With some data now emerging that suggest stabilization in the macroeconomic picture, investors are increasingly interested in finding the stocks and sectors that will outperform when a broad recovery from this deep recession finally arrives.
We thought it would be helpful, therefore, to convene a virtual roundtable with four fund managers to discuss (1) how the brighter macro picture impacts their methodology for stock selection, and (2) what specific stocks or ETFs their methods yield as top opportunities at this time.
Jeffrey Miller, PhD - President and Portfolio Manager at Chicago based New Arc Investments LLC
Sean Hannon, CFA, CFP - President of EPIC Advisors, LLC
Dr. Charles Lieberman - Chief Investment Officer for Advisors Capital Management LLC
David Hartzell - President and CEO of Buffalo, New York-based Cornell Capital Management
Mick Weinstein, Editor in Chief of Seeking Alpha
Part 1: Methods - What methods do you use to find attractive stocks or sectors at this stage in the cycle - and does the macro picture impact that?
Hartzell: We use in-house, proprietary financial screens to narrow the list of stocks that we want to invest in. After we find companies with the right financials, we drill down into the management, marketing and product as we try to decide what to buy. We also look at where the both the market and the stock are selling in relation to the last month, year and 10-year cycle. If all the stars line up, we buy. If not, we wait.
Lieberman: We follow a similar process, though we do also use a macroeconomic analysis to help identify sectors where we may wish to have more exposure if the security valuations are attractive. By this I mean that we first look at the economic environment, and today it is our judgment that an economic recovery is just getting started.
Stocks ran up in 2009, but market valuations are attractive. Therefore, we think we should have a somewhat more optimistic/aggressive stance relative to the market with somewhat greater exposure in the most depressed areas, which means consumer discretionary, industrials, materials, and financials and a relatively underweight exposure in the more stable consumer staples, utility and health care sectors.
This narrows our search somewhat, so we can focus our screens on companies in the targeted areas to see if we can uncover good values. If the market shares our thinking, we then choose to go with a more market type exposure, because the opportunities we seek are not available.
Weinstein: Chuck, what do you mean "if the market shares our thinking... we go with a more market type exposure"? Can you add some more color on that?
Lieberman: In investing, there's always a question of what's already priced in. If we think a company will do very well, but it's already trading at 25 times next year's earnings, then the market already understands to some degree that the company will do very well. So, stock selection is not just a matter of thinking which companies will do well. It goes a very important step beyond that, which is which companies will do well that the market hasn't yet figured out will do well.
More often, the market may remain focused on some risk and overlook the other side of the story. As an example, the market became very focused on the credit crisis and the recession, so severely marked down the value of cruise companies. Both Carnival and Royal Caribbean fell so sharply, it was as if the market feared no recovery might occur for a number of years and that both might be unable to roll over their maturing debt. This was quite unreasonable, yet that's how the market priced these stocks and both have rebounded very sharply. And looking further out, I think both represent excellent value. So, it is not just how will the companies perform, but also what does the market expect. It isn't always easy to determine the market's judgment, but when future value is much greater than current discounted future value, there is typically a very good investment opportunity.
Weinstein: Sean, do you give any weight to the sector factor - that is, whether that sector is likely to perform well in this stage in the cycle (as Chuck said that he does)?
Hannon: I do look at sector factors, but in a slightly different manner. Taking a bottom-up approach, sector factors matter as they influence fair value. For example, if a company is struggling in the current economic environment, but will prosper when the economy begins expanding, I will model increasing margins and rising sales into my scenario analysis. This will result in a higher fair value estimate and increases the attractiveness of the investment. While some investors look for the top-down view of determining which sectors will perform well and then picking stocks within that sector, I come from the opposite direction and allow the individual investments to dictate my actions.
Miller: I especially like to follow cyclical stocks. These can be very hard to value. When something is difficult, mistakes will be made. This is the source of opportunity. The key concept -- the need for normalized earnings -- is implied by my colleagues on the panel.
While some readers may understand the basics of this issue, let me make sure we are all starting at the same point. When times are wonderful, earnings are very high, but the P/E multiples are lower. Why? In cyclical names investors rightly expect that their future cash flows will not grow (or even continue) at peak levels. Mean reversion is expected. In poor times we see the opposite. In very poor times, earnings can be zero or even negative. P/E multiples get very high, even if the stock price is low.
The only solution is to normalize earnings, often by finding some trend in long term earnings. David, Chuck, and Sean are each doing this, albeit in somewhat different ways. One problem is that cycles do not happen often enough, so we do not have enough data. It is pretty difficult to create a nice trend for normalized earnings with a small number of recessions in recent years. Also, the current recession is different and deeper. It is a challenge for any methodology. One positive for the normalized earnings method is that you have a starting point for valuation. This does not mean that the market will agree! Cyclical stocks are making outsized moves in recent trading, even in the absence of specific corporate data.
Hannon: Jeff makes an excellent point about needing to create normalized earnings for cyclical companies, but running into difficulties with the absence of data and determining how the current recession differs from those in the past. For this reason, I always return to the concept of fair value. If we can create an estimate of fair value and wait for the market to offer the shares to us at a discount to that value, our odds of success increase.
An example of a cyclical name I currently own and have traded many times in the past is trucking company Arkansas Best (ABFS). Believing fair value is somewhere between $29 and $32, three different times in the past year I have bought the shares in the low to mid-20s and then sold above $30. In this example, patience and following my research has paid off. It is a story that I am sure everyone has seen in the cyclical names they follow.