Investors ignore US company fundamentals at their peril
Investors without exposure to US equities are ignoring company profitability fundamentals, and risk missing what could possibly become only the third sustained period of rising annualised returns from the S&P 500 since the 1930s, said Grant Bowers, vice president and portfolio manager at the Franklin Equity group.
Earnings and cashflow positions of individual companies continue to improve, along with a steadily improving business environment in the US and other markets where those companies operate. This in turn means that the challenge to investors increasingly is whether to push for higher dividends or re-investments for higher future returns, rather than consider whether companies will survive the ongoing macroeconomic environment, Bowers said.
However, because of the current risk-off attitude by investors towards equities in gerneral, the prices of US equity is low compared to historical price/earnings and other multiples. But Bowers expects that to change significantly in the coming 24-36 months assuming signs of a firm resolution to Europe’s sovereign debt crisis.
The challenge to investors considering US equity is to alter their way of thinking; from chasing the return patterns of the past decade, towards recognising the fundamentals now in place.
“Current valuations suggest equities have fallen out of favor as an asset class.
But if you look forward I think there’s a once-in-a-decade opportunity to acquire the asset,” Bowers said.
Prior to 2011, the last two times that annualised returns from the S&P 500 troughed were in the 1970s and the 1930s, data suggests.
Global growth will help: Bowers estimates 45% of returns from the index are ex-US and that constituents tend to be leveraged to global growth.
Add in other data suggesting bond to equity pricing relationship is reaching levels not seen since the 1970s, then it also suggests investors may start to reconsider their approach to the asset class.
The key driver of S&P returns going forward is likely to be globalisation, Bowers said. This will benefit many markets where US companies operate, while the companies themselves become more efficient through technology advances.
Meanwhile, the market requires further assurance that the worst case scenario – ie, 2008 – is not being repeated. 2008 as a year for investors was a surprise, which is why it caused such problems, Bowers said. Markets may be edging closer to pricing in a Greek exit from the euro and the calamity that would ensue – such as the need to reprice financial services contracts – but if that does not happen then 2008 is unlikely to be repeated.
While uncertainty around contracts is a problem, Greece itself is not: in terms of its relative size to Europe, it is the equivalent of Maryland to the wider United States. If that State went bankrupt, the US could easily handle it, Bowers said.
And even if Europe should fall into deeper recession, this is not necessarily going to significantly impact many US companies, where sales to the region only make up single digit percentages of their overall global sales.
And us growth of just 2-3% will be enough to sustain recovery in that market, Bowers suggests. Apart from the last month, jobless figures had been falling for eight straight months, even as home ownership affordability has hit all time highs.
The decision of what to do with the benefits obtained from this environment from US companies – such as their large and growing cash piles – is what Bowers and other investors have to increasingly consider, he said.
He sees three ways that the cash may be used: M&A, investments in capital plant to boost efficiency, and lastly buy backs and dividends.
As an investor he said he prefers dividends. That said, should the reinvestment point to attractive future returns, he would support this.
“Businesses need to be investing for the future,” he said.
Apple is a good example: it has more cash than it requires for its business, and there is little that would make sense for it to acquire by way of a defensive move against disruptive and competing technology.
Bowers said he supports the company’s move to pay a dividend, and he expects this to grow, pointing to dividends accounting for a growing share of total return.
In sectors such as Industrials, the key to growth in investor returns is cheap energy. The prevalence of cheap natural gas is affecting the input costs for manufacturing of “pretty much everything consumers buy,” Bowers said.
He pointed to a US price of $2 per therm against a European average of about $8 per therm. One US company is dismantling its Chile methanol factory and moving it to the US to take advantage – one of many examples why he feels that manufacturing will have an advantage in coming decades.
This may not play out as an immediate trend, but over time it could, for example, increase the number of manufacturing jobs in the country, further benefiting the economy.
However, currently Bowers is focused on other sectors, including being overweight in Technology, with names such as Apple, Qualcomm and Citrix in the top 10 holdings of his Franklin US Opportunities portfolio.