Seeking US equities value in 2015
US equity markets can continue to advance from here. Our research analysts currently estimate S&P 500 earnings growth of 5% in 2015. Our earnings estimates have come down slightly, mostly as a result of our downward revisions in the energy sector. We also believe that a stronger dollar and struggling European growth could be a headwind for profits.
Whilst absolute equity valuations are at the highest point of this market rally, fundamentals remain strong. US profits continue to increase, with margins at records and still rising and until this economic cycle ends, we don’t see that changing. Strong profits and cash flows should encourage continued stock buybacks, higher dividends and acquisitions too.
It is our opinion that the US economy is firmly set in a mid cycle expansion. At times, investors get caught by measuring market advances in calendar years and not where we are in the economic cycle. There remains considerable under investment in the US economy as both residential and commercial construction as a percent of GDP remains below long term averages. The Fed’s measure of capacity utilization for October came in at 80.1%, a point where capital spending has historically begun to accelerate.
The employment situation continues to improve and while wage growth has been muted, we should expect it to flow through at some stage this year. We believe this could help boost durable goods sales, which remain near recessionary levels.
Financials remain an area of both significant potential earnings per share upside as well as multiple expansion as the interest rate and regulatory environments normalize. If the Fed raises rates in recognition of a strong economy and better unemployment rate, we would expect the most positive direct earnings impact to be realized by our regional bank holdings. For example, regional banks should be able to price new loans at higher rates, while they will lag paying higher rates on deposits, thereby expanding net interest margins. Additionally, a stronger economy should translate into greater loan demand. Both of these factors should lead to higher net interest margins and net interest income for regional banks.
There is one regional bank that we feel is a stand out investment, Wells Fargo. Wells has a different business mix to Citigroup, Bank of America and JPMorgan. It does compete with them in various areas, but it has much less exposure to investment banking as a whole, less exposure to credit cards than the other three and much less international exposure. It is a much simpler business in a way, although with a lot of moving parts, because it is still a very big company. Wells Fargo has a very powerful position in consumer banking, business banking and financial advisory. However, probably the biggest dominant position they have is in mortgage origination and mortgage servicing. While this area has not reaped a lot of rewards in the last few years, not only due to litigation and working their way through problem mortgages, but also because the US consumer has been somewhat reluctant to take on debt. Long term we think they are the dominant mortgage company in the US — that’s a business that will generate good returns.
We continue to have significant exposure to the consumer discretionary sector. While our overall allocation to the sector has not really changed during the year, we did trim and add from a few names on valuation. We do feel it’s an area of the portfolio where we probably have the biggest opportunity. We have positions in Home Depot, AutoZone, Bed Bath & Beyond and a number of companies in the retail space because they have very strong balance sheets, very strong cash flow and great management teams who are disciplined capital allocators.
Jonathan Simon is fund manager on the JP Morgan Funds US Value Fund