Posts tagged Equity Sector Strategies
With a little more than one month left until the Champagne corks pop on New Year’s Eve, it’s a good time to survey the investment landscape and see how we might be ringing out 2014. With U.S. equity market indexes back in double digits, it looks very likely to be another good year for long-only portfolios loaded up with domestic stocks. And fixed income has not disappointed either; the Barclays U.S. Aggregate bonds index is up a bit more than 5% as of the 11/20 close. Not bad for a year which began with an overwhelming consensus among market watchers that bond prices would fall as interest rates continued to rise. Should we flip the cruise control switch and ride the wave into 2015, or are there still some bumps in the road that could make for tricky navigating?
The seasonal phenomenon of Black Friday – and its new twin sister Cyber Monday – puts retail spending firmly in the spotlight. The consumer discretionary sector has underperformed the broader market for most of the year, and there are some signs that mainline and specialty retail names with relatively cheap valuations are attracting investors. The National Retail Federation forecasts a 4.1% growth rate for holiday spending this year, a better performance than last year and well above the average for the past ten years. What may make shares in this sector even more attractive is fund managers looking for ways to beef up their portfolios before year-end. This has been a dreadful year for active fund managers, fewer than 20% of whom have beaten their benchmark in the U.S. large cap space. “Window dressing” is the (somewhat derisory) term of art to describe late-season fund manager scrambling to embellish their numbers, and it would seem to be a likely year for this activity to make the scene.
As good a year as it has been for stocks, commodities have suffered mightily. Oil prices reached a peak in June and began a downward spiral of more than 30% -- good for consumers at the gas pump but unwelcome for oil production companies and emerging markets resource exporters. Investors have been looking for a potential catalyst in this sector that could spur a rally. They may have found one in the surprise announcement this morning that China’s central bank is cutting its benchmark lending rates. While cheaper credit in China could signal building weaknesses for the longer term, the more immediate effect would likely stimulate growth in areas like infrastructure and construction. That would provide a decent tailwind to the prices of commodity inputs for which China is the world’s leading customer.
So far so good – but it is never a good idea to be too complacent. One joker in the deck is the U.S. political landscape, where another deal on the budget and debt ceiling – sound familiar? – will face lawmakers in December. With the executive and legislative branches doing their best imitation of an OK Corral standoff, swift resolution of this deal is anything but certain. Odds are that we’ll wind up with some messy but workable compromise, but we will keep a close eye on how these shenanigans unfold. It’s never a bad idea to expect the unexpected – particularly when it comes to the unfortunate dysfunction of our political system.
The health care sector has done more recently than to supply therapies and cures for mental and physical ailments. It has also showered investors with very healthy portfolio gains. In 2013 the S&P health care sector index returned over 41%, a good 10% more than the broad S&P 500 index. The good times continue to roll; sector gains in 2014 to date are just under 25%, more than double the broader market’s total return. This kind of sustained performance logically leads to the question of whether it can last and, if so, for how long?
Follow the Earnings
We have spent some time in recent weeks talking about the importance we place on earnings as a guide to what might happen in equity markets next year. Specifically, with valuation multiples already expensive by long term historical comparisons, we don’t see a particularly compelling case for multiple expansion – for stock prices to gain significantly more than the pace of underlying earnings per share (EPS) growth. “Follow the earnings” is as good a mantra as any, in our opinion, for 2015 portfolio choices. With this in mind, let’s take a closer look at the internal dynamics of the health care sector as it stands today.
One distinguishing feature of this year’s rally in health care stocks is that it is very broad-based. Of the five major industry groups – biotech, equipment & supplies, insurance providers, pharmaceuticals, and life sciences – four are up by more than 20% year to date. And within each industry group the spoils are widely distributed among larger and smaller companies alike. Contrast this dynamic to the state of play in information technology, another outperforming sector year to date. In tech, a disproportionate share of the outperformance is concentrated in the market cap leaders – behemoths Apple, Microsoft, Intel and Facebook are all up by more than 30%. This is an instructive point of comparison. Selection and business model scrutiny is currently happening in technology, and we think it is likely to be a more defining variable in healthcare going forward than it has been to date.
Not All Multiples Are Equal
So if asset selection does become a bigger deal in health care, where are the chips likely to fall? One interesting comparison we see is between biotech and health care providers. At first glance biotech looks prohibitively expensive, with an industry group P/E of around 45x earnings. And the sector is up more than 40% this year. Unsustainable and crazy expensive, right? But a closer look shows the average consensus estimate for S&P 500 biotech EPS growth to be 80%. They may not be cheap, but it is growth, not multiple expansion, leading the way.
By comparison, health insurance providers are up 21% or so year to date, and the P/E is a seemingly more appealing 16x earnings. But 2014 consensus EPS growth for this industry group is a mere 3% - the price performance is largely due to multiple expansion. And 2015 could be a troubled year for providers, which have greatly benefitted from the Affordable Care Act’s implementation. The ACA will be in the spotlight next year with a potential Supreme Court ruling that could have an adverse impact on insurance rosters in 36 states. Wall Street hates uncertainty. Uncertainty plus slow growth could make providers a troublesome corner of the market. We still see good fundamentals in healthcare overall, but we believe the rewards may be more stingily bestowed.
Our brains are wired to seek explanations for things - to weave a sensible narrative around events in the hope of making them seem less random or threatening. We see this play out every time a reporter stares at us assuredly from behind the anchor desk and tells us that “the stock market did X today because of "Y”. “Y” could be the release of Fed meeting minutes, or Russian troops amassing on the border of Ukraine, or a Chinese bond auction failure. It doesn’t really matter what the day’s headline is; the news anchor is crafting a story out of the millions of random buy and sell orders flashing in trading system centers around the world. The stories may help us process information, but there are limits to how much light they can really shed on the goings-on of the capital markets.
Cyclicals and Defensives
One of the recurring favorites of Wall Street storydom is how various industry sectors and investment styles perform at different stages of the business cycle. The rule of thumb is that defensive sectors tend to do well when the economy turns down; conversely, cyclicals have a history of outperformance during times of economic strength. Slowdowns favor value-oriented stocks, where dividends contribute significantly to total return. Growth stocks are the leaders during the good times. Or so the story goes.
Time for a Value Story?
Consider the last twelve months; we show here below the performance of US large cap value and growth equities.
The chart shows a seemingly nice, tidy style trend. Growth stocks decisively took command in summer 2013 and led the market’s rally through January 2014. That trend started to run out of steam in February and went into sharp reversal last month, with value back in the ascendant. How closely does this trend track the business cycle from last summer through the present?
Quite a lot, perhaps, at least on the surface. During the fourth quarter of 2013, a series of macroeconomic data built a case for stronger than expected growth. The Fed’s December Board of Governors meeting ended with a decision to begin tapering the QE program, another sign of confidence in economic recovery. Markets rallied strongly through the end of the year. But the New Year presented headwinds. Jobs data painted a mixed picture: lower unemployment, but less-than-stellar payroll gains. A harsh winter took a toll on much of the country. Russia amassed troops on the Ukrainian border. This would seem to paint a compelling value/defensive narrative.
More Than Meets the Eye
If you look closely enough at the underlying data in any given market trend, though, you are likely to see more complexity than the top-line narrative would suggest. Consider that the top-performing sector during that growth run in the second half of 2013 was healthcare, traditionally considered to be one of the more defensive sectors. Or that the cyclical materials and consumer discretionary sectors were strongest during the February pullback.
Moreover, with the harsh winter behind us, the US economic picture for the rest of the year continues to look relatively upbeat. Economists have lowered their expectations for first quarter earnings, but expectations for the full calendar year are in the high single digits – hardly indicative of a burgeoning slowdown.
Certain growth sectors do indeed seem to be reversing – much of the decline in major US indexes this week has come from the tech and biotech sectors. But that may be more about investors rebalancing their portfolios – buying the losers and selling the winners – than it is about any meta “return to value” narrative. If there is a sector story, maybe it is simply this: mean reversion happens. Every now and then it’s time for something to mean-revert up, and something else to mean-revert down. It’s not a very colorful story, to be sure. But letting the data speak for themselves may be a better way to invest than trying to guess what the next big-picture story will be.
Stop us if you’ve heard this one before: an Internet company with an unproven, highly risky business model values itself at gajillions of dollars and offers its shares to credulous investors who never seem to learn their lesson…
2014 has been a choppy year for equities thus far, with the S&P 500 struggling to keep itself above the level at which it ended 2013. But weakness in the broad market has not stopped entrepreneurs and venture capitalists from enjoying the most fecund environment for initial public offerings – IPOs – since the final spurt of the dot-com bubble in the first three months of 2000. Sixty-two new issues have been priced and offered so far this year. But this week gave a sign that the good times may be coming to an end. That sign has a befitting name: “Candy Crush”.
This past Wednesday King Digital Entertainment PLC, a U.K. company with an online game application called Candy Crush Saga, went public with a $6.8 billion price tag. That’s right – a company known for a single (albeit extremely popular) game was deemed to possess a higher market worth than Avon Products or Goodyear Tire, to name just two well-known brands that have been around for a much longer time. That valuation was based on the set offering price of $22.50. On this day, though, the market did not agree with the numbers wisdom of King and its investment bankers, JPMorgan. Share prices quickly went into freefall and finished the day at $19.00, 15.9% below the offering price. Perhaps virtual lollipop hammers which crush gumdrops are not all they’re cracked up to be…
King’s miserable opening performance was not entirely of its own doing; there are other signs of a chill in the high growth sectors of late. Earlier in the week the red-hot biotech sector gave up more than 6% in a broad two day sell-off, sparked by concerns over a Congressional inquiry into the pricing practices of Gilead Sciences, a maker of drug treatments for hepatitis C. The blues surrounding the King IPO caught other tech names in its downdraft – sector darlings Twitter and Facebook, among others, were big losers that day. In the broader market we see the evidence slowly mounting for a rotation away from growth back into value sectors and styles.
Beware the IPO Hype Machine
IPOs are sexy: there is hype and glitz and new gizmos ready to turn the world as we know it upside down. But they often have considerably less appeal as smart investments. There are exceptions, of course. Google’s shares today are worth more than 1,000 times where they debuted in 2004. But those are the exceptions, not the rules. Most IPO companies do not, in fact, go on to “change everything” as the hype promises. Maybe those lollipop hammers really can beget a category killer for the ages. But in our opinion it may be a bet worth not taking.
The utilities sector is the traditional safe port in a storm among the nine major industry groups that make up the U.S. stock market. It is typically the last space investors vacate when risk turns up and the threat of a market correction looms. Over the last twelve months, however, the world of power grids and water treatment facilities has been anything but boring or predictable. This has very little to do with the basic business models of the sector, which mostly involve collecting regular, easily quantifiable monthly payments from residential and business customers. Rather, the volatile price performance of utilities stocks illuminates the far-reaching and sometimes unexpected ways that the Fed’s monetary policy decisions continue to impact the equities market. It was on display again this week, as Janet Yellen made her debut post-Fed meeting press conference.
The chart above shows a close correlation between the performance of the utilities sector (shown here by the SPDR S&P 500 Utilities Sector ETF) and key Fed events over the past year. During the first four months of 2013 utilities, along with health care and consumer staples, led a broad-based market rally. But in early May utilities parted company with those other two traditional defensive sectors as the word “taper” escaped from Ben Bernanke’s lips into the market lexicon. Having led the market up, utilities was now at the leading edge of a cyclical pullback, falling twice as far from its peak to trough as the overall S&P 500. That is not typical behavior for an asset class typically thought of as a relatively safe haven. Why did utilities fall so far, so fast, and then go on to do a repeat performance later in the summer of ’13?
All About Yield
The answer to that question is summed up in one word: yield. In the yield-parched world of the past several years, investors have gone hunting outside the traditional confines of investment grade fixed income products to increase their portfolios’ yields. Utilities names have been one of the big beneficiaries of this trend: dividends tend to make up a larger percentage of the total return for utilities than is the case for other sectors. Of course, owning shares in utilities companies is riskier than owning triple-A corporate or U.S. government bonds, but investors increasingly put these risk concerns on the back burner in the quest for yield.
When the “taper talk” began last May, yields on Treasuries and other interest rate-sensitive securities soared. The 10-year Treasury yield, a key benchmark interest rate, surged a nearly unprecedented 160 basis points from May to September. Suddenly those yields from the utilities sector started looking less appetizing. Even when the Fed pulled back from a widely expected tapering decision in September, the consensus view had already set in that rate increases were only a matter of time. The utilities sector finished the year far behind the broader market: a total return of 13% versus 32% for the S&P 500.
Will utilities be a permanent casualty of a long-term structural trend towards higher rates? For now it’s too early to make that case, partly because we don’t know with any certainty what that rate trajectory will look like. In her inaugural post-meeting press conference on March 19 Fed Chairwoman Yellen removed quantitative benchmarks from the forward guidance equation. With the unemployment rate hovering just above the earlier 6.5% benchmark, the Fed has given itself more leeway to hold down rates for longer if it believes that is more advisable.
Of course, the markets blithely overlooked that and reacted instead to a slight rise in the Governors’ consensus views on the likely Fed funds rate in 2015-16. Treasury yields shot up, and utilities stocks duly tumbled. Whether this presages another irrational rate surge is anybody’s guess, but it could make for another tough year for utilities.