Recent bouts of volatility have unnerved many investors. At Westwood we believe this is a return to more normal levels of volatility and is a healthy sign. Some investors will invariably decide the volatility is too much and it is time to stand on the sidelines. For those who are long-term investors, this presents a great opportunity to identify unique opportunities given the changing market environment. With that in mind, we interviewed two senior members of our investment team, Lisa Dong, CFA and Matt Lockridge to get their insights on the large cap market, and where opportunities might lie in the months ahead.
The energy market has been a key driver of recent volatility. Share your perspective on what is going on in this sector and where you see upside potential in the large cap market.
Lisa: Oil rebounded from its recent bottom of around $25 on Feb. 11, 2016, and the benchmark, West Texas Intermediate (WTI), is trading at around $37 as of March 10, 2016. Our energy team’s work on industry costs and profitability suggested that oil prices below $30 is not sustainable in the long run and we were not surprised to see the recent rebound of oil prices. The market agrees with us and currently energy stocks, especially the high-quality ones that would survive the downturn with a strong balance sheet, have factored in a near-term oil price of $45 and long-term oil price of $60. At current stock prices for these high-quality energy names, the reward/risk based on upside of $60/$3.50 (oil/natural gas prices) and downside of $30/$1.80 position them well in the near-term. However, the tailwind created by low energy costs to the overall U.S. economy, which is largely driven by consumer spending, is positive for certain companies in the market and our analysts seek those that can generate undervalued growth. In particular, we see growth in home-related consumer spending at big-box retailers.
Matt: The supply/demand equation for oil fundamentally changed over the last several years as U.S. shale flourished and OPEC members shifted their stance to protect market share of global production. With crude oil down over 70% from the peak, we believe we may be seeing the start of the bottoming process as higher-cost oil players are forced to leave the market. Throughout this commodity price downturn, our energy analysts have done a terrific job of ensuring that we are only exposed to higherquality businesses that can manage this difficult environment. The large cap portfolio has remained invested in a diverse set of best-of-breed businesses, including low-cost exploration and production companies, industry-leading service companies, and financially stable integrated oil names with growing dividend streams. While future commodity prices are likely to remain volatile, we’re confident our portfolio companies will exit this downturn in a stronger competitive position and offer attractive future risk-adjusted-return opportunities.
Another key driver of recent volatility has been China. To what extent is the large cap space influenced by what is happening in the Chinese markets?
Lisa: Slower growth in China has sent commodity prices lower and there is global deflationary fear as a result. We have been trying to avoid the pure mining and metal exposure for this reason. We also think the market is overly concerned about the transmission of Chinese problems into the U.S. economy. The U.S. economy is mainly driven by consumers who actually would benefit from cheaper consumer goods exported by China. However, when we pick stocks, we are keenly aware of the negative impact on U.S. companies or multi-national sales from excess capacity in certain sectors of the Chinese economy, such as construction and certain pockets of manufacturing economy. We aim to use our knowledge of the fundamentals of individual companies to take advantage of the opportunities created by general fear.
Matt: China has been a large engine of global growth for decades and the deceleration we’re seeing in the region will have large repercussions across many areas. First, China is a large buyer of many raw materials, and represents roughly 50% of global steel consumption. As China continues to slow, we expect this weakness in demand to continue to ripple across much of the industrial metals complex. Additionally, China is the No. 1 trading partner for countries such as Australia, Brazil and South Korea. We expect many of these other economies to see weakening trends because of their strong relationship to China. Understanding the derivative impact that China’s slowdown will have in other parts of the world is important to us as we try to gauge risk within our portfolio.
Normally an environment like this might be a good opportunity to consider less economically sensitive sectors such as Utilities and Consumer Staples. Is that the case now?
Lisa: Utilities and Consumer Staples have been used as safe havens to hide out in this volatile market in their outperformance year-to-date and the elevated relative multiples of these sectors. We are bottom-up stock pickers and still find attractive names in these two groups based on their own growth and valuation merits. However, we do not think that being overweight these two groups, simply to reduce exposure to volatility, is the right way to invest in them right now.
Matt: While it’s true that Utilities and Consumer Staples offer defensive characteristics, we also want to be mindful of valuation. Many defensive names in the market have been revalued higher as investors have migrated toward areas of safety. Accordingly, we have relied heavily on our industry analysts to uncover those company-specific opportunities within these sectors that continue to be mispriced in the market.
Let’s talk about the bright spots: consumer spending and an improving housing sector. What are you seeing there in terms of large cap market trends?
Lisa: As mentioned above, we still see consumer spending improving especially with promising wage growth trends. Recent improvement in household formation and pent-up demand for single family houses are all providing a favorable backdrop for housing-related consumer spending.
Matt: The biggest beneficiary of lower gasoline prices is the U.S. consumer. This increase in disposable income is slowly making its way into retail sales. Specifically, spending on home-related purchases continues to be a bright spot. The large cap portfolio continues to benefit from exposure to steady repair and remodel trends.
What implications would continued interest rate increases have on the large cap landscape?
Lisa: It seems that the only reason we would get rate increases by the Fed is a strong economy. In that sense, rate increases would come with a stronger labor market and more wage growth, which implies a stronger consumer and overall economy. We rarely have a bear market without a recession. So rate increases may not be as bad for the market as some people fear. Rate increases would be good for a financial sector whose profitability driver, such as net interest margin, had been depressed because of the extreme low rates in the past several years.
Matt: Clearly an increase in interest rates will have a positive impact on many of our financial holdings. But as we’ve seen in previous investment cycles, as interest rates normalize, the market tends to seek out those businesses that can manage this increase in cost of capital. This higher quality focus favors our style of investing and gives us increased optimism for the future.
The elections are dominating the news cycle right now. Do you see any election cycle implications?
Lisa and Matt agree the uncertainty created by the election contributed to the already volatile capital markets. We believe volatility will create more opportunities for fundamental stock pickers.
There are many reasons to keep a close eye on the markets right now. We will continue to monitor the environment for shifts relative to oil, China and interest rates. Certainly the Presidential elections will continue to be at the forefront over the next several months. For now, we are not making changes to our asset allocation, but we will continue to look for buying opportunities given the market environment.
Thank you for the continued trust you have placed in us. We look forward to discussing your portfolios with you.
For more information, please contact:
Dallas: Randy Root at 214.756.6980 or firstname.lastname@example.org
Omaha: Art Burtscher at 402.393.1300 or email@example.com
The information contained herein represents the views of Westwood Holdings Group, Inc. at a specific point in time and is based on information believed to be reliable. No representation or warranty is made concerning the accuracy or completeness of any data compiled herein. Any statements non-factual in nature constitute only current opinion, which is subject to change. Any statements concerning financial market trends are based on current market conditions, which will fluctuate. Past performance is not indicative of future results. All information provided herein is for informational purposes only and is not intended to be, and should not be interpreted as, an offer, solicitation, or recommendation to buy or sell or otherwise invest in any of the securities/sectors/countries that may be mentioned.