In the virus induced global equity market correction in March, value stocks in particular experienced a collapse in earnings expectations and a capitulation among investors. This was especially true for financial companies which were marked down on higher expectations of a prolonged environment with lower interest rates and a flat yield curve for the foreseeable future. The US 10-year yield, for example, collapsed almost 100 bps in this period.
Interestingly, companies are now beating these depressed estimates. For the third quarter, 86% of S&P 500 companies reported a positive earnings surprise, the highest percentage since FactSet began tracking this metric in 2008. We have also observed a similar outcome among European small and mid-cap industrials, illustrated by strong results in our own positions in German joint-engineering company Norma and truck and trailer component producer SAF-Holland.
The yield curve, as measured by the US 10-year treasury bond yield minus the 3-month equivalent, is now steepening (see figure 1). This typically indicates stronger economic activity with rising inflation and expectations of economic expansion. If continued, we believe this has important implications for global equity markets. First, higher interest rates will ignite the financial sector which has underperformed severely for several years. Banks will be boosted by increased net interest margins and enhanced reinvestment yields. The latter will also benefit insurers who will see a better future return on their bond portfolios and reduced pressure on fulfilling guaranteed interest rate products. Second, the yield curve steepening will also implicitly de-rate the earnings and valuations of mega-cap technology companies in the US. These stocks are today effectively bond proxies and rising discount rates will reduce the current value of their future profits and therefore their shareholder value.
The vaccine progress in recent weeks is also rotating investor interest from 'COVID-winners' towards 'COVID-losers' and reversing investors' road map. We currently see substantial value in previously out-of-favour small and mid-cap industrial companies, particularly outside the US.
Moreover, travel and leisure-related companies are clearly trading significantly below their normalized earnings power and would be major winners in the more normal investment environment of a post-COVID world. The banking sector, again, could see normalized provision levels following an elevation during the pandemic and we believe it has the potential to distribute substantial capital returns in 2021 and onwards since the 2019 dividend has been largely held back in 2020. SKAGEN Focus has meaningfully increased its exposure towards this under-owned segment as of late.
We also believe that the US election results will have important implications for the tug-of-war between value and growth, and are particularly positive for value stocks outside the US. The country's stricter tax regime and more limited fiscal stimulus than hoped for in a split Congress would increase the appeal for equities outside the US. However, we believe the most important implication is the normalization of global trade relations which would create a vastly improved operating climate for dependent equities outside the US. The end to "America First" will also draw the curtain on stock market manipulation by the White House Twitter account which will work to close the huge valuation gap between US and Non-US equities.
Hopes of a vaccine and US political stability are also boosting global M&A activity with deals worth over $40bn announced in November as companies put their cash piles to work. Further consolidation is likely as management teams gain confidence under more normal market conditions, which should benefit undervalued and smaller companies, in particular.
We explored many of these factors supportive for value investing in detail earlier this year, before the Coronavirus took hold. While the pandemic may have delayed some of the catalysts to reversing the underperformance of value stocks it has likely accelerated others and the prospects for a sustained rotation now look stronger than ever.
With our portfolio centred on value and tilted towards smaller companies, SKAGEN Focus has had direct experience of the changing winds blowing across our investment universe. Since the March lows and what we believe to be the start of a new investment cycle, the fund has delivered strong absolute and relative performance driven by good stock picking, particularly in the Industrials and Materials sectors (see figure 2).
Despite this re-rating, we still see over 50% upside across the portfolio, which has been strengthened recently by several new additions. With three quarters of the fund weighted towards carefully selected small and mid-cap companies well-placed to benefit from economic recovery, the future looks increasingly bright and we look forward to updating you on our progress.