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Will 2014 Be a 2013?
Posted by: David G. Dietze, JD, CFA, CFP (IP Logged)
Date: December 16, 2013 09:13PM
2014 is unlikely to match 2013’s robust 24% gain so far midway through December. In a nutshell, 2013’s tailwind of full throttle monetary policy giving rise to a sharp increase in valuations is unlikely to repeat itself. Investors may expect a 2014 return in the high single digits from the equity markets. Stocks will shine relative to fixed income. Volatility is likely to increase relative to 2013 – the most severe drawdown in 2013 was just 6%, so the market is overdue for a correction of 10% or more. The starting line from a valuation perspective will also handicap 2014’s potential. Last year at this time stocks traded at 13 times forward earnings but no longer: Following 2014’s rally accompanied by little corporate earnings growth, stocks command over 15 times.
The taper will commence and gather momentum in 2014, as the Federal Reserve reduces its bond buying program. While the pundits will proclaim that a taper does not mean an increase in the Federal funds rate, at some point that, too, will be spied in the future, and investors will adjust their expectations.
Of course, the taper is only made possible because the economy’s health has improved. To fend off the drag of tougher monetary conditions, investors expect improved corporate earnings. Indeed, many strategists expect corporate earnings overall to advance in the high single digits, spurred by 3% GDP growth in this country and improvements in economic conditions abroad, particularly in Europe.
No matter the outlook, investors will want to tilt their portfolios to include economic sectors that have more value, are either returning more cash in the form of stock buybacks and dividends to shareholders or have the potential to, and the sentiment around which is not too ebullient. Consider these themes and ideas:
Rising Energy Prices
Energy stocks look like a good bet if the economy is improving. With increased activity there will be greater energy consumption.
At the same time, valuations on energy companies are some of the lowest in the market, following their underperformance in four out of the last five years. They are great inflation hedges but are cheap because most of Wall Street sees no inflation. We think the time to buy your inflation insurance is when the price is low.
Chevron (CVX), one of the largest diversified energy companies, is a fine way to play this sector. It boasts the sixth best dividend on the Dow and is the third cheapest based on its price to earnings ratio. Led by 33 year company veteran John Watson, this company has the experience and heft to tackle profitably just about any assignment in the world.
Financials Still Cheap
Financials were one of the strongest sectors in 2013, up nearly 29%. The quality of their loan portfolios strengthened as the value of the collateral, largely real estate, rose in value significantly. With loan losses diminishing, rainy day funds previously set aside are now being released to augment their earnings.
Financials have more room to run. Valuations remain low, in many cases below book value. Real estate prices, while clearly off their bottom, are nowhere near their peaks.
An improving economy should spur loan volume, as borrowers develop plans and lenders have more confidence in being repaid. While the taper undoubtedly will push interest rates higher, this will allow financials to increase rates on their loans, boosting their margins.
Financials have historically returned a significant portion of their earnings to shareholders in the form of dividends and stock buybacks. However, this activity is only slowly being restored, as balance sheets are being repaired, capital levels boosted, and permission for payouts received from regulators.
Both American International Group (AIG) and Citigroup (C) should benefit from an improving climate for financials. Both were hit hard during the sub-prime crisis; investor confidence is returning slowly. As a result, they both trade at discounts to their book values.
Both are poised to commence returning significant cash to shareholders, which will spur interest and their share prices. Citigroup’s dividend may go from virtually nil to over 3% if they pay out just 30% of their earnings.
Finally, both have unique franchises, with AIG having a commanding market share in the property and casualty market, while Citi is a truly global bank, operating in close to 200 countries.
Spying Both Growth and Value in Large Cap Tech
During the dot com craze over a decade ago, many tech names traded at wild multiples of earnings, if they had earnings at all. Predictions of an all-digital world trumped any considerations of value.
Today, newer technologies, like “the cloud,” mobile, social, smart phones and wireless have left many tech companies appearing like dinosaurs, struggling to stay relevant. Growth investors have little use for the legacy players, as they move on to the next new thing.
However, many of these traditional tech names have solid franchises, with software and services that are quite “sticky,” meaning it’s difficult for their customers to migrate away. Many trade at very attractive valuations, and have started to return money to shareholders, an unheard of practice a decade ago.
Few value investors have embraced these opportunities, frequently citing a lack of understanding of exactly what they do, or fear that the tech landscape is changing too fast to make the businesses predictable.
Two names we think have solid potential are Cisco (CSCO) and Hewlett Packard (HPQ). Cisco is currently the fourth cheapest stock on the Dow, a far cry from the 100 or so times earnings it commanded at its peak 13 years ago, and offers an attractive 3.3% dividend. It remains the leading player in the enterprise-class networking equipment, with significant scale advantages.
HP sports one of the lowest valuations in the S&P 500, with a diverse set of businesses including printers, servers, PCs, and consulting. Meg Whitman is the newly installed CEO, and is leading a turnaround at the company. The stock has nearly doubled in 2013.
Are Emerging Markets Poised to Re-Emerge?
Some experts believe that you should commit 20% of your portfolio to the developing world’s stocks. The developing world now constitutes over half the world’s GDP but comprises only 17% of the world’s stock value and just 2% of global mutual funds. Emerging market stocks are poised to catch up to the developed world’s.
Valuations are attractive after the emerging markets have essentially flat lined over the last three years, missing out on the party in US markets. A leading ETF of emerging market stocks trade at just 11.5 times earnings versus 15.7 times for a leading global ETF of developed nations’ stocks.
To play an emerging market rebound, consider Petrobras (PBR). This diversified energy behemoth is the largest company in Brazil, indeed in South America. It’s trading 80% off its all-time high in 2008, battered by declining energy prices, a volatile political environment, and tremendous capital needs required to develop its deep water resources. However, now trading at well under 10 times earnings it’s hard to imagine the emerging markets rebounding without full participation by Petrobras.
Gold has had a disastrous 2013, down 26%, as signs of inflation were muted, alternative investments like stocks surged, and the buying power of traditional hoarders in Asia slumped. Gold mining stocks fared even worse, off 52%, the victims of overexpansion in the good times, heavy debt loads, and high extraction costs.
As a result, it’s now cheaper to mine on Wall Street than in the ground, as many of these companies are trading at record discounts to the value of their reserves. That may not help if gold prices continue to slide. But, experts believe that all investors should have some portion of their portfolios dedicated to the yellow metal, as insurance against inflation, systemic breakdown, or worse.
ASA (ASA) is an attractive vehicle to get that exposure. It’s a closed end fund trading at a significant discount to net asset value, holding a diversified portfolio of blue chip miners. Investors can profit if the gold price moves north, the discount closes between that price and the value of stocks mining the metal, and/or there’s any narrowing of the discount between the price of ASA shares and the per share value of its portfolio.
Many analysts advocate a transition from stocks that are basically bond surrogates, sporting large but non-growing dividends, to more cyclical stocks. If interest rates rise due to a strengthening economy, companies that can most benefit from an improving economy, like cyclical stocks, will be best positioned to grow their businesses and dividends to offset the rate rise.
Deere (DE) for 175 years has been a leading vendor of agriculture equipment. Its growth prospects in emerging markets are solid. For example, Deere has half the Indian market, but tractors above 50 horsepower are only 10% of that overall market, versus 50% in North America. That will have to change if India wants to feed all of its people. Deere offers an above average dividend while you wait, and the dividend has grown 12% annually for the last five years. Deere beat the Street in in its latest earnings and just recently upped its stock buyback.
The Power of Utilities
Electric utilities have been a big disappointment in 2013, up just 5% versus the market’s 24%. That’s partly due to their being seen as mere bond substitutes; with the fear of the taper driving investors from bonds, they are also abandoning widows’ and orphans’ electric utility stocks.
There’s no question that there’ll be better investments than utilities if inflation and or a rip roaring economy is at hand, as these stocks are not particularly cyclical. However, a belief that utilities will not be useful in 2014 appears priced in, and of course the economy could sputter, making their steady eddy type businesses attractive again.
First Energy (FE) provides solid utility exposure. It trades at a low multiple of earnings and with an attractive near 7% dividend. 70% of its earnings come from regulated distribution and generating businesses in a diversified array of jurisdictions.
The Affordable Care Act Will Increase Healthcare Spending
Say what you will about Obamacare, but it’s sure to spur the healthcare sector. From insurers, to device makers, to biotech and Big Pharma, these stocks have had a marvelous 2013, often offer robust dividends, and are well positioned going forward.
Teva (TEVA) offers potential. It’s the world’s largest generic drug manufacturer; these non-proprietary products are seen as an answer to soaring med costs. Its sophisticated manufacturing facilities can handle complex formulations, while its global footprint and hefty financial resources can support its penetration into fast growing emerging market opportunities.
Stocks Discussed: CVX, AIG, C, CSCO, HPQ, PBR, ASA, DE, FE, TEVA,