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© Copyright 2000 Rogers Media. The following article first appeared in the April 2001 edition of
BENEFITS CANADA magazine.
Equities Report--U.S.
There is a breadth of attractively valued opportunities in the U.S. equities market. The outlook
for 2001 is optimistic.
By John Hock
Recent volatility in the world's major equity markets has caused many Canadian pension funds to review their
portfolio exposure in U.S. equities. Institutional investors should be encouraged by what they see, as
underlying fundamentals are regaining their influence on stock prices.
Few investors have been immune to the market volatility and weakness during the past year, but those
adhering to fundamental, value-oriented investment disciplines generally outperformed the market.
While the abundance of attractively valued and fundamentally strong companies in the U.S. is encouraging,
it is more difficult to get excited about near-term prospects for broad market indexes. The Standard &
Poor's (S&P) 500 composite index and the Nasdaq, in particular, have large representations of many
stocks that appear to be vulnerable to downward earnings revisions and further unwinding of the excessive
valuations that accumulated during the liquidity and momentum-driven environment of recent years.
More accommodating U.S. interest rate policy will help matters, but successful investing this year will
depend largely on an investor's focus on fundamentals. The 20.6% annual appreciation of the S&P 500
over the last five years has outpaced the underlying 9.5% annual increase in earnings per share over the
same period. This suggests that the market is discounting far higher growth rates and/or lower risk levels
going forward.
Although this trend and valuation might at first appear alarming, it is important to keep in mind the
massive divergences that escalated during the recent years leading up to March 2000. During this period,
broad market statistics became skewed because of the strength in a small number of large-cap growth stocks
that seemed to defy gravity.
Much of the excess has subsequently been worked out of the market, but there is more to go in many sectors.
Downward earnings revisions could provide further risk to inflated sectors and be a significant overhang
for the broader market indexes. Even a soft economic landing could coincide with a hard profit landing as
the impact of negative operating leverage affects results. Investors should not be discouraged by current
index levels.
The U.S. Securities and Exchange Commission's newly introduced rules on financial disclosure, commonly
referred to as Reg FD, will have a notable impact on the investment landscape in the U.S., and could add to
near-term volatility. Reg FD effectively levels the playing field for corporate disclosure to ensure full
and fair dissemination of information to the investment community.
Brokerage analysts and large momentum-driven investors will no longer benefit from 'whisper' numbers, and
original fundamental research will regain its prominence. Although volatility will remain high as reported
results increasingly deviate from sell-side earnings estimates, it is likely that stock prices will
increasingly be driven by their sustainable earnings power rather than prospects for quarterly results.
Considering the great disparity among valuations in the U.S. stock markets, this trend could be beneficial
for fundamental value-oriented investors.
PICKING PERFORMERS
The carnage among technology and telecommunications stocks has been severe during the past year. Nasdaq
recorded its worst performance since its inception in 1971. Companies that recently had an abundant supply
of low-cost capital, suddenly had no access to capital. As is always the case when capital is mispriced, it
is also misallocated. This misallocation contributed to the tech bubble and a substantial buildup of excess
capacity.
Although many stocks in these sectors have fallen by more than 80% from their highs, there is still further
downside potential. Patient investors should consider adding to quality positions in the sector where
balance sheets are strong, business strategies viable, valuations tangible and management is capable.
Apple Computer Inc. is one such company. Having fallen from US$75 to US$13L, the stock has more than US$11
per share of cash on the balance sheet. Apple certainly has its share of challenges in a fiercely
competitive marketplace, but its capital strength provides an added degree of support. Overall, investors
are likely to benefit from being underweight in technology and to a lesser extent, telecoms.
Financial services, consumer staples, aerospace and defence and healthcare stocks were among the best
performing sectors in 2000, and prospects remain encouraging. Characteristics of many stocks in these
groups include attractive valuation, favourable long-term growth prospects and strong near-term earnings
quality. Given the uncertainty of the long-term economic forecast and a stock market environment of
downward earnings revisions, investors are likely to continue applying a premium to quality stocks in these
sectors.
Following strong gains in 2000, healthcare and pharmaceutical stocks have generally reached fairly valued
levels. The sector is poised to remain a beneficiary of the flight to quality earnings growth in light of
lingering economic uncertainty. Drug distribution companies are attractive at current levels, given
prospects for strong growth and margin expansion during the coming years. Aerospace and defence stocks are
positioned to benefit from a recovery in defence spending, growing commercial applications of new
technologies and general improvements in efficiency.
Fundamentals underlying the outlook for financials in North America are encouraging--particularly in the
areas of life insurance and other non-bank financial companies. Although U.S. life insurance stocks
performed well last year, valuations remain attractive, earnings quality is strong and growth rates are
favourable. The pace of merger and acquisition activity and premiums being paid in recent deals also
contributes to this sector's appeal.
A cautious stance is warranted toward many banks and brokerage stocks, however. Valuations for leading
investment banks and brokerage companies are at peak levels during a time of increasingly uncertain and
vulnerable capital market conditions. Rising cost structures--which subject these stocks to greater
negative operating leverage in the event of any downturn in capital markets--compound this outlook.
A similar concern over valuation and deteriorating asset quality justifies an underweight exposure in the
banking sector. More banks are expected to announce rising provisioning levels for deteriorating asset
quality, but this weakness could present attractive buying opportunities for long-term investors.
While more interesting than in the past, cyclical stocks, could see further downward earnings revisions
throughout 2001. Consensus earnings expectations are exceedingly optimistic in many sectors given the
trends in the underlying economy--higher energy prices, widening credit spreads as well as a peak in
capital expenditures and tech spending. Companies experiencing temporary downturns in the cyclical
industries are likely to emerge as buying opportunities this year.
Just as technology stocks have suffered, in part, from over-investment and excess capacity, many energy
stocks are benefiting from a supply-demand imbalance, which is the result of years of under-investment in
the industry. Soaring natural gas prices (up 286% last year, measured in U.S. dollars) have been the most
meaningful adjustment.
This imbalance will not be corrected overnight but exploration budgets are increasing. Natural gas plays
and services companies appear to be the best positioned to benefit this year as the imbalances are worked
out. Considering prospects for mergers and acquisitions, and the relative undervaluation of the Canadian
dollar, Canadian companies are among the more interesting opportunities in the energy sector.
Primary risks in equity markets include credit conditions, high energy prices, further downward revisions
to the outlook for many tech stocks and the pace of Japan's economic growth and restructuring efforts. A
weakening of the U.S. dollar presents both risk and opportunity as it could boost the results of
multinationals and the dollar-based returns of non-U.S. equities.
The correction of the excesses in many sectors still has further to go, but the foundation has been set for
a return to traditional drivers of stock price performance. This transition--and the breadth of growing and
attractively valued opportunities in the U.S. stock market--contributes to a favourable outlook for 2001.
John Hock is chief investment officer with Altrinsic Global Advisors in Old Greenwich, Conn.
jhock@altrinsic.com.
Financial services --a global opportunity
Financial services stocks enjoyed favourable returns last year and the outlook remains promising. In the
immediate future, the sector offers a combination of attractive valuations, strong earnings growth, limited
risk associated with a slowing U.S. economy and ongoing merger and acquisition activity. Falling interest
rates could provide additional support.
From a long-term perspective, the global financial services sector should benefit from favourable
demographic trends, globalization, technological innovation, pension and tax reform as well as industry
consolidation.
In terms of global industry developments and stock market valuations, the financial services industry in
Europe is at least two years behind the North American industry. Japan is 10 years behind. Pension and tax
reform as well as industry consolidation will be the primary drivers in Europe. Additional support could be
provided by a recovering euro.
Although Japanese equities continued to disappoint in 2000, the valuations, profits and expectations are
depressed at a time when the economy has been languishing for 10 years. Risk levels remain high in Japan,
but a slow economic recovery is under way and growth in financial services will proceed at a faster pace.
Strong growth is likely to take place in mutual funds, real estate investment trusts, securitization, loan
syndication, mergers and acquisitions and securities trading, much in the same way that these products and
services have flourished in North America.
The currency factor
All eyes are on the U.S. dollar. It may have peaked.
One of the greatest macroeconomic imbalances in the world today involves the strength of the U.S. dollar
and the severe deterioration of America's current account deficit. U.S. dependence on foreign capital to
fund this deficit creates a degree of risk in the marketplace and a degree of opportunity for certain
multinational companies.
Overseas investors have been financing this deficit through aggressive purchases of U.S. dollar assets in
the hopes of achieving higher returns than those available in their respective home countries. Much of this
dollar support has been provided by aggressive foreign purchases of U.S. assets, especially stocks--a trend
that has historically signalled a peak in the U.S. dollar.
The euro appears to have bottomed out, and encouraging developments are taking place in the areas of tax
reform and corporate restructuring throughout Europe. Confidence levels can rise rapidly, and repatriation
of capital could contribute to weakness in the U.S. dollar, particularly relative to the euro and both the
Canadian and Australian dollars.
Although this adds to the risk for U.S. dollar-based assets, opportunities have arisen among several
multinational companies that generate earnings overseas. Weak currency translation and economic conditions
in Europe have hurt stocks such as McDonalds, which generates 35% of its operating income from Europe. But
this short-term weakness is overdone and presents an attractive investment opportunity.
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