Perspectives

Perspective: Balancing Risk and Return in Markets With Limited Appeal

With the U.S. stock market reaching a five-year high earlier this year and bond yields remaining at historically low levels, it’s become more challenging to find attractive values in the financial markets. David Giroux, manager of the Capital Appreciation Fund, discusses the market environment and current strategy.

Q. What have been the key drivers in the stock market’s recovery?

A. There is a realization that equities are more attractive than other asset classes, and, with interest rates more likely to go higher than lower, fixed income is less attractive than it has been historically. The economy is only growing at a modest 2% rate or so, but corporate profits continue to be reasonably good, although growth is slowing from the double-digit to the mid-single-digit range now.

And the market is not as fearful of the serial budget crises in Washington; investors have a bit of fiscal fatigue. Having said that, corporations are still very concerned about investing capital in the U.S., given our high level of debt and deficit spending.

Looking ahead to next year, investors are expecting a better macro environment and are hopeful for a reacceleration in corporate profits. So now the market sees a world where the glass is half full whereas in mid-2010 and mid-2011 they saw it as half empty.

Q. How much impact has the Federal Reserve’s unprecedented accommodative policies had on the economy and the market?

A. The market has been convinced that the liquidity the Fed is providing is this magic elixir. But what’s really amazing is that despite all this liquidity, the economy hasn’t grown very fast. I believe it’s more of a psychological benefit than a real benefit. As most of the evidence would suggest, when you take it away it might not be as bad as people expect.

I think the Fed’s policy [of keeping rates so low] is somewhere between reckless and not having much impact. It has contributed to a bond bubble that has forced many investors into asset classes they shouldn’t be in to earn higher yields, such as high yield bonds, emerging markets debt, and longer-term corporates.

Q. How do you generally view equity valuations now?

A. The market is trading at the higher end of where it has traded over the past three years, at about 14 times estimated earnings. That’s in line with the historical average. However, that long-term average was when the U.S. economy grew at a 3.5% rate over 40 years or so. For the last 15 years it’s been closer to 2%, and the quality of earnings keeps going lower. So 14 times earnings today is not on a par with a historical price/earnings ratio. So I would say we’re at the upper band of valuation.

Q. In this uncertain environment, how are you positioning the fund?

A. We consider equities to be the most attractive asset class, but that’s by default because the other asset classes are not that appealing. Equities have a better potential reward/risk profile than other options. Our net equity exposure [as a percentage of fund assets] typically ranges from the low to mid-50s to the low 70s. Now we’re in the middle of that range in the low 60s.

With bond yields so low and rates more likely to rise than decline over the next three to five years, we see limited value and real risk of losses in traditional fixed income securities, including Treasuries, investment-grade corporates, and high yield debt.

Leveraged loans look more reasonable. They are at the top of the capital structure, which can reduce risk of principal loss, and they are not as exposed to rising rates because their rates reset every three months. Floating rate securities account for more than half of our fixed income exposure.

We have kept our average fixed income duration less than two years, so we’re not as exposed to the impact of rising rates on principal values.

Q. What are you focusing on in the equity portion of the portfolio?

A. The market underappreciates companies that deploy capital well. If we are in a slow-growth environment and companies are not generating enough topline revenue growth or profit margin expansion, how do you grow earnings? You can do it either by buying back your own stock, which produces earnings growth and improves return on invested capital; by growing your dividend; or by making acquisitions that provide good returns on capital, though few companies do that well.

So our largest structural overweight is in companies that deploy capital very well, such as AutoZone, State Street, and Danaher. All of these companies can generate double-digit earnings growth even in a low-growth environment.

Also, the portfolio is well positioned for rising rates, not only in our fixed income strategy, but in equities as well. Some financials could be beneficiaries of higher rates, including Ameritrade, State Street, and Northern Trust.

We also see value in stocks in the middle that the market has left behind for various reasons. They are not low quality or super growth and do not offer super-high dividends, but they are very high-quality, steady growers that have been overlooked, whether it is a United Technologies or a Danaher or a Marsh & McLennan.

Q. You also participate in so-called event stocks?

A. Yes, we look for opportunities where the odds of a company getting acquired, going private, or breaking up into pieces may be small but the valuation does not reflect that potential benefit to investors. We look at industry structure, management, and valuation and then try to identify the companies most likely to be consolidated in an industry, either from a product or geographic perspective.

The environment now is very ripe for leveraged buyouts and takeovers because debt is cheap relative to equity from a buyer’s perspective and because companies are struggling to grow earnings, so we expect to see more consolidation.

We own 20 to 25 companies where the odds of an event are modest, but it seems every year one or two of these pay off.

Q. What is your general outlook now?

A. I think investors should expect to see modest U.S. economic growth; continued modest contraction in Europe; and emerging markets doing better, which should produce decent global GDP [gross domestic product] growth overall. One concern is what happens when the Fed pulls back and takes the punch bowl away. Even though I think the benefit of Fed policy has been modest, we don’t know how the market will react when the Fed is no longer as aggressive or when it starts raising rates down the road in a couple of years.

For the market to go higher in the near term we need to see better earnings growth and start to see investors taking money out of fixed income and investing in equities. Once that trend takes hold, it could be a powerful force to drive the market higher.

In this environment, I would advise investors to be aware of the risk in their fixed income strategy and not to chase high growth, low quality, or high dividend yield in the equity markets. Focus on companies with 2% to 3% dividend yields that have high-quality business models and trade for no more than 15 times earnings.

As of March 31, 2013, stocks mentioned by Mr. Giroux made up 14.2% of the Capital Appreciation Fund assets.

Charts in the article are for illustrative purposes only and not intended to represent the returns of any specific security. Past performance cannot guarantee future results.

Because of the fund’s fixed-income holdings or cash position, it may not keep pace in a rapidly rising market. And its value orientation carries the possibility that the market will not recognize a security’s intrinsic worth for an unexpectedly long time or that a stock judged to be undervalued may actually be appropriately priced.

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