It’s been a cruel, cruel summer for equities. Uncertainty continues to roil the markets, as choppy data neither confirm a robust economic recovery nor rule out the possibility of future weakness. Financial and health care reform, as well as the ongoing disaster in the Gulf of Mexico, likewise rattled investors’ frayed nerves. Markets may loathe uncertainty, but Tyler Dann II, portfolio manager at Invesco Charter (CHTRX), welcomes this instability, noting that such dislocations create opportunities for patient investors who do their homework.
What’s your outlook for the market?
I wouldn’t be surprised to find the broader market in the same place a year from now, though a 20 percent upswing and a 20 percent downswing could occur over that period.
It’s tough for investors to find their bearings in this grinding, range-bound market. Revenue growth drives the animal spirits and gooses people up about buying stocks, but companies continue to disappoint on this score.
Margins have increased, and profit levels have exceeded expectations, albeit lowered ones. However, profit multiples remain low because revenue growth isn’t driving earnings.
Broad revenue growth requires a favorable economic backdrop and companies that are committed to investing in their businesses despite the short-term hit to earnings.
In a choppy and uncertain macroeconomic environment, only the bravest corporate managers are willing to make the investments needed to grow revenue; the market punishes names that fail to forecast higher earnings.
Companies appear to be eating their seed corn, boosting profits by cutting costs. The cost of goods sold as a percentage of sales is at multiyear lows; productivity is at multiyear highs; and capital spending as a percentage of sales is at multiyear lows.
It sounds as though you expect a recovery that’s tepid at best.
That’s fair to say. Right now corporations are playing turtle because of concerns about regulations and taxes. Still, if companies grow confident in the availability of credit and increase capital spending, a positive feedback loop emerges that’s conducive to growth.
Do you see more regulation on the horizon?
Energy, carbon dioxide emissions--you name it. Regulators across the board have morphed into activist agencies rather than passive observers.
Evolving regulation creates opportunities as well as challenges. Health care reform, for example, has created quite a few opportunities on the valuation side.
New regulation will constrain growth rates at some health care companies, but in many cases the market’s reaction exaggerates these challenges.
Along the same lines, we’ve also added defense stocks because conventional wisdom calls for a decline in military spending, particularly on supplemental items. This broad-brush approach to the sector obscures defense companies that are positioned for robust revenue growth.
Are there any sectors you recommend avoiding?
For better or worse, we don’t have a great deal of exposure to large banks because, as much research as we do, we just can’t get comfortable with the composition of earnings and balance sheets. We recognize that it’s an extremely favorable environment for banks right now as far as traditional spread-lending is concerned--that’s why we own US Bancorp (NYSE: USB).
But we continue to worry about the things that people all too willingly sweep under the rug--namely legacy investments that could still cause pain. And although a lot of people say the new regulations will be relatively toothless, the costs of these new rules are difficult to foresee.
What are some of your favorite names right now?
We like CVS Caremark (NYSE: CVS), which has two operating segments: pharmacy benefit management (PBM) and retail pharmacy. Despite stiff competition, the company continues to perform well in both business lines. However, the market struggles to value the combined operation; in our minds, the sum of the parts suggests a valuation of at least $40 a share.
Some of the controversy surrounding CVS Caremark, from the fall 2009 pullback to the recent spat with Walgreen (NYSE: WAG), stemmed from the business model that management is implementing. The Maintenance Choice program integrates the PBM business with the retail pharmacy, offering customers the choice of filling prescriptions via mail order or at a retail location.
Investors questioned whether this move would attract new customers or ultimately detract from business. The early read on the most recent renewal season suggests that not only has business stabilized, but the company is also winning share from the competition.
Aetna’s (NYSE: AET) recent decision to outsource its PBM business to CVS Caremark is another endorsement of this strategy.
Higher levels of insured customers should boost volumes, while a wave of patent expirations on branded drugs in 2011 and 2012 also bodes well for business; generally speaking, sales of generic drugs offer significantly higher margins than branded products.
Apache Corp (NYSE: APA) is another baby that was thrown out with the bathwater, another instance where controversy clouds investors’ minds.
Over time management has demonstrated itself to be a good steward of shareholder capital, buying mature fields from big oil companies and squeezing production--and profits--from these deposits. This strategy has enabled Apache to post good internal rates of return and grow output at a high rate.
The turmoil that roiled shares of oil producers as crude flowed from BP’s (NYSE: BP) blown-out Macondo well into the Gulf of Mexico enabled us to pick up the stock on the cheap.
Better yet, the disaster allowed Apache to reload its portfolio at attractive terms, buying critical assets from BP--an opportunity that wouldn’t have emerged if BP didn’t have to raise money to put into the escrowed clean-up fund.
Apache also acquired Mariner Energy (NYSE: ME) back in April, a deal that increased its offshore exposure in the Gulf of Mexico--a prospect that became less desirable after the Obama administration banned deepwater drilling in the region. This pushed the stock into value territory.
We believe that investors’ undue focus on the controversial moratorium (a short-term headwind), coupled with a long-term opportunity to acquire mature assets at cheap valuations, create an ideal opportunity to increase our position.
Kroger (NYSE: KR) is a prime example of a company that has continued to invest in its business throughout the downturn--an admirable commitment that has gone unrewarded in the stock market.
Operating in a highly competitive environment, Kroger continues to win market share through pricing initiatives, a compelling strategy in a weak economy. Investors have complained that inflation hasn’t been embedded into food prices.
We take a different tack. Kroger may be winning market share through lower prices, but the company will benefit disproportionately when the industry recovers.
And management has a history of using free cash flow in a shareholder friendly manner, buying back shares and growing the dividend.
What’s your best piece of advice for individual investors?
Don’t get caught up in the hysteria, but be sure to have definite reasons for sticking with your stocks.
Choppy markets require discipline and patience; you can’t let your emotions take over.
As Warren Buffett says, you have to be greedy when others are fearful and fearful when others are greedy. We try to follow that mantra every day; I would advise investors to follow a similar approach.
Disclosure: No positions