Investors are making a mistake by ignoring these 3 discounted stocks, says a value portfolio manager who beat 92% of peers in 2021

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Scott McBride, the CEO of Hotchkis & Wiley Capital Management, helps run a fund that excelled in 2021. Scott McBride/Hotchkis & Wiley This story is available exclusively to Insider subscribers. Become an Insider and start reading now. Scott McBride, CEO of Hotchkis & Wiley Capital Management, runs a fund that lapped peers in 2021. Focusing on quality stocks, ignoring volatility, and diversifying were keys to his success. These three stocks stand out for being undervalued, McBride said. Scott McBride, the CEO of Hotchkis & Wiley Capital Management, is part of a team that runs the firm’s Hotchkis & Wiley Diversified Value A fund (HWCAX). That fund was a top performer in 2021, according to Morningstar, beating 92% of its peers by climbing 32% while the S&P 500 rose 28.7%, including dividends.

Last year’s standout performance was no fluke. The fund — the success of which is broadly correlated to the performance of value stocks — was also in the top 15% of funds in 2012, 2013, 2016, and 2019. This year, the Hotchkis & Wiley Diversified Value A fund has topped 76% of competing funds on the back of a 1.8% gain that’s so far bested the S&P 500 (-7.8%).

Back in early January, McBride told Insider about what makes the fund tick. His team’s strategy has little sizzle; targeting shares of high-quality, well-run companies isn’t sexy. But providing investors with strong returns is — and that’s precisely what McBride and company have consistently done over the past decade. The key is keeping calm as the stock market inevitably lurches up and down.

“Changing macro conditions can create volatility that can create opportunity,” McBride told Insider in a recent interview.

Opportunity surely abounds in today’s stock market. The challenge for strategists is determining whether it’s an opportunity to buy equities or sell them as risks like red-hot inflation, rapidly rising interest rates, softer economic growth, and the Russia-Ukraine war roil markets.

Fortunately for McBride, he doesn’t need to have a hot take about the biggest risks that stocks face, like when inflation will peak and whether a recession is around the corner or not.

“We’re not in the game of predicting markets,” McBride said. “We’re really in the game of trying to look for attractive companies to invest in.”

McBride continued: “When we invest in businesses, we want to assume that there will be recessions and that the companies we invest in are positioned to weather that recession. And that ultimately, we’re buying a business at a good price relative to long-term earnings power.”

Top investments to make nowBesides prioritizing quality stocks and ignoring near-term volatility, McBride and his team employ another widely recognized tenet of investing: diversification.

Stocks from all sectors can find a home in the Hotchkis & Wiley Diversified Value A fund, but McBride said that his team does pick favorites: energy, financials, industrials, healthcare, and technology, to name a few. By contrast, McBride said that the fund is light on stocks in the consumer staples, materials, utilities, and real estate sectors.

Those first two groups — energy and financials — were the two that McBride highlighted at the start of the year in his interview with Insider. After a hot start for both, the performance of those two sectors has drastically diverged this year: energy is up 43.7% year-to-date, while financials are down 5.6%.

Though it’s laughable in hindsight, one of the biggest concerns for the energy sector heading into 2022 was whether the group had peaked after returning 53% in 2021, including dividends. McBride insisted that the group was still “really unloved” and would benefit from oil prices rising because of a supply-demand imbalance caused by years of underinvestment in the space.

Four and a half months later, McBride hasn’t changed his tune on the energy sector, especially as the Russia-Ukraine war has worsened supply-side issues. The catalysts that lifted the group for the past 18 months will remain in place, he said, adding that fading energy stocks simply because they’ve been on a tear is unwise.

“Our anchor for our decisions is really on valuing the companies,” McBride said. “We don’t think about it as ‘chasing performance.’ We try to think about, ‘Well, what are these businesses worth?’ And while the stock prices are up a lot, I would say that you have to take a longer-term perspective.”

McBride continued: “They really haven’t done very well over a long period of time. They’ve done very well over from the bottom of the pandemic to today. But many of these stocks are not back to where they were 10 years ago.”

Energy stocks are still a top sector pick because of “attractively priced” valuations based on normal earnings power that’s steadily growing, McBride said, adding that elevated oil prices and a flood of capital coming back to investors through share buybacks are also key tailwinds.

Financials have paled in comparison to energy this year as fears about a possible recession, a flattening yield curve, and far weaker earnings than in 2021 have all depressed sentiment for stocks in the space, particularly banks. Inflation, which typically lifts stocks in the sector, has instead been a headwind because it’s threatening to slow or halt the economic expansion.

But McBride isn’t stressed about the issues the sector is facing, as he reasons that rising interest rates should still help financials. Ultimately, he believes that nabbing shares of firms that are undervalued relative to their earnings potential will be a winning proposition.

“Over a long period of time, what’s going to be important is: ‘Are we right about what these companies can earn?” McBride said.

Below are three stocks that McBride said he thinks are undervalued right now. One of them, Citigroup (C), was also one of McBride’s picks in early January. Along with each name is its ticker, market capitalization, price-to-earnings ratio (P/E), and McBride’s thesis.

1. Citigroup

Markets Insider Ticker: C

Market cap: $100.5B

P/E ratio: 5x

Thesis: “Citigroup — it’s at five times our estimate of normal earnings power, which is a really low number. That’s a recession-level number.”

“There’s two reasons for the stock being weak. The first is the one we talked about earlier in the year, which is just the company’s investing. The reason that they’re underearning our estimate of normal as the new CEO is — there’s a couple reasons, but a big reason is — the new CEO is investing in the business. And I think the Street is skeptical that she’ll get a return on that investment if the big investments don’t go on for longer than she’s saying.”

“And I think the most recent move is all about concerns around recession, concerns around global recessions and what that means for Citi in the near term. And I think that that is the opportunity for us.”

“We’re long-term investors. We’re focused on what a company’s going to earn over the long term. And I think that a big opportunity for us is often that the market is shortsighted.”

2. Wells Fargo

Markets Insider Ticker: WFC

Market cap: $176.2B

P/E ratio: 9.4x

Thesis: “Companies that have a consumer banking franchise, like Wells Fargo, have historically been able to generate high returns. And the evidence of that would be what Bank of America and JP Morgan are able to generate today, what some of the other very high-quality regional banks are able to generate in terms of returns today, and what Wells Fargo was able to generate.”

“What has happened to Wells Fargo is they had that sales practices scandal, which resulted in the entire management team of the company being replaced. Which resulted in the company dealing with serious regulatory headwinds that they had to pass and also resulted in the company having to spend a lot of money to improve their systems and processes that should have been in place and preventing this sales practices scandal.”

“So those three things have really been big headwinds to the company in recent years, which is: regulatory headwinds, management change, and increasing OpEx (operating expenses).”

“We think the franchise is still intact here. What enabled Wells Fargo to generate high returns in the past — that consumer deposit franchise — is still intact. And it’s taken longer than we would have expected to fix these problems, but we do think they’re on the path to fixing these problems. That should enable Wells Fargo in future years to generate returns on assets — which also means return on equity — that are much higher than they’re generating today.”

3. Oracle

Markets Insider Ticker: ORCL

Market cap: $212B

P/E ratio: 30.5x

Thesis: “Oracle is one of the world’s largest software companies. One thing that we’ve always liked about Oracle is that the customer relationships are extremely sticky. So if your company is running Oracle software — whether it’s their database products or their application products — it’s extremely difficult and expensive to switch off those products. So it takes a lot of time and a lot of money to try and switch from one of their products to another.”

“Oracle was a little late to the cloud, I’d say. They have spent the better part of the last decade investing in their cloud products, and I think really starting to show signs of growth in these products.”

“They’re a real leader in that market [ERP, or enterprise resource planning], which is a big market. That’s a market that they’ve been a player in for a long time, but they’re a real leader in the SaaS (software-as-a-service) part of the market. They have about a $5 billion business that’s growing 20% to 30% there and I think has a long runway for growth.”

“What’s also starting to happen is they’re starting to see real growth in what they call OCI — Oracle Cloud Infrastructure — or their infrastructure-as-a-service offering that competes with Amazon Web Services, Microsoft Azure, and Google Cloud. And we expect them to be a much smaller player than those players — a niche player really focused on serving existing Oracle customers. But Oracle is a much smaller company than those companies.”

“The combination of their good growth in their ERP/SaaS business and in the Oracle OCI — their infrastructure-as-a-service product — the result has been Oracle growing their software business 7% to 8% in the last two quarters. The company’s talking about double-digit growth next year. The stock is at 16 times the rest of normal earnings. So I’d say that, to me, the stock is priced for lower growth than they’ve been putting up the last few quarters.”

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