MARKET COMMENTARY

Happy Days Are Here Again?

Equities Overview

07.13.2016 - Carin L. Pai

Following a significant downturn triggered by Brexit and other economic uncertainties, global financial markets bounced back this week. The main beneficiary of this rebound was the S&P 500 Index, which hit a record high as investors turned to US equities as a perceived "safe haven."

Investors certainly seem to have regained a level of confidence in the US equity market—a level that may be questionable given the market's seemingly full valuations and the deterioration of corporate profits.

Whether this market rebound is a temporary blip or a sustainable trend remains to be seen. But based on our observations of corporate fundamentals and economic growth in recent months, we believe risk in the equity market is still disproportionately high compared to the potential rewards.

Under these conditions, our experience tells us to tread lightly and proceed with an extra degree of caution. But that doesn't mean we are standing on the sidelines. To the contrary, our selectivity and focus on fundamentals has sparked an uptick of activity among analysts and portfolio managers. Our goal is to take profits when the time is appropriate, capture valuations that appear attractive during bouts of market volatility and enhance returns without adding an inordinate amount of risk.

In this market, that process becomes a bit more challenging.

Measuring Intrinsic Value

Our high degree of selectivity means that we are carefully measuring and closely monitoring the so-called "margin of safety" that surrounds the securities we are evaluating to help ensure that we are being properly compensated for the risks we are taking. This cushion doesn't guarantee positive returns, but it does represent our best estimate of the price range we expect an individual stock or sector to fall within over a given period.

Technically, this margin is the difference between a security's market price and our estimation of its intrinsic value. For example, we might conclude that a security trading at 17 times earnings is trading at the upper limits of its intrinsic value. That represents limited growth potential and a narrow margin of safety. It is calculated by combining a variety of fundamental and quantitative measurements that reflect the financial health of the company itself and the environment it operates in.

Last quarter, that environment included the widespread decline of earnings estimates for S&P 500 companies, with fewer companies contributing to profits. In fact, more than half of the Index's total net income in 2015 was generated by just 6% of the companies in the S&P.

Mining for Growth Opportunities

Currently, investors seem willing to pay significantly for yield. Valuations on dividend-yielding stocks are roughly 150% (or 1.5 times the value) of the broader market. These valuations offer very little margin of safety.

The takeaway is that we don't foresee a lot of top-line growth or strong direction in the market. But under the surface of this market we see earnings growth that varies dramatically from one S&P 500 subcategory to the next, even among the top earnings growers.

While absolute growth numbers are important, the path and consistency of earnings growth over the longer term are also meaningful. We are mindful of the quality of earnings and prefer lower debt leverage and stronger free cash-flow generation. We would still buy stocks that appear to offer growth at a reasonable price, but acknowledge that in a low-return environment, yield at a reasonable price is compelling.
  
At the end of the day, individual security analysis is our determining factor. We firmly believe in letting corporate fundamentals drive our decisions. So our investment professionals are vigorously researching and analyzing balance sheets and other fundamentals for pockets of growth.

As we search for opportunities beneath the surface, selectivity is key.


This communication is intended solely to provide general information. The information and opinions stated are as of July 13, 2016, and may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. 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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