The Four C’s of Evaluating Markets
If you were to stop a man on the street, show him a diamond, and then ask him what he thinks the diamond is worth, his guess would likely be based upon the size of the diamond. The size, measured in carats, is definitely important; the bigger the diamond, the more valuable it tends to be. However, as is true with most things, value is rarely a function of a single factor. A slightly more discerning individual might notice if the diamond sparkles. The better the cut of the diamond, the more brilliant it appears; the greater the brilliance, the greater the value. An even more discerning individual might also notice the color of the diamond, or rather the lack thereof. Exceptionally clear diamonds are rare, and therefore tend to be more valuable. And if perchance, the individual being queried happened to be especially knowledgeable (and just happened to have a magnifying glass in his pocket) he could examine the diamond for blemishes and/or inclusions. Diamonds with few imperfections are said to have better clarity; the better the clarity, the greater the value.
What do the four C’s of diamond valuation (carat, cut, color, and clarity) have to do with the forces driving the market during the first quarter of 2010? Nothing really, but as is true with diamonds, market values are rarely a function of a single factor. Just as size, or number of carats, is the most obvious determinant of a diamond’s value, all investors recognize that markets are dependent upon the state of the economy. However, the more discerning investor looks closer, focusing on earnings growth, which for the purposes of this analogy is consistent with “cut”; the better the earnings, the more the company sparkles. A slightly more thorough analysis would lead the investor to examine profit margins, or continuing the analogy, “color”; as margins improve, the future becomes decidedly less clouded. And finally, the professional investor recognizes that it’s the individual companies that ultimately drive the market; investment success therefore becomes a search for “clarity”, finding those companies with the fewest imperfections. With that analogy in mind…
The U.S. entered the first quarter of the year on a positive note. During the fourth quarter of 2009, GDP grew at a seasonally adjusted annualized rate (SAAR) of 5.9%. While a significant percentage of that growth can be attributed to a slower rate of inventory liquidations, business investment did grow at a double-digit SAAR and personal consumption expenditures (PCE’s) were up 3.2%. Early indications are that both of those sectors continued to do well. Retail sales, less the volatile auto component, were up 0.5% month-over-month in January and an even better 0.8% month-over-month in February. As for business investment, new orders for durable goods were up 2.6% month-over-month at the start of 2010.
What is somewhat unique about the current environment is the fact that larger multi-national manufacturers seem to be faring better than smaller businesses. That is reflected in the disparity between the Institute of Supply Management’s Composite Index, which tends to represent larger entities and has been at robust levels for seven months now, and the National Federation of Independent Businesses Index (small businesses), which has languished over the same period. Some of that is due to the fact that larger entities are more likely to transact in the developing world where growth has held up; larger companies also have access to the capital markets, which are functioning much more normally today as compared to 12 months ago. Smaller businesses tend to be domestic-centric, and they have been negatively impacted by banks tightening credit standards and cutting back on their lending activities.
The news in the labor markets continues to improve. Unemployment moved down below 10%, job losses have slowed substantially, the average workweek is up, and temporary employment is also up. It is troubling, however, that initial claims for unemployment insurance have moved sideways since November. It is also disconcerting that the percentage of respondents of the Conference Board’s survey suggesting that “jobs are hard to get” remains significantly higher than those suggesting that “jobs are plentiful”.
Of course the markets are not strictly dependent upon domestic economic events. During the first quarter of the year, the fiscal/debt problems in Greece, which impacted the European Union, were a not so subtle reminder of the credit crisis that wreaked havoc not that long ago. During the first quarter, those difficulties helped the dollar and improved the bid for risk-free assets (specifically U.S. Treasuries), at the same that it raised the risk premiums associated with riskier assets (stocks and corporate bonds).
Looking beyond the economic environment, what is noticeable is that corporate profits are growing, meaningfully. Based on the National Income & Product Account (NIPA) measures, corporate profits were up 10% in the third quarter of last year (the most recent release). S&P 5001 earnings provide a more current measure, from the third quarter of last year through the first quarter of this year, S&P 5001 earnings are up more than 10%.
What is equally encouraging is that profit margins are likely to improve. Companies are enjoying above average productivity gains at a time of below average compensation gains; the net result is that unit labor costs are decreasing at a SAAR of more than 5%. With employee compensation being one of the most important costs of doing business, decreasing unit labor costs tend to be a very good margin story. The equity markets performed well during the first two weeks of the year, partially reflecting the economic momentum that carried into 2010. The markets were then under pressure, partially due to the sovereign credit problems in Greece. As those problems were addressed and the market worked through the earnings season, it recovered nicely, retracing their losses and posting solid, if unspectacular, gains. The bond market reacted to the same inputs, but followed the opposite track; rallying through early February and then given back some of those gains as the first quarter progressed.
It was a relatively quiet quarter. Market movements were based on the standard metrics; first and foremost, the economy (carats), then profits (cut), and finally margins (color). All are improving. What is equally important, and which we did not specifically address in this write-up is “clarity”. The market is always driven by the companies that make up the index. Identifying those with the fewest imperfections, the companies that will ultimately drive the market, looking for “clarity” is what Manning & Napier has been providing to its clients for 40 years.
Where Do We Go From Here?
This March marked the one-year anniversary of last year’s U.S. stock market bottom, a time when the destruction from the financial crisis seemed to be never-ending. The impact of this chaos was difficult to digest, and widespread fear was prevalent across all levels of the markets and the economy. Yet in hindsight, the March 2009 low was one of the best buying opportunities in decades.
As the saying goes, hindsight is 20/20. Predicting the exact level of last year’s market trough or the extent of the ensuing rally (up about 70% as of mid-March) may have been very tough, if not impossible. However, taking an opportunistic view of price declines and using a discerning eye to search for strong values, did prove to be beneficial. When the stock market was falling, Manning & Napier actively upgraded clients’ holdings into strong, high-quality companies that were trading at relatively cheap prices, a disciplined investment approach that served clients well over the past year.
Looking back, the early stages of the recent market rebound represented a period of extraordinary and generally easy returns, but the path ahead does not appear as easy. So far in 2010, the stock market has continued to advance, but the progress has been fairly choppy, a trend that could continue for some time. Given this uncertain outlook, viewing the current environment from a top-down perspective helps provide some insight into the challenges that lie ahead.
The Big Picture: Forks in the Road Ahead
When looking at the world from a top-down perspective, the most obvious point seems to be that the relatively clear part of the recovery has started to fade. This leaves us with several possibilities for the future, and in particular there appear to be forks in the road ahead related to the economy, inflation, and stock market returns.
The economic fork in the road ahead has two distinct scenarios: a possible double dip recession or a more typical robust recovery. Factors such as fading government stimulus, weak consumers with heavy debt burdens, and difficult lending conditions for small businesses raise the risk of a potential double dip recession down the road. In contrast, several economic developments point toward a stronger recovery. Companies cut inventories dramatically during the recession, which means the restocking process is a source of potential growth. In a similar reaction, firms were quick to fire workers in the downturn, and the extensive layoffs could imply a need to rehire once activity accelerates, which would help the labor markets and thus add to final consumer demand. The precise level of economic growth over the next few years is all but impossible to predict, but actively monitoring these economic components is far more important to understanding where the economy is heading. The picture will likely be fuzzy for a while. For instance, recent reports show consumer spending and retail sales have risen slightly, but consumer confidence, as measured by the Conference Board, dropped sharply in February. This type of uneven activity may be par for the course for a while, but it does suggest the consumer may not be in a position to drive a solid recovery.
Another fork in the road ahead applies to inflation, which could move higher or lower over the coming years. The risk of a highly inflationary environment could be provoked by aggressively loose monetary policy allowing too much money to work its way through the economy. Also, rapid growth in emerging markets could drive up commodity prices, causing some emerging markets’ inflation to impact the rest of the world. Yet signs of modest to lower inflation are quite convincing. Right now, banks are generally holding cash instead of lending, and inflation expectations remain stable. Furthermore, the U.S. faces substantial economic slack (i.e., high unemployment and low capacity utilization), and weak labor markets could pressure wages for several years, both inherently disinflationary.
The extreme cases of deflation and hyper inflation seem unlikely, but the Federal Reserve must try to strike a delicate balance when the economy is ready for liquidity to be withdrawn. As with the economic outlook, the key is to closely monitor the inflation situation, especially the specific supply and demand dynamics within industries.
The final fork in the road ahead pertains to the equity markets. After an impressive double-digit rally, the outlook for stocks is far from certain. No longer are economic, valuation, and sentiment indicators sending a strong signal that equities are likely to continue to outperform. In fact, there is persuasive evidence for a downside or upside scenario going forward.
As for the downside scenario, current expectations are calling for one of the sharpest earnings recoveries on record, which means stocks may not perform as well as some projections are implying. Also, while valuation measures such as price-to-sales do not look expensive by historical standards, they have moved dramatically from their lows of early 2009, so stocks may not have as much room to run going forward.
Despite potential downside risks, a strong case can also be made for equities to continue delivering positive returns for investors, albeit at a slower pace than in 2009. Short-term expectations may be calling for an optimistic earnings recovery, but long-term earnings expectations are near 15-year lows. Investors seem to have tempered their hopes for future growth, which implies that stocks could perform better than expected. Additionally, some fundamental valuation measures continue to point toward favorable equity returns going forward. For instance, corporate balance sheets currently contain a lot of cash, which could potentially fund merger & acquisition (M&A) activity.
The lack of clarity for the economy, inflation, and the stock market may seem unsettling, but this uncertainty can breed opportunity. While a challenging environment will not promote all players, it will likely separate the winners from the losers, making it ripe for a stock-picking approach like that of Manning & Napier.
Selective and Flexible
Over the past year, virtually all stocks soared higher, though lower quality companies and industries most impacted by the credit crisis led the pack. Their strong performance was primarily a recovery from extremely depressed prices, which probably won’t be the driver of results going forward. Investors will want to see fundamental value such as earnings growth, cash flow generation, and reasonable valuations as evidence of future return potential.
Given these more discriminating conditions, Manning & Napier believes that having a selective eye will be important for navigating the markets ahead. As the last issue of Update discussed, investment opportunities are likely to be found by analyzing specific company and industry dynamics, a bottom-up focus that has been at the core of our investment approach for 40 years.
Manning & Napier has three proprietary stock selection strategies that shape our investment decisions. Our Strategic Profile strategy seeks high-quality companies with a sustainable competitive advantage that will drive future growth. Our Hurdle Rate strategy identifies the strongest companies in a struggling cyclical industry that should benefit when weaker players cut back or exit the market. Lastly, our Bankable Deal strategy finds companies trading at dramatic discounts to what we deem are their fair market value.
These time-tested strategies apply to all industries and all equities that are approved for clients’ portfolios. They set the standards for a disciplined investment process, yet they also provide the flexibility to take advantage of evolving market conditions. For example, through the lens of our Hurdle Rate strategy, we have invested in some of the best-positioned airlines that have continued to grow throughout the stress in the airline industry, while many of their competitors have been forced to downsize. Our Strategic Profile strategy gives the framework for investing in some first-class Technology companies that are market leaders in key growth areas such networking equipment.
Manning & Napier’s investment strategies are designed to help guide us through market fluctuations, which will likely be part of the environment over the next few years. It is important to keep in mind that volatility is not necessarily a bad thing; movements in the market can create buying and selling opportunities. As we emphasized in last quarter’s Update, being nimble is an essential tool for finding value in inevitably changing conditions. Having a flexible approach enables us to take advantage of swings in sentiment by buying into fear and selling greed.
In the end, uncertainty remains in the current environment, but such challenges often produce opportunities. Using the same flexible investment approach that has served our clients since we opened our doors in 1970, Manning & Napier is well-equipped to take what the market gives. While every market environment may look a little different, Manning & Napier’s prudent stock selection strategies have stood the test of time and continue to allow us to focus on what’s most important – delivering clients absolute returns over full market cycles.