Seeking Alpha
Research analyst, CFA, Director of Research, long/short equity
Profile| Send Message|
( followers)  

It is dangerously premature for bulls to declare victory in 2013 - but nothing short of cataclysm is likely to turn the 2013 stock market year negative. If you have been out of the market, you may feel the parade has passed you by, as you watch the street-cleaners sweep up the confetti of shredded short positions.

That said, look for 2014 to be a stock-picker's year. There is more to "stock-picker's year" than trotting out the old favorites; remember how well that worked with AIG and C in 2008. Below we describe a few things we look for before doing our stock-picking.

Bull: Not Dead Yet

We do see more ahead for this bull market. Since World War II, every bull market has ended with a period in which earnings slowed, flattened, and then reversed; and a concurrent period in which multiples expanded, as last-ditch bulls kept pushing the index higher without realizing that the party was ending. We're not there yet.

The third-quarter earnings season demonstrated that cautious company guidance disguises the aggregate earnings power of the S&P 500, which comprises about 80% of the investable domestic equity market. With 3Q13 EPS season nearly over, Bloomberg's compilation shows that S&P 500 earnings have advanced 7% year over year (compared with the clueless pre-reporting consensus of 1% growth).

Years of EPS growth that has roughly tracked index appreciation have kept P/Es from becoming too stretched. At 1,765, the S&P 500 trades at 16.1-times our 2013 estimate of $110 - in line with the five-year multiple of 15.7 - and at 14.5-times our 2014 estimate of $122. Since World War II, bull market-ending P/Es have tended to be north of 17-times.

Prerequisites for Earnings Growth: Innovation…

Neither of the two signs of the dying bull - stalled or falling earnings, and stretched P/Es - are yet in view. But they will be if earnings fail to grow while blithe bulls keep buying the market. For earnings to continue growing, individual companies must continue to invest and innovate. And they must anticipate and adapt to secular change. That's a tall order, and not every company will succeed.

One key to relative outperformance is innovation. Every company promises to innovate, but many of those claims are half-hearted and me-too. Rather than take these pledges at face value, we measure the outcomes, which include sustainable cash flows, persistent innovation, market leadership, and a high percentage of new products in the mix.

Sustainability of cash flows: In the past, innovative companies paid little attention to capital allocation & shareholder-friendly practices. Paying a dividend or buying back shares were seen as a sign of stodginess, that the growth was over. Now, innovative companies use capital allocation, including dividend growth, to express confidence in the sustainability of their cash flows. We prefer a flexible and balanced capital allocation program, including buybacks and dividends. This bifurcated strategy enables companies to reduce buybacks in economic down cycles without sending a negative signal by cutting the dividend.

Persistent Innovation: As the bull market matures, investors may want to begin paring exposure to start-ups and high-flyers and start to focus on mature but still innovative companies. Such companies cultivate a culture of innovation, in many cases stretching back decades, and regularly allocate "blue-sky" thinking within the R&D budget and engineers' work day. These companies have heard time and again that a new upstart will take their business; but usually these companies stay one step ahead of the competition. Persistently innovative companies tend to have a high percentage of their production being no more than two-three years old, and usually they keep investors updated on that number.

…Anticipation, and Adaptability

Keep in mind that maturity in itself is not protection against the new. Disruption from new technologies, new government policies, new resources and other as yet unforeseen factors will create opportunities for proactive companies while shaking out ill-prepared incumbents. There's market logic in that fabled Chinese character that simultaneously means "calamity" and "opportunity."

We expect the bull market in (what are likely) its final phases to become much more selective. The frenzy around the Twitter IPO signals that as traditional growth stories struggle to grow, investing sentiment will be shifting to the disruptors.

Every sector and industry presents challenges to the status quo but also opportunities for the savvy investor. We took a look at the dynamic changes buffeting three sectors. Rather than offer specific stock ideas - such recommendations can have very short shelf lives in a dynamic environment - we offer our view of the trends the savvy investor will want to understand in order to make informed investments, along with a few groaner puns.

Technology: Leader of the SMAC

Technology used to a place of "silos." Discreet boxes such as servers and PCs were linked by LAN or public network, with a thin software overlay to enable these devices to work together. Those days are done. The four overarching disruptive trends can be captured in the acronym "SMAC": Social, Mobile, Analytics, and Cloud.

Social Media represents the bi-directional flow of data, including the important (this month's sales figures) and the really crucial (fan videos of Justin Bieber). Superfluous or vital, these data flows must be secure, scalable and extensible, precisely directed, and stored accessibly.

Mobility includes the consumer device but also increasing enterprise mobility, the great productivity enhancer but another network security threat. Social media and ubiquitous mobility blur the lines between the professional/work world and the consumer/home world, creating the prosumer - where BYOD (bring your own device) creates new issues around data tracking, data security, and device interoperability.

A decade ago at an IBM investor event, then CEO Sam Palmisano stated, "IBM is an enterprise company." The CEO sought to assure his investor base that IBM was not chasing low-margined consumer business. In our "blurred lines" era of social media, BYOD, and the prosumer, no CEO would make such a limiting claim.

All this social and mobile broadband traffic is straining carrier and enterprise networks. The data stream is so fast-moving and intense that it threatens to overwhelm us; extracting useful data from this stream can be like trying to "drink from a fire hose." Analytics organizes, prioritizes, tames and manages data, enabling us to "drink from the garden hose" or sip data at a productive pace.

Of all the letters in this acronym, C for Cloud is the most disruptive. Cloud is really just utility computing; we don't all generate our electricity in the back yard, we rely on the utility company. Cloud does something similar. It enables infrastructure/platform as a service provided from an off-site, shared facility, rather than requiring an entire physical data center on premises.

Virtualization is the first step to cloud, turning one physical machine into many machines. Cloud can be created in a server farm that is like a bee hive; the low-end servers on site, like one-task worker bees, need not be sophisticated multi-taskers. Cloud thus represents an enormous challenge to the makers of high-end server and client architecture, from Intel (NASDAQ:INTC) to Microsoft (NASDAQ:MSFT) to Hewlett-Packard (NYSE:HPQ) and IBM.

Cloud also serves as a data tamer, because shared data requires fewer devices for storage. We are familiar with the notion that start-up manufacturing companies will never run a factory; after internal prototypes and new product testing, actual production is outsourced to China, Mexico, or an EMS company. Similarly, the business services start-ups of today likely will never own an on-site data center. That data center never built is a lost opportunity for the hardware and software incumbents

But Cloud also represents enormous opportunity for the hardware and software incumbents. These companies already have top-tier customers with disparate data centers securely linked across multiple nations, each with their own regulatory tangle. This kind of interoperability expertise is not easily duplicated. The SMAC challenge for old-line technology incumbents is to provide their existing high-end clients an integrated solution that protects embedded data center investment while integrating with public, private, and hybrid cloud where applicable.

Cloud service providers (CSPs) will struggle to provide mature companies with what the incumbents can do: a vertical-specific solution that integrates disparate hard and soft assets in far-flung locales across a common platform that is secure, extensible, manageable, scalable, and (we repeat) secure. And cloud provides the big boys with something they could not previously do: a chance to reach down-market. Start-ups that could never have afforded an IBM system z mainframe will be able to afford IBM Cloud services. And in a back-at-ya world, that should make the CSPs nervous.

While innovation is necessary in every sector, in technology it is rapidly becoming "innovate or die." We have seen tremendous sector disruption caused by social media, enterprise mobility, analytics & big data, and virtualization & cloud. We have begun issuing a SMAC scorecard for companies we analyze, and we recommend that every technology investor do the same.

Healthcare: Policy Matters

Whether it gives you a warm fuzzy feeling or makes your blood boil, the Affordable Care Act (aka Obamacare) is here to stay, at least through the next election cycle. In healthcare, we are focused on the opportunities surrounding the Affordable Care Act. The Act, which has had a rough technology rollout ahead of its implementation early in 2014 (now a moving target), focuses on controlling costs and improving outcomes.

The Generics segment is likely to benefit from increased demand for products that demonstrate branded-drug efficacy but that cost 50-80% less. Healthcare data companies can expect increased demand as service establishments and payers such as hospitals, outpatient centers and insurance companies coordinate information to lower the cost of care.

Companies in the middle of the supply chain - such as the drug distributors - will be leveraging economies of scale to lower costs and improve margins. And even Big Pharma - known for expensive R&D budgets and costly DTC ads - has an opportunity to take advantage of the ACA by bringing to market new products that target chronic and costly conditions. Finally, we could see the growing trend of outsourced pharmaceutical R&D begin to impact bottom lines in this sector.

Energy: Managing through Turm-Oil

In Energy, we expect oil prices to embark on a long, slow decline. There are multiple levers to this transition. Development of shale oilfields in mid-America is not only a domestic phenomenon; increasingly such sites are being discovered and developed overseas. Simultaneously, eco-sensitivity has evolved from do-gooder status to a business strategy. Fuel-efficient vehicles such as the Toyota (NYSE:TM) Prius have evolved from a novelty to become the backbone of taxi fleets from San Francisco to New York. And the status luxury car is not a Mercedes or a Lexus, but a Tesla (NASDAQ:TSLA).

But perhaps the biggest driver of oil price declines will ensue as companies and consumers increasingly switch to natural gas. The mathematical correlation between the prices of oil and natural gas is extremely distorted, driven by abundant supplies of natural gas and uneven supply of crude.

We expect manufacturing companies to take advantage of this arbitrage opportunity over the next 3-5 years by replacing oil as an input with natural gas. This move could cut manufacturer costs by 5%-10%, increasing margins and potentially reintroducing an industrial renaissance.

Companies that could benefit include E&P firms leveraged to natural gas, pipelines and logistics companies, and progressive industrial and utility managements willing to invest in new infrastructure in exchange for lower energy prices over the long term. For investors willing to risk additional downside in income plays, and don't have a problem with the K-1 tax form, we recommend the master limited partnerships in the pipeline space.

Conclusion

If you have been in this market since March 2009, enjoy your prosperous retirement. If you have been on the sidelines with that old bearish feeling, you can still get in. But the rising tide that lifted all boats is now far out to sea.

Recognize that this is a stock-pickers' market. Focus on persistently innovative companies with sufficient confidence in their cash flows to deliver shareholder-friendly capital allocation programs. And look for companies on the right side of disruption.

(Jim Kelleher, CFA, Director of Research)

Source: Profiting From Disruption: Stay In Front Of Sector Trends