This week’s Conjecture panel discusses the issues around the US recovery
The US remains the world’s largest economy but have investors missed the recovery or is this the perfect time for exposure to US equities? To disucss this, the Conjecture panel this week consists of Cormac Weldon, head of US equities at Threadneedle Investments, Mary Chris Gay, portfolio manager at Legg Mason Capital Management, and Simon Dorricott, associate director of fund services at Standard & Poor’s.
What are the key arguments in favour of advisers and investors considering the US at this moment in time?
Cormac Weldon (CW): We think the market is quite attractively valued. It is about 12-and-a-half times earnings this year on our estimates. In addition, what you are buying today is a high-quality equity in general and debt is much lower than it has been over the past number of decades.
Also, cashflow is much higher than it has been and incremental – we are still at the point where incremental profitability is quite high. So certainly, valuations and what you are buying is very attractive. I would point out that as UK investors we are also quite positive on the dollar, which has the potential for giving an additional kicker to a UK investor. There are much fewer people today thinking the euro is going to displace the dollar as the world’s reserve. There are many other aspects to investing in the US but I would cite those at the moment.
Mary Chris Gay (MCG): We entirely agree on the valuation levels. The US market – especially with the pullback we have had in the midst of this correction – has given investors an opportunity to get re-engaged in the US at valuation levels we have not seen in quite some time. If you look at the forward estimates on earnings, the market right now has a forward earnings yield of close to 9%.
The returns on equity are extremely high – close to 20% – and pre-cashflow yields are very high – over 8% currently, which is much better than many of the other developed countries around the world.
When you consider where valuations are and the fact that in the US market many large-cap companies find an increasing portion of revenues derived from sources outside the US, in particular in the faster growing parts of the world such as Asia.
Also, when you consider the underlying growth rates, the quality of earnings, the fact balance sheets have been rebuilt virtually in the midst of the crisis, we think the opportunity for the US, certainly relative to other developed markets, is about as compelling as we have ever seen it.
Simon what have you been finding from speaking to US managers?
Simon Dorricott (SD): Well it is a pretty similar story from all the managers we have been in contact with recently. Most have highlighted the issues already talked about. Obviously, the Q1 earning season was reasonably strong both in terms of the earnings numbers and in a good many cases in terms of revenue growth as well.
The economic data coming out of the US has shown some clear improvements. Most of the managers we are speaking to are expecting stockpicking to come to the fore over the rest of this year, as the market focuses on more sustainable growth and particularly revenue growth. Also, most managers are expecting the gap between the winning and losing companies to become greater.
The only other broader point to make is the size of the US equity market makes it difficult to ignore and there are a huge number of highly experienced portfolio managers with many different styles of investment available, which makes building a fund of funds quite attractive in this area.
Is it the case that the large-cap US market is now so efficient it is enormously difficult to find managers that can outperform?
CW: The US market is widely accepted as being more efficient than other markets and it is at its most efficient in large-cap stocks. That is not to say there are not opportunities to outperform within large cap, but I would say our consistent strategy over the years has been the market is less efficient in mid and small cap. We have tended, for that reason, to be overweight in that part of the market rather than large cap. So we acknowledge the observation but also feel there is a way around it and a way to perform.
MCG: The way we are positioned is in large cap and even moving into mega cap, and if you look at the relative valuations of the largest 100 companies in the US today, they are well below their historic levels.
Even if you go back to the past 50 years, the large-cap US stock, especially the largest of the large caps, are as cheap today as they were in the early 1980s. And in terms of the efficiency of pricing, if I could use IBM as an example, it is a stock we have owned for a long time and we have pretty optimistic views about it. It is a company that has been around for 100 years, so there is lots of data out there everyone can see. They are very transparent. They give guidance for the next 10 years. It is probably one of the most well followed companies in the US market and yet the stock trades at a discount to the market and about, in our view, nine times forward earnings with a 2% dividend yield.
IBM’s guidance for the next five years is they will earn roughly $20 a share and the stock is $123 today. Even if you assume no valuation expansion in five years, that would result in a double of the stock.
Simon, do managers have preferences for larger-cap stocks?
SD: On the large versus small side of things, I think there is a slight preference for the larger names fitting in with that idea of high-quality sustainable growth stocks coming to the fore over the next year or so. A number of managers are pointing to that area where they feel these stocks in a lower-growth environment and deserve a premium to the market they do not have at the minute.
The only other thing to say with regard to the other part of the question is with regard to efficiency – the same sort of ideas can be leveled at UK managers with regard to the FTSE 100, with most dipping down into the FTSE 250 to outperform. I think with regard to finding managers who can outperform consistently, we have got a couple here who have pretty much managed to do that. Certainly at Threadneedle, Cormac’s fund has done well, and on the Legg Mason side of things, Bill Miller has still got a pretty healthy longer-term track record.
What are your views on some of the financial stocks and are there still opportunities in this sector.
MCG: We believe financials remain extremely cheap, and if you look at them on a price-to-book basis or a normalised earnings basis, they are among the most attractive today. They are as attractive as they have been in quite a long time, since the early 1990 period after the last financial crisis, the Savings and Loans crisis. We do believe it is important to be selective so we have got a lot of diversification within our exposure.
But if you consider the multiples many of these companies are trading at – even with where we are in terms of the financial reform – the stocks in this sector trade at a very steep discount to other areas of the market and we believe that is certainly unwarranted.
CW: We absolutely favour the larger-cap banks for many if not all of the reasons Mary Chris alluded to. We are not exposed to smaller banks at this point in time but I certainly do remember in the post-Savings and Loans crisis period when there became a point in time when that was the right thing to do, most especially when M&A activity picked up.
At this point, it does not appear to be the case in mid- and small-cap banks, and for that reason we are in the larger-cap banks and like them quite a bit.
