The first few months of 2019 were remarkably buoyant for stock markets before trade talks between the U.S. and China hit a snag in May.
Despite that stumbling block, the glowing returns of U.S. equity funds for this year so far reflect an upward shift in investors’ spirits after the dismal fourth quarter of 2018.
For the four months ended April 30, 2019, the S&P 500 total return index rang up a robust 18.2% return. That gain undid the damage inflicted in late 2018 and restored healthy numbers for long-term mutual fund performance.
Just a few months ago, investors were alarmed by a variety of dark clouds, including rising interest rates, the prolonged U.S. government shutdown, trade conflicts between the U.S. and China, fears related to Brexit and Special Counsel Robert Mueller’s ongoing investigation into U.S. President Donald Trump’s ties to Russia during the 2016 election campaign. (Mueller’s investigation wrapped up in March.) By late December 2018, the S&P 500 had slipped by almost 20% from its peak of early autumn.
“There was a long list in large print of things that were spooking investors last fall, and the market sold off hard,” says Stephen DuFour, portfolio manager with Boston-based FMR LLC (a.k.a. Fidelity Investments) and lead portfolio manager of the $1.2-billion Fidelity U.S. Focused Stock Fund.
“If you were looking for a problem [in 2018], you could find it,” DuFour says. “But in the first quarter of this year, a lot of those problems got crossed off. When the Federal Reserve Board stopped talking about raising interest rates, it removed a big headwind that we no longer have to plow through.”
For now, the decade-long economic growth cycle appears to be intact. First-quarter numbers show the U.S. economy expanded by a healthy 3.2%. In addition, the U.S. unemployment rate reported in April was 3.6% – a 50-year low.
China’s economy also defied expectations that it would slow in the first quarter, having been given fiscal and monetary stimulus, and kept the pot simmering for the global economy.
One of the biggest catalysts this year has been the shift to a dovish outlook for interest rates by both the Fed and other central banks around the world, setting the stage for continued business investment and capital spending.
During the three-year period ended Dec. 31, 2018, the Fed hiked interest rates nine times, taking the bellwether federal funds rate into the 2.25%-2.5% range. As 2018 drew to a close, investors feared more hikes were in store and that the Fed would move too aggressively and kill economic growth.
However, in early January 2019, the Fed changed its tone, stating that “patience” was its new mantra. Investors’ fears of recession melted away and confidence was reinforced when Fed chairman Jerome Powell said in March that further rate hikes could be on hold for the rest of 2019. The yield on 10-year U.S. treasuries dropped to 2.47% in mid-May from around 3.2% in early November.
However, risk has not disappeared, DuFour warns. Un- resolved U.S./China trade issues, escalating tariffs, Brexit repercussions and global political friction could deflate the mood. Falling interest rates may portend the feared economic slowdown. But for now, with bond yields skimpy, investors continue to favour stocks for capital gains potential as well as for attractive dividend yields.
“We took advantage of the opportunity to pick up franchise companies on sale during the downturn,” DuFour says. “It was a great time to reinforce the portfolio and add to the best of the best.”
DuFour looks for companies with unit sales growth, pricing power and earnings growth that surpasses the market, then buys their shares at attractive prices. He avoids “asset bloat” in the Fidelity fund by focusing on a tight portfolio of 35 to 45 stocks. The fund now holds shares in 36 companies.
While DuFour is a disciplined, bottom-up portfolio manager, he tends to scan the market for big-picture themes, then drills down to find well-run companies that benefit from change or disruption. For example, the shift to online retailing is leading to changes in warehousing and delivery systems, as well as payment habits. Payments for online purchases usually are made with debit and credit cards, and cash is used less in general, even for point-of-sale payments.
In keeping with that trend, the top holdings in the Fidelity fund are PayPal Holdings Inc., Mastercard Inc. and Visa Inc., all of which benefit from the shift to online payments. While the initial growth in this business has been in payments being made by consumers for goods and services, DuFour foresees huge potential growth in facilitating business-to-business transactions.
“The whole payment system is morphing,” DuFour says. “The days of sending an invoice and waiting for a cheque are disappearing. There will be a lot of disruption to traditional banking practices. Even the ‘unbanked’ population can be brought into the world of electronic payments.”
Information technology is the Fidelity fund’s biggest sector weighting, at 39% of assets under management (AUM), followed by financials and health care, both of which stand at around 15%.
Microsoft Corp., which benefits from the movement to cloud-based services that reduce the need for businesses to have large in-house tech departments, is another top holding in the Fidelity fund.
“People who used to buy packaged software are now purchasing through the cloud with monthly subscriptions,” DuFour says. “Software is a service, and this creates an ongoing income stream for providers rather than a one-time sale.”
DuFour regards Moody’s Corp., a financial research provider and credit rating agency, as another “franchise” company that became attractively priced during the downturn, during which the Fidelity fund bought additional shares in that firm. DuFour says the company is in a “duopoly” situation as a global bond-rating service along with S&P Global Inc., another provider of financial information and analytics; shares in the latter also are held by the fund.
S&P Global, as a provider of stock market indices, benefits from the surging popularity of ETFs. ETFs, which are based on various stock and bond market indices, pay a fee to their index providers. This fee grows with AUM.
“ETFs are a disruptor in the financial services industry,” DuFour says. “The index business is high-margin and it’s a play on the rapid growth of ETFs.”
Noah Blackstein, vice president and senior portfolio manager with Toronto-based 1832 Investment Management LP and portfolio manager of the $1.4-billion Dynamic Power American Growth Fund for the past 21 years, has outshone his peers in the U.S. equity fund category over short and long periods.
For the 10 years ended April 30, the Dynamic fund’s F Series reported an average annual compounded return of 21.7%. That’s well ahead of the 15.3% shown by the S&P index. The fund also beat Morningstar’s U.S. equity fund category average by almost eight percentage points.
Blackstein takes a “high conviction” approach and runs a concentrated portfolio of 20 to 25 stocks. He is not afraid to have heavy exposure in any sector. Technology, for example, accounts for more than half of the Dynamic fund’s AUM but, he says, the sector includes a large number and variety of businesses.
The key characteristics Blackstein looks for are a company’s ability to grow both its top and bottom lines and a potential for continued double-digit earnings growth looking several years out.
Interest rate risk has dissipated, Blackstein says, but he is watching for effects of rising gas prices on consumers or unresolved U.S./China trade issues.
“The Fed is done raising rates for 2019 – and likely into 2020, with the U.S. election coming up in November of that year,” Blackstein says.
While the outcome of the U.S. presidential election is unpredictable, Blackstein says, some health-care companies may be affected by changing government policies, so he has reduced the Dynamic fund’s exposure to that sector.
In the tech sector, holdings include Workday Inc., a software company offering cloud-based financial-management services in such areas as payroll and human resources. In a similar vein, other holdings include ServiceNow Inc., which provides cloud-based software that helps companies manage data and workflow; Twilio Inc., which offers cloud-based communications management tied to voice and text-messaging systems; and Zendesk Inc., which offers cloud-based customer service software.
Like DuFour, Blackstein is keen on PayPal Holdings, which has experienced huge demand for its Venmo app, which allows for cash transfers using mobile devices. He says PayPal may benefit from partnering with banks as their service models evolve in an increasingly “cashless” society.
The Dynamic fund holds shares of specialized retailers expected to ride changing trends: discount chain Five Below Inc. and e-commerce company Etsy Inc.