductor stock yields about $7.44 in dividends or just over 1%. While the yield is meh, ASML is a dividend grower, increasing its payout an average of 33% annually since 2017. Notably, ASML is a Dutch company so those dividends get taxed, likely at 15%, right off the top. Also, as its financial performance is reported in euros, the dollar figures here were all converted at a rate of $1.10 to the euro.
Apple
- Market value: $2.93 trillion
- Dividend yield: 0.5%
Apple’s (AAPL, $187.65) iPhone is the heavyweight in the smartphone market. In the U.S., Apple accounted for more than half (55%) of smartphone shipments in the second quarter of 2023, and 17% of smartphone shipments worldwide, according to data from Counterpoint Research.
While Apple is only second to Samsung in global smartphone shipments, the iPhone’s premium pricing and high profit margin are where it takes the cake. In the first quarter of 2023, Apple claimed 50% of global smartphone revenues and more than 80% share of global smartphone operating profits.
The question for investors is what this monopoly stock is doing with its dominance to drive growth and increase shareholder value for the long term. In this regard, many investors zero in on the company’s service revenue. That’s what Apple earns from selling everything from television subscriptions to cloud storage.
Services growth is not dramatic, but it’s steady and highly profitable. Last year, it was nearly $78 billion, or about 20% of total sales. In 2017, services sales were about $30 billion and about 13% of total sales.
But services are much more profitable. The gross margin on products (sales minus the cost of sales) was about 36% last year. The gross margin on services was 72%, a neat double over the product margin. This means that every dollar in gross profit Apple earns in its services business is the equivalent of $2 in product sales.
But the importance of this feature of Apple’s goes beyond dollars and cents. It makes the Apple ecosystem sticky and difficult (some would say impossible) to leave. This all but ensures growth in its highly profitable services business. Further, each new dollar Apple earns in product sales guarantees downstream service sales at twice the margin.
So while product sales vary, and Apple shares vary with it, services may prove to be the great stabilizer long term. And for long-term investors, don’t forget that AAPL is a dividend growth stock. In May, Apple raised its quarterly dividend for the 11th year in a row and announced that its board of directors authorized repurchasing up to $90 billion of the company’s stock.
Nvidia
- Market value: $1.21 trillion
- Dividend yield: 0.03%
The AI boom has catapulted Nvidia (NVDA, $492.64) to the top. With a whopping 240% jump in its share price year-to-date, NVDA has become the first semiconductor company to reach a valuation of a trillion dollars. The company’s early lead in AI made it essentially a monopoly in the AI computing space, with a reported market share of as high as 95%.
NVDA’s position as a leader in AI is part of the company’s long-term plan, investing in chips that can handle artificial intelligence applications as far back as a decade ago.
And with the launch of OpenAI’s ChatGPT, a large language model-based chatbot which runs on tens of thousands of Nvidia’s graphics processing units (GPUs), the demand for the company’s data center products that are capable of supporting AI workloads is skyrocketing. In fact, its data center division generated 76% of NVDA’s revenue in the second quarter of fiscal 2024, up from 25% in the second quarter of fiscal 2020.
Meanwhile, its gaming division revenue which used to be the company’s strongest growth driver, accounted for 18% of total revenue in the second quarter of fiscal 2024, down from 51% in the second quarter of fiscal 2020.
Looking at the details of its most recent earnings report, NVDA had a record data center revenue of $10.3 billion, up 141% quarter-over-quarter and 171% from a year ago. The company attributed this jump to the growing demand for generative AI and large language models using GPUs from large consumer internet companies and cloud service providers.
NVDA’s automotive revenue came in at $253 million (2% of total revenue), up 15% from a year ago, driven by the growth in sales of self-driving platforms and AI cockpit solutions.
The company reported diluted earnings per share of 82 cents, a healthy increase of 28% year-over-year and 44% quarter-over-quarter, and gave revenue guidance of $16 billion for the third quarter, up from $13.51 billion recorded in the second quarter.
At about $500 per share, is NVDA worth considering now? It’s easy to say, and imagine, there remains much more untapped potential. However, with a price-earnings ratio of 118, maybe all this potential is already priced in.
There is a case to be made that it can’t yet be accurately baked in. The recent AI craze is mostly due to one type of AI, and that’s generative AI. This relatively new technology has the potential to expand, and it is likely that other artificial intelligence-related user markets will emerge in the coming years/decades.
Still, NVDA is not immune to macroeconomic challenges. One such glitch is the Biden administration’s push to restrict China’s access to AI via cloud computing. Bearishness in the broad market could also return unexpectedly, especially due to the uncertainty surrounding the Fed’s fight against inflation and whether or not it will continue to raise interest rates.
Getting behind the leader in the early stages of a new technology has its merits, but is speculative. Remember, during the 12 months following October 2007, shares declined to less than $2 from about $9. And from August 2018 through December of that year, NVDA shares fell to $32 from $70. More recently, from the fall of 2021 to the fall of 2022, shares dropped to $114 from $329. Investors who take the plunge with this monopoly stock should be ready to hold on for a wild ride.
This article was originally published on this site
