Value abounds despite fears of double dip

While the US market appeared to stage a recovery last year and in the first quarter of this year, the S&P 500 has slipped more than 1000 points since its peak in April, amidst concerns about the European banking sector and consumer debt levels.

“This sharp decline constitutes a fairly severe correction by historical standards,” says Duilio Ramallo, fund manager of Robeco US Premium Equities Fund. “A barrage of negative news surrounding the May 6 ‘flash crash’, the debt problems of peripheral EU countries, potentially harsh reforms in the banking industry, risks of a hard landing in China, and oil pouring into the Gulf of Mexico, triggered a panicky flight from nearly all risk assets.

“Despite the downturn, we believe meaningful stock price gains can be driven by a sustained earnings recovery, which has some way to go even after the first quarter produced the best earnings reports in over 30 years, with 80 per cent of S&P 500 companies beating estimates,” he explains.

“Progressively better earnings rather than expanding price-earnings multiples are likely to be the major force pushing the market higher. PE multiple expansion usually drives gains in the market during its initial recovery from a low point; however, multiples now are likely capped by upward pressure on interest rates and growth constraints derived from debt levels, especially in the public sector,” adds Mr Ramallo. “In contrast, corporate earnings power remains solidly intact; 2010 & 2011 per share earnings in the high 70s to mid 80s readily support an S&P 500 of between 1200 and 1300, 10-15 per cent higher than today.”

Uncertain times

For many fund managers, however, the climate is less certain and easy to read than three months ago. “The big question is whether we are in a double dip or a typical mid-cycle slowdown following strong early stage recovery growth,” says Adrian Brass, fund manager of the Fidelity America fund.

“My view is the latter, that inevitably such a high growth rate could not be sustained, but I do worry about the serious structural issues across investor markets as a whole, which will constrain growth in the coming years.”

Mr Brass predicts a fall in GDP growth from 3-3.5 per cent, to 2-2.5 per cent, largely as a result of reduced government and consumer spending. However, he believes that profits will come back to normal levels in the next quarter because the US is a broad, diverse and highly flexible market, and companies can cut costs relatively easily compared with Europe, where

rationalisation is a longer process.

“Europe is further behind in its cleansing,” maintains Mr Brass. “The core issues at the heart of the crisis are the financial sector and housing, and the US is closer to sorting out these problems.”

If the recovery does stall then other factors, such as the currency, support the case for the US over European markets. “My sense is that if we are in a double dip then the US is where investors should want to be,” says Bill O’Neill, chief investment officer, EMEA Wealth Management, Merrill Lynch. “The US will outperform in currency terms because the dollar will hold up well in an environment where equities are under pressure. The US has a big weighting in consumer goods and technology stocks which are less cyclical, whereas Europe has greater exposure to materials and financials.”

The US market is neither cheap nor expensive at 13.5x , while the UK is on 11x earnings and Europe is on 10x this year’s earnings, reflecting the higher ratings in the technology sector. However if you compare the US market on a risk premium basis against Treasuries, then it continues to look cheap.

“If, on the other hand, you don’t anticipate a double dip and believe growth may accelerate, then the US is not the place to prosper,” adds Mr O’Neill. “Emerging markets and Europe will perform better because earnings momentum will be stronger. The US will lag if recovery accelerates next year.”

Historically, value funds tend to perform well after a recession and many that were positioned for recovery did well last year. The issue is whether good valuation opportunities remain.

“The case for The Bear is easy to make, with all this pessimism about the macro-economic backdrop, but investment success starts with the price you pay to buy a company and stocks have corrected throughout the summer, raising the possibility of a winning investment,” says Kevin Rendino, managing director and portfolio manager at BlackRock’s Basic Value US fund.

“At current valuations, this is the optimal point for the last 20 years in terms of the quality of companies versus the multiple investors must pay for them,” he says.

“The companies with the highest cashflow yields and the highest operating margins happen to be the companies with the lowest multiples, such as Microsoft, Johnson & Johnson and Exxon Mobil, which are trading at all time lows. We buy good, well managed companies that are out of favour. It’s easy to see how Apple is a great company today. We bought it seven years ago when nobody cared about it. Over the next few years, I think it will be possible to look back and say

buying Microsoft, Exxon, IBM and Johnson proved to be a winning strategy. “

Most fund managers agree good valuation opportunities remain, particularly in healthcare, energy and technology. The greatest upside is expected from the technology sector, encouraged by enterprise spending data, as companies look to upgrade PCs and servers and buy innovative products such as Microsoft 7, to make up for lack of IT spending in the downturn.

They cite multiple compression in large cap technology names such as Oracle which, on 10x earnings and 11 per cent free cashflow yield, is particularly cheap for a company with a market leading position and defensive growth profile. Microsoft is trading on a PE of 10 compared with 60 a decade ago and IBM is also trading on 10. Semiconductor companies are also cheap by historical standards, such as Applied Materials, on 6x 2011 earnings.

“There are a lot of macro headwinds still restraining growth in the US,” says Greg Woodard, portfolio strategist at Manning & Napier, New York, which runs the GAM Star US All Cap Equity fund. “We see the investment world as a zero-sum game, and look to identify companies that will either take market share from competitors in their own market or are looking to expand outside their domestic markets. We are therefore looking for secular growth drivers where we see pent up demand such as in the tech sector where projects have dried up in the last four to five years. We expect to see an upgrade cycle in data storage and security for example, and there is no need for a return to strong economic growth for this to happen.”

“In cyclical sectors fund managers are also looking to industries where supply has been constrained such as energy, and freight and airlines that have seen a fall in supply as a result of the crisis.”

Turnaround stories never go out of fashion but they crop up regularly in an uncertain climate. Bradley T Galko, Portfolio Manager of Pioneer US Research Fund, cites Starbucks where management has cut over 600 underperforming stores, and has a number of strategic initiatives including new products for the grocery and food-service channels.

“It’s not just turnarounds, however,” says Mr Galko. “There are instances where managements have invested to improve their competitive advantage. For example, Comcast has invested in a network upgrade to better compete with telecom providers and cable peers, while at 3M, management has increased R&D at what many investors perceived was a staid, mature company that had lost its edge. It’s now starting to generate the highest sales growth in its 100-plus year history.”

Sustained growth will ultimately depend on whether companies can continue to grow their top-lines. The recovery in corporate earnings has been primarily driven by cost cutting.

“According to Bloomberg data, revenue for S&P500 companies grew by 13 per cent year over year in Q1 this year, and it is expected to grow by 10 per cent in this quarter,” says Seung Minn, CIO at Disciplined Equities Group, RCM. “However, the sustainability of revenue growth at this level is more challenging, and depends on whether the US consumer resumes spending, particularly in the holiday season.”

Consumer confidence

The US consumer has held up relatively well in view of the housing market difficulties, he argues. “However, consumer confidence is determined to a large extent by high-end consumers, who drive disproportionately large amount of discretionary spending. If they become more concerned about the stock market and the economy, then consumer spending will contract significantly.

“If the higher-paid bought real estate, it would flush out the inventory in the housing market,” says Mr Minn.

“Housing inventory numbers are well below the peak in late 2008/early 2009, however, part of this decline was driven by government tax incentives, which are temporary in nature. In addition, although it appears housing prices have stabilised, there may still be a lot of hidden inventory, as people are not actively putting properties on the market, but are sitting on the sidelines. House prices could fall further if a large amount of hidden inventory comes onto the market.”

The overhang in supply of existing homes could take two years to absorb although only 0.5m new builds are under construction this year, around half the normal annual rate.

High unemployment levels at 9.5-10 per cent have in turn largely been driven by the housing market crisis, and the deterioration is structural as long term unemployment is increasing in young people and certain demographics. However, there are early signs that companies are starting to re-hire.

Stable dividend returns give eurozone edge over US

The market is split on whether the US or Europe is the more attractive prospect. “We compare the US to the eurozone using factors such as GDP and yield differentials,” says Christoph Riniker, head of strategy research at Bank Julius Baer.

“At least for the remainder of the year, GDP differentials are expected to move in favour of eurozone equities, and then to move sideways in 2011. We also expect base rate differentials to eventually move in favour of eurozone equities. After the strong moves in $/E, the forex impact is largely made and does not imply any further support for either of the two markets. With North American equity markets quite expensive, we put an underweight rating to the market as we see better opportunities in other regions.”

Regarding fund styles, Mr Riniker favours small caps as investors prepare to take more risk again. “Earnings expectations for smaller companies are higher, which offsets the different valuation levels. On a growth-adjusted basis (PE to growth: PEG), smaller caps and large caps are similarly valued. We recommend concentrating on European and North American small and mid caps.”

“As markets move sideways, we reiterate our recommendation for high and stable dividend strategies to compensate for lost returns on the market side,” adds Mr Riniker. “We recommend avoiding dividend cutters and ‘yield traps’ [stocks that have a high dividends, but insufficient cover]. Dividend strategies contribute to a larger part to the total return in Europe than in other regions.”

“We are overweight consumer discretionary which is a beneficiary of a weak euro and IT, and underweight the telecoms sector. Although prices should not fall, we expect other sectors to perform better.”

In practice investors have been abandoning US equity funds, and switching instead to global equity and emerging markets funds. Merrill Lynch’s recent fund management survey shows mutual fund inflows into the US market and non-US markets have converged and are now similar by volume, a trend that started way back in 1998, as investors looked to diversify their holdings.