U.S. Large Cap Equities Continue To Be Strong – But Choose Carefully
Q&A with Evan Bauman, Portfolio Manager at ClearBridge Investments
How do you approach U.S. equity markets that are very crowded and very rich, by valuation?
The reality is – and we have been saying this for some time – the market is bifurcated. There are some very rich, very expensive parts of the market. It has been rewarding momentum, and concepts, as opposed to earnings or cash flows. Over the last two years it has left in its wake companies that are not just undervalued, but mispriced: some valuations are simply too cheap.
Investors can buy companies like Comcast at six and a half times cash flow, or AMC Networks at six times earnings, or Discovery at seven times earnings. In the health care sector, Allergan, Biogen and Amgen are all at less than 13 times earnings (as of June 7, 2018), with tremendous free cash flow and potential for consolidation, activist and strategic investor involvement. So much can go right for these businesses. When buying stocks at 200 times earnings and 50 times book, there is significant potential downside risk. That is not being fully understood by the passive investor or the Johnny-come-lately investor who is simply watching technology stocks go up en masse.
We have started to see a rotation, slowly, into some of the areas we are involved in such as energy and media. Even biotech is starting to catch a bid, but I think it’s in the early days.
What is history telling you about the direction of today’s U.S. equity markets?
The dot-com era is a good example. If you look at the 1999/2000 time period, broadly speaking the market topped out in early January 2000. After a decent correction the Nasdaq moved higher, about 18 percent in a couple of weeks, and it really topped out in March 2000. Then the Nasdaq declined 78 percent for the next two-plus years. The rest of the market progressed higher after making a good bottom.
I think we could be going through that right now: a massive rotation into undervalued growth. It has potential to be a real sector rotation – out of some crowded areas, into undervalued areas.
How much longer do you see the FAANG momentum trade going? Are we at a turning point?
The toughest thing is predicting the timing. The biggest misnomer, frankly, is looking at the FAANGs1 as a monolith, assuming they will move together. There are reasons they have been correlated, such as money flowing into passive funds and into the benchmarks. About a quarter of the benchmark is in five or six big cap tech names, which has become a self-fulfilling trade. That has fed this rally, but the reality is you must look at each stock individually.
What happens when these things reverse? In 2000, everybody defended Nasdaq stocks on the way down, yet there was an 80 percent correction. There was no valuation support whatsoever for the concept stocks. Owners of the big tech names argue this time it is different because these companies have earnings, and some are not necessarily expensive. They are simply up a lot and have crowded shareholder ownership. It’s scary that big passive funds control 25-30 percent of some of these names. Pretty much every big long-only growth fund owns the same areas.
Have you been bullish on any of the other big-name technology stocks?
About a year ago I spoke about Twitter. I said the beauty of Twitter is so much can go right from a valuation perspective, from an undervalued brand perspective, and nobody owns the shares. Everybody was negative on it, from a consensus sell-side view. Everybody had a sell or a hold rating on it. We looked at the brand and said if we get everything wrong, the shares may get bought by a Disney, or Salesforce, or another streaming media company. If we get it right, there are multiples of upside ahead. The point is to not necessarily be negative.
In terms of market dynamics, if money starts to rotate into health care, energy and the massively undervalued media companies, potentially – the money must come from somewhere. That’s the fear for the owners of the big tech names. The definition of a crowded trade is when the feedback loop starts to reverse, and there are no bids left.
Have you seen these market dynamics often?
Yes, a few times. This February the market had another “flash crash,” with bids basically being pulled as stocks sold off. That type of event can happen without a correction (going down 20 percent), but just with a rotation in the market. We are starting to see it, but it is slow.
The key for every asset manager is continuing to know what we own, engage in our companies, focus on businesses where a tremendous amount can go right, and they are doing a lot about it.
Not only are many companies undervalued, but recently Biogen, Amgen and UnitedHealth Group re-upped their buybacks. Broadcom did a significant accelerated buyback. AMC continues to take stock off the market. I would rather own shares in companies trading at six or 10 times earnings, with cash flow that can take advantage of the dislocation, rather than owning something at 200 times and hoping that everything continues to go right. For some of the names that are in the stratosphere in terms of valuation, there is no rational downside support.
When will the reversal happen? I think we are getting close. Generally, markets tend to top out with an exponential move higher, as the Nasdaq did in 2000. Look at the major averages: the Nasdaq is up about 12 percent year-to-date; the Dow is pretty much flat; and the S&P is up a couple of percent. We probably are in the last inning or so of the big Nasdaq move. We shall see.
How are the recent oil production and price moves impacting your view of the energy sector?
I still like the energy sector. It had a very strong move this year that should continue. We may see a prominent shift towards service names, and profit-taking in the E&Ps if they continue to rally. Assuming continued global growth and demand, oil prices should remain strong long-term.
Last year and earlier this year, we had never seen such a dislocation between energy equities, particularly the well-funded U.S. E&Ps, and oil prices. The gap had never been wider between oil and price-to-book stock valuations. When oil prices rallied late last year, stocks basically did not move. That created some very undervalued energy equities, especially in asset-heavy E&Ps.
There has been a sharp run up in rig counts and production. But oil prices notwithstanding, a lot of energy stocks continue to make multi-year highs because, even in this higher price environment, U.S. companies have shown good capital discipline. They are not acting recklessly.
Do you see a pronounced need to modernize American oil infrastructure?
Absolutely. For almost four years, the big oil companies have deferred capital expenditures, which has left a lot of rigs needing modernization and new drilling technologies. A big pick up in capex should benefit demand and pricing for service companies.
How are you approaching the health care space at ClearBridge? What do you think about the Allergan situation? Is it a one-off, or are we going to see more of it in the industry?
In health care, there are some really cheap companies. Allergan is a good example, priced at less than 10 times earnings. In terms of base business earnings, assuming no contribution from their pipeline, the stock is trading at a crazy discount both to its peer group and the market.
With cheap growth companies, the question is always, “What is going to be the catalyst?” When a stock is trading at eight or 10 times earnings, sometimes you don’t need a catalyst; the market simply figures out that these companies are trading at too big a discount to their intrinsic value. Sometimes a takeover offer comes from a third-party, but that can actually be counterintuitive. We would not want Allergan or other undervalued health care names to sell out and give away a lot of their long-term value, but the first movers tend to be strategic or activist investors.
The way its shares trade, could there be significant turnover in the Allergan shareholder base?
Strategic investors are saying, “From this level, from $150 or $160 a share, so many things can go right.” It could result in a takeover bid, splitting up the company, using the balance sheet more aggressively to repurchase shares. The company has spoken about selling off underperforming or non-core assets and buying back significant amounts of stock.
We have never seen the health care sector this cheap. It’s just a matter of time until more announcements come. We are going to see a tremendous amount of consolidation in the space.
Is that type of activity likely to continue in other areas, such as media?
Media has many haves and have-nots. Some stocks have underperformed dramatically, Comcast among them. Comcast trades at about two times book, one and a half times sales, and six and a half times cash flow: a solid $150 billion company. Yet its market cap is exceeded by Netflix, which trades at 230 times earnings, 40 times book, 12 times sales and an infinite multiple of cash flow – because they have none. But the stock continues to work higher.
There are real analogies to be made between the market today and the end of the Nasdaq bull market in 1999 into 2000. We continue to believe that this year is playing out a lot like 2000: there is money to be made, but not in the stuff that has worked for the last 3-5 years.
Evan Bauman is a Portfolio Manager at ClearBridge Investments, a subsidiary of Legg Mason. His opinions are not meant to be viewed as investment advice or a solicitation for investment.
1FAANG is an acronym for the market's five most popular tech stocks, namely Facebook, Apple, Amazon, Netflix and Alphabet’s Google.
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