5 experts on today’s markets
Why stocks could outperform bonds. Where experts are finding opportunities.
Will the economy double dip? Are stocks a steal—or a steel trap? What’s next for bonds? And what are the smart moves for investors now?
In the midst of mixed signals on the economy, Viewpoints brought together a blue-chip panel of veteran money managers for our third Inside/Out Roundtable, this time in New York City.
Their bottom line: They don’t expect a double dip, but rather foresee continued slow growth and potential upside for stocks. With corporations sitting on a mountain of cash and valuations low to reasonable, our experts—including our bond manager—agree that stocks could outperform bonds in the years ahead. Another potential plus for stocks: a rising tide of mergers, dividends, and stock buybacks as corporations begin putting cash to work.
What should investors consider to make the most of these trends? Here are our five experts’ top insights and investing ideas.
Hear ideas from:
- Bob Doll, Chief equity strategist, BlackRock, Inc.: Focus on free cash flow.
- Tom Soviero, Portfolio manager at Fidelity Investments: Watch for more M&A activity and stock buybacks.
- Mario J. Gabelli, Chairman and chief executive officer of GAMCO Investors, Inc.: Q3 earnings could surprise.
- Ford O’Neil, Fixed income portfolio manager at Fidelity Investments: Bond yields plunge to generational lows.
- Whitney George, Co-chief investment officer and portfolio manager at Royce & Associates, LLC: Look for good balance sheets and high returns on capital.
There are a few simple rules I believe can help in volatile times. First, don’t panic in and buy at the top, and don’t panic out and sell at the bottom. If you have to run, run when stocks are up, not when they’re down. Second, in periods of volatility like this, rebalancing can add a lot of value to portfolios, and dollar cost averaging works.1 Third, if you agree with us that the world’s not going to end, lean toward stocks, to the extent you can, at the expense of bonds.
The consensus estimate has a 10% to 15% rise in earnings for 2012 over 2011, and I think the market—at its low in August—was discounting a 15% decline. I believe the market is pricing in a recession that we’re unlikely to get, which makes me reasonably interested in stocks versus other investments.
Corporations setting the pace
American companies are gaining market share globally because they have done a better job serving markets than their European and Japanese competitors. This has been helped by the decline of the dollar. At the same time, corporate CFOs have gotten pretty good at managing their businesses in a very slow-growth world.
Of course, the U.S. economy can’t grow 1% forever while corporate America grows earnings at double-digit rates. But if we can grow 2% or 3%, I think earnings growth can continue to be healthy.
Corporate America’s balance sheets are also as healthy as they’ve been since the 1950s, and free cash flow is equally strong. As a result, I think there are four things that we will enjoy: inordinate dividend increases, higher-than-normal share buybacks, rising merger and acquisition deals, and plain old-fashioned business reinvestment. The first three we are already seeing, while the fourth is coming in fits and starts.
As for Europe, there are risks, but I don’t invest in the governments or economies of those countries, I invest in the companies that happen to be domiciled there. If you can buy lots of company stocks in this realm at very cheap prices because of overhangs and put them away, somewhere down the line, you may be pretty happy.
Tech and health services
When I sit with my analysts and look at a company, my first question usually is: What is its free cash flow and what is it doing with that free cash flow? It’s incredibly important in this environment.
We are in a slow economy, but nevertheless one that is growing. So I want some cyclicality in the companies I invest in. Technology is one of my favorite cyclical sectors. Tech learned a lot of their lessons the hard way in the technology bust of 2000. So they entered the Great Recession with stronger balance sheets and better free-cash-flow on their income statements. These companies have done a really good job managing their way through the difficult times.
Among the defensive sectors, my favorite is health care, with an emphasis on health care services. The aging of the population means health care will be more in demand. Most of the companies I like are fantastic free-cash-flow generators, so they’re buying back their stock, which can put some of their earnings per share in double-digit territory, and they’re selling at very low double-digit or single-digit multiples.
Beware of chasing yield
I think many investors should be seeking total return. You can find vehicles that give you lots of income, but I think a lot of high-dividend-paying stocks will behave like bonds, which could mean underperformance. I want companies that have positive free cash flow so if they have a dividend, they can increase it. And if they don’t have a dividend, they can institute one and reward shareholders.
What I’m looking for in the highly leveraged companies I invest in is an improvement in the balance sheet—because that can drive an equity higher.
Leveraged company stocks tend to do well coming out of a recession because companies start to aggressively repair their balance sheets. The worst environments are ones like the one we just went through this summer, where you have this extreme flight to safety. Risk becomes a four-letter word. But that won’t last forever.
Rising M&A and stock buybacks
Corporations are flush with cash now. When there is more business certainty or a better outlook, companies will devote some of that cash to capital spending, which creates growth and jobs. But market volatility and a panic-driven mindset dampen that type of expansion. Instead, companies will lean toward using their cash to acquire other companies or their own stock.
Buying another company can be very beneficial to earnings. I think the premiums on M&A transactions have been pretty high recently, which tells you that when stocks get cheap enough, corporate America will snap them up. That’s especially true when cash is earning less than 1% on the balance sheet. I take a hard look at sectors that are not that levered, that could literally grow their earnings by either borrowing money or just using some of the cash on their balance sheet to buy back equities. There have been a lot of mergers and acquisitions in the U.S., and most of them are cash deals, and I think that’s very bullish for the market.
Since the downturn of 2009, companies did go through a process of reducing leverage, and I would say we’re at least in the seventh inning of that process. In fact, you’re seeing announcements now where companies are trying to leverage up a little bit to buy back their own equity because they feel that their stock has become cheap. If you can borrow money at 6.5%, it makes sense to buy back your stock at 10-times earnings.
Maybe, in this climate, we will see more of that cash going to work. There is at least one company sitting on tens of billions in cash, so it would not be outlandish for them to go out and buy back billions worth of their stock. There comes a point when companies can say, “My stock is cheap and I’m going to buy the heck out of it, because that’s the best use of our capital.”
Tapping into emerging markets
I’ve been looking at consumer companies as well as materials names that have exposure to developing markets. Coal companies have become very cheap, even though coal is used throughout the world in electricity generation. We tend to have a lot of coal in the states and we can export the material to faster-growing countries.
I’m also looking at chemical companies, which have been hit pretty hard with this recent downturn. They’re staples, in the greater sense of the word. Demand will only pick up as China, India, and other emerging markets industrialize. They need these assets.
Evaluating risks from the EU
If the European situation grows more unstable, it could create more long-term uncertainty, which would not be good for global economies. A double-dip recession on a global scale would clearly hurt risk assets such as leveraged equities and cyclical stocks.
On the other hand, it can get to a point where these extremely low valuations can become a catalyst for action—either by investors like me, corporate acquirers, or companies announcing stock buybacks. And when that happens, leveraged companies can outperform.
On balance, I think we’ll have a slow, muddy economy. To jump-start growth, we’ll need to restore confidence so that people will begin spending again. But even without that, stocks can do relatively well.
I thought the market would be up 5% to 10% this year, but the dynamics in Washington over the debt deal crimped our enthusiasm. Still, I think valuations are reasonable—and provide a margin of safety.
I think third-quarter earnings will be better than most people expect, in part, because the euro is higher than a year ago. That could give U.S. companies with earnings in euros a 10% bump—and the market may not expect that.
Over the next 10 years, I take the point of view that the equity markets could grow 5% to 7% a year in real terms, which is pretty good. Within my framework, I hope to add to that return through stock selection. And I think it’s a good time to be buying, because of this little air pocket from falling investor confidence.
Energy, health, farm equipment, and airlines
Some simple themes I’m exploring are things like energy efficiency. How do we reduce the consumption of energy? How do we become less dependent on fragile supplies, and which companies will benefit? In regard to shale gas, companies have developed a way to find gas in areas that we never thought possible. That is going to be a very major perk to the United States, once we work through the issues of water infrastructure and water purity related to that extraction.
A second theme is health and wellness. Consider the fact that the average person in the United States has gained 25 pounds over the last 30 years and we are seeing more obesity. This creates a lot of pressure on our health care system. I think companies that help contain these costs will do well.
Agriculture is another area of focus. There are seven billion people in the world, and soon there will be eight billion. Five of our 13 billion bushels of corn go to ethanol, which adds upward price pressure. In this theme, I see all roads leading to farm equipment companies.
I am also looking at airline makers. Over the next 20 years, 10,000 planes are going to be retired. Given the high propensity of the Chinese and Indians to travel, I estimate a need for about 22,000 new commercial aircraft. This is going to be a very important driver for vendors of major airline manufacturers, though the cutting of military expenditures will present some headwinds.
Why has gold done so well? Those with reserves have to put them somewhere. I don’t think they like the dollar, yen, or the euro, and unless policy around those three currencies changes, it’s hard to see people turning against gold. I think for the next 100 years, I probably would rather own earnings-powered companies, but for the next 10 years I don’t mind owning a portion of my assets in gold. There’s a difference in holding gold as opposed to owning the producers of gold, and at some point I think stocks could catch up.
Bond and equity markets have experienced extreme swings over the past several weeks, as headlines and economic data from around the world increasingly suggest that global demand is slowing and many developed markets, including the United States, are at risk of heading back into a recession. As a result, many central banks are expected to either ease monetary policy further or at least keep interest rates extremely low for several years. This has pushed bond prices to historic highs and interest rates to historic lows.
Given these extremes, are bonds a sell? I’m not so sure.
The cost of safety
At these record-low interest rates, U.S. Treasuries certainly do not generate a lot of income. However, because the Fed has said it will keep interest rates low (and possibly set even lower) for years, U.S. Treasuries also look safe to me… at least for a while. There are very disturbing comparisons and credible reasons why U.S. economic growth could remain elusive and could increasingly look Japan-like. In this scenario, or if deflation or additional risk flares emerge, U.S. Treasuries could even have upside from these extreme levels, while riskier assets sell off.
TIPS offer inflation protection but limited real returns
While Treasuries offer upside in a deflationary environment, they suffer in an inflationary one. Treasury inflation-protected securities (TIPS) are an alternative where the reverse is true. These securities guarantee a real return that is protected from inflation. So if inflation rises above expectations, the TIPS investor is made whole. Currently the two-year TIPS real yield is -1.15% and the 10-year real yield is -0.04%. However, if actual inflation or inflation expectations rise from current levels, TIPS will generate a higher return than Treasuries.
The beauty of TIPS is that you can win two ways. First, when recession fears increase, the market increasingly prices in lower inflation expectations and TIPS become cheaper. And when market sentiment swings the other way, inflation expectations rise and TIPS should outperform. Right now, inflation expectations are at the lower end of their recent range. But they could go lower before they go higher.
The second way to win is if realized inflation is higher than what is priced into the market. Short-maturity TIPS are extremely sensitive to near-term movements in the U.S. dollar and oil prices because those are the biggest drivers of inflation in the short term. But in the long term, inflation should be much more sensitive to the stance of monetary policy, which I believe will remain easy for a long time. Therefore, I believe long-duration TIPS have an important place in a portfolio as a hedge against the unconventional outcome of the Federal Reserve’s unconventional monetary policy.
As the probability of a double dip has increased, high-yield securities have materially declined in price, leaving average yields at a hefty 9.6% as of August 31.2 I believe this has created an excellent opportunity to add to my favorite issuers that came out of the last recession with cleaner balance sheets and relatively healthy cash flows.
CMBS is also attractive
There is a very small pocket of the investment-grade bond universe called commercial mortgage-backed securities (CMBS) that I think is attractively priced today. My fundamental outlook for the sector remains constructive based on improving operating results, access to capital markets, and positive technicals. But it is important to note, each security is truly unique in this sector and it requires a great deal of analysis to find the diamonds in the rough.
Limited opportunities overseas
As for foreign bonds, I have eliminated almost all of my European exposure. I believe that there is still the strong potential for more negative headlines and risk flares as the European sovereign crisis continues to unfold. The only opportunities that I find attractive are in select emerging markets.
The case for bonds
Given the extreme uncertainty and volatility in today’s market environment, fixed income products as part of a fully diversified portfolio provide value even at historic low interest rates. There are some segments of the bond market that will do well if the economy falls into recession, and others that will do well if the economy accelerates. The key is to have a well-balanced portfolio that reflects today’s rapidly changing economic conditions.
One thing I like about the small- and micro-cap universe is that the companies tend to be simpler animals. They have one or two products, or they’re in one industry. Small- and micro-cap companies are just as transparent as the large multinationals, but they are a lot easier to figure out.
In this very dynamic and sometimes volatile part of the market, I look for companies with good balance sheets that earn high returns on invested capital. I try to buy them when they’re out of favor and use a three- to five-year investment horizon as a holding period.
The kinds of markets we saw this summer are difficult periods to outperform in, but they’re also the kind where you get the best opportunities for future returns. The job is to use whatever turmoil is out there to our advantage and respond to opportunities that come along—and there have been many of them recently.
Mining, energy, semiconductors, and manufacturing
The amount of dollars in circulation has tripled in the last three years, so there’s much more paper chasing the same quantity of commodities. People have caught on to the fact that money printing is inflationary, so I am very heavily positioned in hard asset plays, whether in mining, energy, or industrial companies.
Mining companies have not participated in the recent run-up in gold and silver prices, but they have terrific margins. Gold miners are producing new metal at $650 to $800 per ounce, and they can sell it now for around $1,800. Silver costs between $7 and $9 per ounce to produce, and it has recently been selling in the $40 range.
I have also been very active in Canadian energy service companies because the industry has become much more service intensive. It takes a lot more work to get the same amount of hydrocarbon out of the ground than it did last year or the year before, and service companies are benefiting from that.
In technology, I have been buying a lot of analog semiconductor makers. These companies make passive semiconductors, simple products that last a long time and that control power for a variety of products. Their use has been increasing quite dramatically in places like the automotive, lighting, and home appliance industries.
This is a great country to manufacture in, particularly if the dollar stays reasonably cheap, because of infrastructure, because of rule of law, because of patent protection, because of cheap energy. So manufacturing has been a very healthy part of the economy.
When people really get nervous about the euro and start bashing European companies, it creates opportunities. There are German manufacturers that I have come to know and like very well, which have benefited as the euro declined. I have also been interested in some European asset managers, high quality companies that may offer better valuations in bear markets. In fact, I have been finding lots of interesting companies in Europe, where small cap is not as well-established an asset class as it is in the U.S.
- Bob Doll is BlackRock’s chief equity strategist and has primary portfolio management responsibilities for the U.S. Large Cap Series, including BlackRock Large Cap Core Fund (MDLRX | Get Prospectus
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- Tom Soviero is a portfolio manager for Fidelity Management & Research Company (FMRCo.). He manages a number of funds, including Fidelity Leveraged Company Stock Fund (FLVCX | Get Prospectus
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- Mario J. Gabelli is chairman and chief executive officer of GAMCO Investors and a portfolio manager managing a number of funds, including the Gabelli Value Fund (GABVX | Get Prospectus
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- Ford O’Neil is a portfolio manager for Fidelity Management & Research Company (FMRCo.). He manages a number of funds, including Fidelity Total Bond Fund (FTBFX | Get Prospectus
- Whitney George is a co-chief investment officer and a managing director at Royce & Associates and a portfolio manager of a number of funds, including Royce Value Fund (RYVFX | Get Prospectus
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Information provided in this article is general in nature, is provided for informational purposes only, and should not be construed as investment advice. The views and opinions expressed by the speakers are their own as of the date of their interview and do not necessarily represent the views of Fidelity Investments. Any such views are subject to change at any time based on market or other conditions. Fidelity Investments disclaims any liability for any direct or incidental loss incurred by applying any of the information in this article. As with all your investments through Fidelity, you must make your own determination as to whether an investment in any particular security or securities is consistent with your investment objectives, risk tolerance, financial situation, and your evaluation of the security. Fidelity is not recommending or endorsing these investments by making this article available to its customers. Consult your tax or financial adviser for information concerning your specific situation.
1. Dollar cost averaging does not assure a profit or protect against a loss in declining markets. For the strategy to be effective, you must continue to purchase shares both in market ups and downs.
2. Bank of America Merrill Lynch US High Yield Master II Constrained TR USD current yield as of August 31, 2011. Source: FMRCo FactSet. Bank of America Merrill Lynch U.S. High Yield Constrained Index–BB Rated is a modified market capitalization–weighted index of U.S. dollar–denominated, below-investment-grade corporate debt rated BB and publicly issued in the U.S. domestic market. Qualifying securities must have a below-investment-grade BB rating (based on an average of Moody’s, S&P and Fitch) and an investment-grade rated country of risk. In addition, qualifying securities must have at least one year remaining to final maturity, a fixed coupon schedule and at least $100 million in outstanding face value. Defaulted securities are excluded. The index contains all securities of the BofA Merrill Lynch U.S. High Yield Index–BB Rated, but caps issuer exposure at 2%.
Past performance is no guarantee of future results.
In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible. Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
Increases in real interest rates can cause the price of inflation-protected debt securities to decrease.
Government bonds and corporate bonds have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns. U.S. Treasury bills maintain a stable value if held to maturity, but returns are generally only slightly above the inflation rate.
Investments in mortgage securities are subject to the risk that principal will be repaid prior to maturity. As a result, when interest rates decline, gains may be reduced, and when interest rates rise, losses may be greater.
Leverage can magnify the impact that adverse issuer, political, regulatory, market, or economic developments have on a company. In the event of bankruptcy, a company’s creditors take precedence over the company’s stockholders. Although the companies that the fund invests in may be highly leveraged, the fund itself does not use leverage as an investment strategy.
The gold industry can be significantly affected by international monetary and political developments such as currency devaluations or revaluations, central bank movements, economic and social conditions within a country, trade imbalances, or trade or currency restrictions between countries. Fluctuations in the price of gold and precious metals can dramatically affect the profitability of companies in the gold and precious metals sector and can directly affect the value of the securities issued by such companies.
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The municipal market can be affected by adverse tax, legislative, or political changes, and the financial condition of the issuers of municipal securities.
Stock markets, especially foreign markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.
Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. These risks are particularly significant for funds that focus on a single country or region.
The commodities industry can be significantly affected by commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions. Commodities and futures generally are volatile and are not suitable for all investors.
Indexes are unmanaged and you cannot invest directly in an index.
Barclays Capital U.S. Aggregate Bond Index is a market value-weighted index of investment-grade fixed–rate debt issues, including government, corporate, asset-backed, and mortgage-backed securities, with maturities of one year or more.