What's Happening with Large Cap U.S. Equities?
Q&A with Margaret Vitrano, Managing Director, Portfolio Manager at ClearBridge Investments
U.S. stocks went for a wild ride in the fourth quarter of 2018. What happened?
Volatility rose sharply, sending U.S. equities to broad losses. Investors fretted over risks from slowing global growth, rising interest rates and stumbles by some of the largest companies.
As one example, the S&P 500 Index suffered its second-worst December on record, -9.03%, to finish down 13.52% for the fourth quarter and register its first annual loss (‑4.38%) since the Global Financial Crisis (GFC).
How are you positioning for 2019?
We are in the later stages of the economic cycle, but that does not mean parts of the stock market cannot march higher. Technology stocks look attractive after the selling late in the year. We expect volatility to continue, and we think investors will be well served by staying diversified.
Is it true that many of the tailwinds that drove equities higher through the long-running bull market are turning into headwinds?
Yes. In this generally less advantageous environment, we believe it is essential to be much more selective in choosing companies to own for the long term. We look for companies and industries capable of generating visible and durable growth and that are more insulated from macro risks than the general market, which today include biotechnology, enterprise software, e-commerce and select media names.
How robust do you expect economic and market growth to be going forward?
We continue to expect positive GDP growth but at a slower pace than the 3.4% rate in 3Q2018. This may put pressure on companies in the industrials and consumer discretionary sectors; we are maintaining underweights to both areas relative to our benchmark.
What macroeconomic factors are impacting the current market outlook?
Recent action reflects a return to normalized valuations and earnings growth rates as monetary and fiscal stimulus measures are simultaneously removed from the economy. The U.S. Federal Reserve raised short-term interest rates in December for the fourth time in 2018 as it continued a path of tightening.
Meanwhile, the boost to corporate earnings from the 2017 U.S. tax reform is starting to wear off; EPS growth is forecast to decelerate, and companies face tougher quarterly comparisons. Add to this mix uncertainty over trade and tariffs, which is causing corporate managements to delay capex, and it is no surprise that volatility remains elevated.
Has benchmark thinking become more important than absolute return?
While passive investing has become popular, economic conditions since the GFC have been very conducive to stocks: ample liquidity, low interest rates, and accommodative monetary and fiscal policies. The tide lifted all boats, high-quality growth as well as low-quality companies.
As volatility has normalized, we begin to see the benefits of an active management approach that seeks to generate strong absolute returns in all conditions, rather than simply beat the benchmark.
Are you moving to a more defensive investment positioning?
Instead of using excess cash to buy back shares – actions responsible for about 40% of S&P 500 earnings this past year – we believe companies will start paying down debt. We expect capex to slow as the tax benefits of immediate depreciation fade and uncertainty over tariff impacts cause company managements to delay non-critical projects.
We will closely monitor fourth-quarter earnings reports for guidance on how and when companies plan to deploy their cash flow in the year ahead.
What about the FAANGS, which led the market up for so much of last year, but ended the year down?
The underlying businesses for some of these companies were good investments in 2018, and are still strong. Even though Amazon was down 25% for the fourth quarter, it returned 29% for the year. At current levels, it is undervalued relative to the sum of its parts. Its Prime service has more than 100 million subscribers globally and is growing. Amazon continues to dominate and innovate at very high levels, with particularly strong positions in three key areas related to the Internet: e-commerce, cloud infrastructure with Amazon Web Services (AWS), and advertising.
AWS is building off a large lead in workloads moving to the cloud, a total addressable market in the hundreds of billions of dollars. The company also has a new, evolving business in advertising and marketing that features high profit margins and is largely not accounted for by the market.
What other U.S. stocks are you watching?
At this point, late in the market cycle, it is critical to separate business models and identify companies that can move higher based on strong fundamentals rather than passive fund flows.
Bulk retailer Costco, for example, runs a unique, subscription-driven business that has performed well in both healthy and unsettled environments. We consider Costco a stable growth stock, one of three types of growth companies – stable, cyclical and select – that can provide diversification and exposure to organic growth through all types of market conditions.
Stable growers like Coca-Cola also can provide balance, as pricing power and strong execution enabled it to deliver a positive return in a quarter that saw all 10 benchmark sectors suffer losses.
We are also tracking a new position to the portfolio, IHS Markit, a provider of business and information services to enterprise customers across transportation, financial services, energy and similar industries. It operates a diverse set of businesses with consistent growth and high barriers to entry (including the Carfax vehicle history service), and it produces geological reports that are a standard research tool for oil & gas exploration and production companies.
What kinds of companies fall into your second category of growth, cyclical?
Global brewer Anheuser-Busch InBev and communications chipmaker Qualcomm each face near-term headwinds that we believe are fixable and will lead to a step change in growth.
Anheuser-Busch has derated on weakness in its core Latin America and South Africa markets, dollar strength and volume declines in the U.S., but the company is unmatched in its ability to generate cash and maintain a strong moat around its business. Any improvement in Brazil should lead to significant upside for the stock.
Qualcomm has multiple options to accelerate earnings that are mostly independent of the smartphone market it serves.
Which growth stocks make up your third bucket, select?
Companies generating above-average growth rates through disruption and innovation. These stocks also carry higher multiples and higher risk. Select names include new positions Nutanix and Nvidia.
Nutanix has significant market share in a software solution for cloud computing, hyperconverged infrastructure (HCI). HCI enables storage, computing and networking to operate as a single platform; increases the efficiency and scalability of data centers; and its usage as a low-cost solution is expected to more than double in several years. It is transitioning into a software-only vendor of on-premise and cloud solutions, which should result in a better long-term business.
Nvidia is a leading developer of graphics processing units (GPUs) for some of the most attractive markets in technology: PC gaming, data center and artificial intelligence applications.
Margaret Vitrano is a Managing Director and Portfolio Manager at ClearBridge Investments, a subsidiary of Legg Mason. Her opinions are not meant to be viewed as investment advice or a solicitation for investment.
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