Stocks Poised to Benefit from Strong Corporate Earnings
A Q&A with Richard England, lead portfolio manager of Calvert Equity Portfolio
Richard England, lead portfolio manager of Calvert Equity Portfolio and managing director-equities at Atlanta Capital Management Company, LLC, describes his active investment process for the Portfolio and his outlook for a slow rebound of the U.S. economy.
Richard, so far in 2012 there have been some promising signs of economic growth in the United States. What’s your view on the health of the U.S. economy?
It can be useful to think of the U.S. economy as three separate economies that have varying degrees of health right now—the corporate economy, the consumer economy, and the government economy. The corporate U.S. economy is in terrific shape from a profitability perspective, and corporations also have lots of liquidity in the form of cash and short-term investments. Corporate America could scarcely be in a stronger position than it is now. The consumer economy is doing OK, although it is not nearly as robust as the situation at most corporations. Consumers have deleveraged somewhat, which is a step in the right direction, and that deleveraging is likely to continue.
The government economy, however, is still in crisis, and the current hyper-partisan environment in Washington has made it more difficult than ever for legislators to get anything accomplished. The level of U.S. government debt is still rapidly increasing, and that debt will need to be dealt with going forward. Viewed as a whole, we think that the U.S. economy is currently in decent shape, and there is little risk of it sliding back into another recession.
How has the relationship between corporate earnings growth and stock prices been changing?
As I mentioned, U.S. corporations in general are in great financial condition, and their earnings have been growing steadily since the depths of the financial crisis in early 2009. In our view, earnings drive stock prices. However, although the annualized quarterly earnings of companies included in the Standard & Poor’s 500 Index are at new highs, the level of the stock market hasn’t kept up with that earnings growth. We think that corporate earnings growth is starting to slow down, but it’s still solidâ€”and we anticipate that earnings growth will still be positive in 2013. Given the long-term positive relationship between earnings growth and stock prices, we believe that this is a good sign for the broad market.
How does consistent earnings growth enter into the Portfolio’s investment process and affect the timing of buy or sell decisions?
Over any reasonable investment time horizon, it’s earnings that matter, so a close analysis of the earnings potential of individual companies is a key component of the investment process for the Portfolio. About our stock-picking process, it’s important to note that, although we have a distinct macroeconomic outlook and views, we start from the bottom up by analyzing stocks at the company level. We focus on finding high-quality stocks for the Portfolio, with high quality generally defined as greater relative consistency of growth in earningsâ€”and dividends, if a company pays them. This consistency makes the timing of buy and sell decisions less important than it is for stocks with streaky or significantly momentum-driven earnings, when the portfolio manager needs to get the timing of a buy or sell almost exactly right.
What are some of the sectors that look attractive right now?
In general, we’re looking for stocks where our fundamental view is positively differentiated from the consensus. This bottom-up research process means that we’re starting at the stock-specific level instead of picking particular sectors to under- or overweight relative to the S&P 500 Index, but there do end up being sectors where the Portfolio has more or less concentration relative to its passive benchmark.
While we are bottom-up stock pickers, it seems that renewed worries about Europe and China are once again dominating the investment discussion. The effect of this has generally been to cause sectors and stocks that are more exposed to global growth to underperform. As a consequence, we’re finding some good values in the technology, energy, and industrials sectors, though individual examples can be found in nearly all of the sectors. With fear becoming pervasive but growth still very solid, especially in the United States, there are a number of stocks that are touching the valuation lows of last fall and even early 2009. That’s far too pessimistic in our view.
What do you think are the biggest risks to healthy equity market gains for the balance of 2012?
The market posted a very strong gain in the first quarter of 2012. At that time we threw up a caution flag. Despite modest undervaluation for the market and solid, albeit decelerating, earnings growth, we grew concerned that the best levels for the market in 2012 might have already been reached. It’s not that we expect a major sell-off, but it seems quite possible that the market will remain stuck in a trading range bounded on the upside by the April 2 high and on the low side by a 10% or so correction.
The concerns we saw holding the market back included renewed worries about Europe, a potential “hard landing” in China, conflict with Iran over its nuclear program, and what’s become known as the “fiscal cliff” here in the United States—the automatic imposition of tax increases and large spending cuts on January 1, 2013 unless Congress and the Obama administration act to head them off. Another needed increase in the debt ceiling at about the same time is tossed into the mix for good measure.
As of this writing, the disastrous outcome of the Greek elections has Europe once again dominating market action. Uncertainty regarding the eurozone will likely remain at least through mid-summer. Chinese economic data has not yet broken one way or another, though we believe a “soft landing” for China’s economy is the most likely outcome. Iran is almost impossible to handicap. Any of these three issues could end up being “resolved” as far as the market is concerned over the next one to two months.
It’s very unlikely, however, that our domestic fiscal cliff problems will be resolved until after the November election at the earliest. This issue is the main reason that we feel the market may be capped for the year. The bad news is that if we fall off the fiscal cliff, a recession in the United States next year is quite likely. The good news is that it’s in neither political party’s interest to allow the country to go over the fiscal cliff. In the end, we believe the most likely outcome is for all current policy to be extended another three to six months so that the new Congress and the president (whoever it is) can negotiate without an artificial, close-in deadline. The likelihood that clarity will arrive only in the last six weeks of the year is what will probably keep us cautious for the balance of 2012.
This commentary represents the opinions of its author as of 6/1/12 and may change based on market and other conditions. The author’s opinions are not intended to forecast future events, guarantee future results, or serve as investment advice.
Investment in mutual funds involves risk, including possible loss of principal invested. You could lose money on your investment in the Portfolio, or the Portfolio could underperform, because of the following risks: a) the stock market may fall in value, causing prices of stocks held by the Portfolio to fall, b) the individual investments of the Portfolio may not perform as expected, and c) the Portfolio’s management practices may not achieve the desired result. In addition, large-cap companies may be unable to respond quickly to new competitive challenges such as changes in technology, and also may not be able to attain the high growth rate of successful smaller companies, especially during extended periods of economic expansion.