Perspectives

U.S. Stocks: Optimism Despite Myriad Headwinds

 Investors in U.S. equities may be excused if they entered 2013 feeling somewhat torn.

 On one hand, the 2012 total return of the S&P 500 Index of large-cap U.S. stocks was notably healthy, 16%, with returns of the leading sectors—financials and consumer discretionary—topping that. Small-cap U.S. stocks also performed well, with a total return of 16.35% for the year as measured by the Russell 2000 Index.

 On the other hand, investors did not have to look very hard for bad news—from tepid U.S. growth to high domestic unemployment, from the European crisis to a slowdown in China. Moreover, corporate earnings growth is decelerating—casting a pall over stock prospects.

 “Every time I read the paper, it’s always another negative piece of news,” says John Linehan, T. Rowe Price’s director of U.S. equity. “There’s been this huge dichotomy between market performance and sentiment.

“The market climbed a very steep wall of worry last year, but it is well poised to climb it again this year.”

For 2013, Mr. Linehan sees a continuation of this “tug of war between the market’s significant headwinds and its significant tailwinds.”

Among the tailwinds: the extraordinarily accommodative stance by central banks around the world, green shoots of recovery in the U.S. labor and housing markets, deleveraged consumer and corporate balance sheets, improved corporate fundamentals, and the potential end to (and ultimate reversal of) the massive cash outflows from stocks to bonds.

Among the headwinds: a muted outlook for U.S. economic and corporate earnings growth; U.S. fiscal problems, policy uncertainties, and regulatory burdens; and the risks of a eurozone recession and of a “hard landing” for China’s economy.

Despite this continuing struggle between the micro positives and the macro negatives, Mr. Linehan sees the positives prevailing for U.S. stock prices—primarily because of reasonable valuations.

The S&P 500’s dividend yield at year-end was above the 10-year U.S. Treasury yield for only the third time in 60 years. And then there’s the further anomaly of the S&P 500 earnings yield (based on expected earnings) far exceeding the U.S. Treasury yield.

“One of the reasons that valuations are attractive is that markets are very effective at discounting bad news, and right now current valuations reflect a great deal of bad news in the future,” Mr. Linehan says. “If we don’t get that bad news, it then will be very positive for equities.”

Durable Growth

Still, no matter what happens in the near term, the U.S. and world economies likely are going to grow slowly over the next couple years, notes Joe Milano, manager of the New America Growth Fund, which focuses on U.S. large- and mid-cap growth stocks.

As a result, Mr. Milano says he is looking for “secular growth” stocks instead of cyclical growth stocks— companies with high levels of stable or recurring revenues and that have the potential to grow even in a slowing earnings growth environment, because of innovation, better management, or the ability to take market share.

“My vision is to buy great companies that can grow in any environment,” he says, citing two examples, Fastenal and Stericycle, both of which are growing off of solid bases by serving clients in new ways.

Fastenal sells industrial nuts and bolts, as well as supplies for nonresidential construction sites, such as welding supplies, safety glasses, and gloves. It has pioneered on-site vending machines that distribute and track such supplies to each worker, which pays off in greater productivity and less loss. “Within 10 years its vending machine business could be bigger than the entire company is now,” Mr. Milano says.

Stericyle is a big player in the medical waste business, a company that picks up those red bags of hazardous waste from medical facilities. While the firm has steady recurring revenue from its long-term client relationships, it has branched out into new services such as managing medical offices’ patient communications. “Now they’re up-selling,” Mr. Milano says.

Neither stock is cheap, he says, “But when the economy gets tougher, investors shouldn’t buy lower-quality stocks—buy the best.” Sudhir Nanda agrees. Mr. Nanda, the firm’s director of quantitative equity research and manager of the Diversified Small-Cap Growth Fund, sees a “muted, steady-Eddie environment” without big valuation disparities among stocks.

That tells him that “high quality” stocks—stocks with the metrics showing high recurring revenues, high free cash flows, and high returns on equity—should do well, and in late 2012 these sorts of stocks already began to evidence that, he says. “There’s not going to be a sharp upshift in the economy this year, so it’s likely going to be an environment in which the quality companies will rise relative to others—a stock picker’s environment,” Mr. Nanda says.

Opportunities

 Overall, managers of T. Rowe Price’s asset allocation portfolios entered 2013 with a strong tilt toward large-cap stocks over small-caps and a less pronounced tilt toward growth stocks over value plays.

Within that, Mr. Linehan sees a wide range of opportunities among the following investment themes:

  • U.S.- and international-based companies with exposure to the explosive growth in emerging market consumers.
  • Derivative plays on the housing recovery, such as regional banks.
  • Companies with growing dividend payments (versus high-dividend-yield stocks, whose valuations have become expensive).
  • Providers of new treatments in healthcare.
  • Companies with exposure to mobile and cloud computing.
  • Compelling “sum of the parts” valuations in energy, in which certain firms are trading significantly below their breakup values.

Not particularly prominent within that list are companies within 2012’s top S&P 500 sector—financials.

Financials did well in 2012 because, first, they started the year with very cheap valuations, says Eric Veiel, manager of the Financial Services Fund. The sector had singularly underperformed the market for each of the prior five consecutive years. Second, he says, “While there are still a lot of problems in financials, a lot of things stopped getting worse for the sector last year. So these companies started bottoming and the market reacted positively.”

For 2013, Mr. Veiel believes that the sector’s returns may keep up with or exceed that of the overall market but not notably so, unless the low interest rate environment significantly improves. Low rates have muted returns for banks and other financial institutions.

As for small-cap stocks, Greg McCrickard, manager of the Small-Cap Stock Fund, notes that the asset class has typically done best coming out of recessions, when economic growth has been negative. That will not likely be the case in 2013’s muted-but-positive growth environment, he says.

Moreover, he says, while small-cap valuations relative to large-caps have fallen some, they’re still higher than large-caps—when the long-term trend is for them to be even with or at a small discount to large-caps.

“Even if we solve our other problems, we’re still looking at a fairly slow economic recovery,” Mr. McCrickard says, “and that implies relatively middling performance for small-caps. Until we get valuations at a discount to large-caps, it’s going to be a challenge to outperform the S&P 500.”

The stocks mentioned by Mr. Milano accounted for 3.4% of the New America Growth Fund as of December 31, 2012.

All funds are subject to market risk, including possible loss of principal. Small companies tend to have less experienced management, unpredictable earnings growth, and limited product lines, which can cause their share prices to fluctuate more than those of larger firms.

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

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