Editor’s note: With just one month to go in 2013, it’s been a prosperous year for investors in U.S. stocks. What’s next for the world’s largest market? For answers, columnist Sonita Horvitch convened Morningstar’s manager roundtable on U.S. equities.
Janet Navon, managing director, director of research and member of the U.S. investment team at New-York-based Epoch Investment Partners Inc. Epoch manages assets for Toronto-based TD Asset Management Inc. and CI Investments Inc. Epoch’s funds managed include TD U.S. Large-Cap Value, TD U.S. Large-Cap Value Class, CI American Value and CI American Value Corporate Class.
Glenn Fortin, portfolio manager at Beutel Goodman & Co. Ltd, a value-style firm. Fortin is a member of the global team, with his focus on U.S. equities. The team’s mandates include Beutel Goodman Global Equity and the award-winning Beutel Goodman American Equity, which was honoured as the best U.S. Equity Fund at the Morningstar Awards gala on November 27.
Q: The U.S. equity market has had an outstanding performance this year. The S&P 500 Index has been reaching new highs and there are concerns that the market is getting extended.
Young: In certain sectors we are seeing some frothiness. The recent initial-public-offering activity in social-media companies is an example. A narrow area like social-media stocks can do what they’re doing and this doesn’t impact the market overall. We’re four and a half years from the bottom in the U.S. equity market following the global financial crisis. There hasn’t been much enthusiasm for the equity market until this year. It has been a hated bull market. Many sectors are doing fine and are not overvalued. They’re well grounded in the fundamentals.
Q: Which sectors currently offer opportunities, Jim?
Young: You can find value in financial services, technology, industrials and consumer-related companies. I don’t find it challenging to find names these days. They’re not as cheap as they were. Valuations have improved since the financial crisis, which is what you would expect. We’ll get worried when we see excesses in the mainstream sectors. Valuations should continue to rise, driven by one of the largest asset-mix shifts in financial history, as investors move out of low-yielding bonds into total-return equities. These are stocks that have a price increase of 6% to 7% a year and have a 2% to 3% dividend, for a total return of close to 10%.
Navon: Some of the social-media stocks have become overvalued. Also, valuations on some high distributors of cash flow, such as pharmaceuticals and certain consumer-staples companies, have become stretched. Those investors looking to redeploy money from bonds are targeting these stocks. They’re big dividend-payers, but not very good growers.
Fortin: Coming out of the recession, the largest companies in the United States have become increasingly global. They have a more diversified revenue and earnings base and are more efficient. There is a greater attention to shareholder total returns, be it share buy-backs or more importantly, dividends.
Navon: We have seen a re-emergence of investor activists.
Fortin: This increases management accountability.
Young: The dividend theme is important. Payouts are historically low and shareholders are pressing for dividends. The companies are responding. The payout ratios are going up and earnings are growing, so you have a double impact on dividends. A new and big investing theme that has emerged is a focus on constant dividend increasers. These companies are attracting a lot of money.
Navon: As a result, you have also seen companies splitting into more of a dividend-oriented company and more of a growth-oriented company. An example is the diversified health-care company Abbott Laboratories Inc. (NYSE:ABT), which hived off the pharmaceutical portion of its business into AbbVie Inc. (NYSE:ABBV). Agilent Technologies Inc. (NYSE:A) is splitting off its more traditional electronic-measurement business into a public company. There are a lot of examples of this.
Q: It is the reverse of the conglomerate?
Navon: Yes. It’s no big surprise that we, as value managers, are invested in some of these companies. We look at the sum of the parts and say there is value there.
Fortin: This is where many investor activists have been concentrating on.
Young: PepsiCo Inc. (NYSE:PEP) is being challenged to do the same thing.
Q: Where are the dividend growers to be found?
Young: Some of the banks are an example, now that they have sorted out their capital requirements. Their dividend yields and dividend payouts are a little low for banks. Wells Fargo & Co. (NYSE:WFC) and PNC Financial Services Group Inc. (NYSE:PNC) hold promise in this regard. Insurer ACE Ltd. (NYSE:ACE) recently increased its quarterly dividend by 24%. Johnson & Johnson (NYSE:JNJ) will consistently increase its dividend.
Navon: Leading off-price retailer TJX Companies, Inc. (NYSE:TJX) is a company we own.
Fortin: In the retail space, the companies are mature and generating strong cash flow. Companies such as TJX and Lowe’s Cos Inc. (NYSE:LOW) are now harvesting the cash and returning it to shareholders.
Q: Small-caps versus large-caps?
Navon: It’s easier to find investment ideas in large-caps than in small-caps.
Fortin: I agree. U.S. stocks have done well this year. But large-cap stocks continue to underperform. A big part of this underperformance reflects the size of a lot of the mature information-technology companies. They have large market caps and good global franchises, but many have lagged the market year-to-date.
Young: Information technology has been one of the worst performing sectors so far this year.
Q: Having discussed trends in the U.S. equity market, what is its outlook?
Young: Generally, after there has been a big year in the equity market, you don’t get a down year, you usually get a more modest year. There can be a couple of them. The economic framework calls for an extended period of modest non-inflationary growth in the world. There could be 2% or 3% GDP growth in the United States, 2% in Europe, China has slowed, but the growth is still 6% or 7%. This modest global growth is a good backdrop for the U.S. equity market. Valuations are not extreme. The S&P 500 is trading at about 15 times next year’s earnings estimates. If we had P/E multiples of 25 times, we would be more concerned.
Q: Earnings growth?
Young: The expectation is for S&P 500 earnings per share to grow by 10% or so in 2014.
Navon: We’re looking for earnings growth to be a little lower than that at 6% to 8%.
Fortin: This is pretty normal on a long-term basis.
Navon: We’re looking for a 2% run rate in real U.S. GDP growth in 2014. The political backdrop in the United States will remain uncertain. It’s tough to forecast what will come out of Washington. It defies reason because the extremes are driving each party’s platform. This year’s automatic budget cuts failed to result in the intended compromise in Washington. The next and deeper round of cuts are due in mid-January. This unpredictability creates a considerable level of uncertainty for businesses and undermines confidence.
Q: What about the U.S. Federal Reserve Board’s quantitative-easing program?
Navon: Even though the Fed has backed off from tapering, the yield curve has stayed more positively sloped and long-term rates have remained somewhat higher. This has adversely impacted the U.S. consumer. Those consumers who could were refinancing their borrowings at the lower rates, thereby adding to their disposable income. This helped to compensate for their fairly stagnant overall income over the last couple of years. These higher long-term rates are making us a little more cautious on the consumer, who represents about two-thirds of the GDP in the United States.
Fortin: The unemployment rate in the United States is just over 7%.
Young: That excludes all the people who gave up.
Navon: The work-force participation rate is the lowest it has been since women started to really enter the work force in the ‘80s. There is a large component of structural unemployment in the United States.
Young: You don’t hire a lot of people in factories any more. It’s highly automated. The real drivers of job creation are still the innovative sectors such as technology and the life sciences. It’s hard to create jobs. You have to create a favourable environment. You need to encourage entrepreneurs to take risk. This all this ties back to the political issue.
This week’s roundtable series continues on Wednesday and concludes on Friday.