MARKET COMMENTARY

Our Top Investment Themes for the Second Half of 2016

07.26.2016 - Ronald J. Sanchez

Our top investment themes represent the best ideas of our portfolio managers—not about specific securities or asset classes, but about the best practices they have identified as potential sources of strength in the challenging market environment that lies ahead.

The descriptions below offer a glimpse into our current themes and their implications for investors. Look for more detailed discussions of each theme over the course of the next several months.

1. Durable Growers. 
The pool of attractive candidates in today's equity market is shrinking. Just 28 companies were responsible for half of the profits earned by all S&P 500 companies in 2015. That is an unusually high level of concentration. Therefore, we are moving cautiously in this environment while still leveraging all the active management resources and intellectual capital at our disposal.

Our sights are set on durable-growth companies which don't rely on low interest rates for growth. Instead, they have competitive advantages that are strong enough to keep challengers from encroaching on their territory (so-called economic moats), along with steadily improving sales and profits over full market cycles.

Our high degree of selectivity in this market also means we are carefully measuring the "margin of safety" around the securities we are evaluating. In essence, the margin of safety is the difference between a security's market price and our (higher) estimation of its intrinsic value. If a security is trading at 17 times earnings, for example, we might conclude that it is trading at the upper limits of its intrinsic value. This could represent limited growth potential, or a narrow margin of safety.

These characteristics are especially meaningful when valuations are full.

2. Income Builders.

High quality dividend-paying stocks offer a number of potential advantages in today's low-yield investment landscape. In addition to the potential stream of income they offer, dividends have also accounted for approximately 47% of the S&P's total return over the past 85 years. They vary considerably from decade to decade, ranging from a high of 74% in the 1970s to a low of 23% so far this decade. Low tax rates on long-term capital gains and dividend income play a role in determining the appeal of dividends.

Consistent and growing dividend-payers also tend to perform well over the long haul. For example, Standard & Poor's tracks a group of "Dividend Aristocrats" that have increased their dividend payouts for at least 25 consecutive years, and found that they have outperformed the S&P 500 Index over time, with lower volatility.

It is important to remember that, unlike the periodic interest payments offered by bonds, dividends are never guaranteed. But dividend-paying firms usually appreciate the importance of consistency: Wall Street analysts see a steadily rising stream of dividend payouts as evidence of fiscal discipline.

We do find stocks that provide reliable income streams attractive. However, in this environment of ultra-low interest rates, investors have overly turned to high dividend-yielders as a source of potential income, driving valuations to extreme levels. We have to remain disciplined to be sure we don't overpay for yield, which could carry downside risk, and would rather focus on sustainable yield at a reasonable price.

3. Healthcare Innovators.

We expect the healthcare sector to grow faster than many other sectors over the next several years, driven by an aging population and strong demand for new and effective medical treatments.

As we research and evaluate potential acquisition targets for our portfolios, we are most interested in finding companies that have strong balance sheets and are developing medications for life-threatening illnesses that are high on the FDA's priority list, including diabetes, hepatitis C, Alzheimer's and cancer. Drugs that treat these high-profile illnesses may be more likely to receive fast-track approval from the FDA, and may receive more favorable treatment from health insurance companies when they determine reimbursement rates for new medications. 

So far, many of the healthcare opportunities we have found most appealing have been in large-cap pharmaceutical companies. But we have also identified companies that appear attractive to us in the biotech field (which received half of all FDA drug approvals in 2015), med-tech equipment manufacturing and distribution. 

Finally, we recognize that the healthcare sector has not demonstrated its typical defensive characteristics so far this year-an aberration we attribute mainly to election-season uncertainties about the future of drug prices under a new presidential administration. But prices have declined recently, pushing valuations down to a level that appears attractive to us and to many other investors across the market. Over the longer term, healthcare has exhibited a relatively low level of sensitivity to macroeconomic shocks and market disruptions. 

4. Technology Leaders.

We are following a barbell approach to the tech sector, investing in two areas that are on opposite ends of the spectrum. One end of the barbell is focused on newer technology firms that appear to show potential for rapid long-term growth. On the other end of the barbell, we concentrate on well-established technology companies with strong balance sheets that appear attractively priced (but may grow at a slower pace than their younger counterparts).

Both ends of the barbell have their own strengths and weaknesses. While younger firms can be nimble and creative, they face significant barriers to entry in a market that is dominated by large multinational corporations. Conversely, while well-established firms have a stronger foothold in the market and reliable distribution networks, they may lack the agility to keep pace with changing consumer tastes.

Companies on both ends of the barbell are competing for extremely crowded shelf space.

Still, we see strong defensive characteristics across the tech industry that could be especially helpful for investors in a soft economy, valuations that appear reasonable, and prolific cash generation among the largest competitors, much of which is being returned to shareholders as dividends. Many of the fast-growing firms in cloud-based software licensing are already generating prodigious amounts of free cash flow, contributing to higher valuations in the sector.

5. Shock Absorbers.

Investors who follow the performance of different asset classes, sectors and investment styles over the years know that the markets can shift suddenly and without warning, often in directions that are impossible to predict.

Experience shows that one of the most effective ways to prepare for these unexpected market rotations is to hold a diversified portfolio of stocks, bonds and other asset classes.

Diversification has come under some pressure in recent years as the S&P advanced steadily and bond yields sank to record lows. However, all market cycles eventually run out of steam and different asset classes move in and out of favor with investors. As long-term investors, we remain convinced that fixed income securities and alternative investments play an important role in many of the portfolios we manage, adding valuable capital preservation qualities and non-correlated performance potential.

Diversification requires patience. Nevertheless, it can ultimately create portfolios that produce higher returns with less risk than more heavily concentrated portfolios. In our view, the principles of global diversification are as relevant today as they have ever been.



This communication is intended solely to provide general information. The information and opinions stated are as of July 26, 2016, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

CFA® and Chartered Financial Analyst® are trademarks owned by CFA institute

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