Q410 Market and Economic Commentary
Granite Investment Advisors
By Mike Timm
January 29, 2011
We remain positive on equities. Valuations on large capitalization stocks remain attractive. Though smaller cap companies outperformed large cap stocks in 2010, we believe the valuation gap will close in 2011 in large part because many of the large cap names have significant sales exposure to emerging economies around the world.
In fixed income, we continue to favor corporate securities with maturities shorter than five to six years, cushion bonds, step-up bonds, and selected non-investment grade bonds. We expect rates to continue to rise over the next eighteen months.
Economic prospects brighten: The lame-duck Congress and the President lost little time after the mid-term elections in adding a stimulus package to bolster what appeared to be an already improving economy. The extension of the Bush tax cuts, paired with a temporary reduction in all workers’ Social Security tax rate, means working Americans will actually have more money in their pockets in 2011 than they did in 2010. Additionally, the package included a provision allowing American companies to deduct the total cost of their capital expenditures in 2011 in just one year—again effectively reducing taxes in an effort to boost the economy and presumably create jobs. Most analysts now see that US GDP growth in 2011 will be closer to 3.5% instead of the more anemic 2.5% previously anticipated.
The case for large cap leadership in the equity market: Certainly the stock market has become increasingly convinced that 2011 will see improved GDP growth. The S&P 500 jumped 10.8% in the fourth quarter, capping a year where the index rose 15.1%.
But the performance of small and mid-cap companies again exceeded the rise in large cap stock prices; for example, the S&P 600 (a proxy for smaller companies) jumped 26.1% versus the 15.1% returned by the S&P 500 in 2010. Importantly, large cap names make up only 56% of the S&P 500; the other 44% are small and mid cap companies. Before dividends, the fifty largest names in the S&P 500 were up only 8.4% compared to the entire index’s rise of 12.8% before dividends. Clearly the small and mid-cap names in the S&P 500 made an important contribution to the index’s overall performance last year. This performance disparity begs the question, why not own small cap names? Equity valuation and our economic outlook provide the answer.
Exposure to Developing Economies
We have often highlighted the benefits of investing in companies whose sales are boosted by their exposure to developing economies. For the foreseeable future, growth in emerging economies will be greater than the improvement in economies of more developed countries. Too often small cap companies’ businesses are dominated by the domestic economy and do not benefit from sales to the faster growing economies in the developing world. If the biggest economic growth is going to come from developing economies, we want to be positioned in those companies that have sales to that part of the world— and many large cap names fit that bill.
Small versus Large Cap Company Valuations
The other important reason why large cap names look more attractive than their small cap counterparts is valuation—small caps are much more expensive than many large cap choices. Take a look at Exhibit 1.
Large companies, as measured by the S&P 500, are selling for roughly 15X 2010 earnings whereas the S&P 600 is currently at 27X earnings. As Exhibit 1 demonstrates, this valuation disparity is quite large compared to historical averages. Given the significant outperformance of small cap equities over large companies in 2010, one might assume that small caps always sell at a price/earnings premium to large caps; but, as the Exhibit demonstrates, this is not true. There have been long periods of time when large companies sold at a premium to their smaller brethren. 2011 looks to be a period where that valuation gap will shrink and favor large cap names because of their more diversified end markets.
2011 Cautionary Note: Can Profit Margins Remain High?
Equity valuations are reasonable so long as profit margins remain at current levels. Based on analysts’ estimates for 2011 earnings, margins will hit all time highs based upon the past forty years. These rosy forecasts worry us. Why are margins so high? Have we truly become smarter and more efficient? Though innovation and productivity are part of the American fabric, we are skeptical that these alone will push us to forty year highs in profit margins.
The enviable profit margins currently enjoyed by many American companies are due to some one time events coupled with some unsustainable occurrences. As for the one time events, corporate America did an excellent job, with the exception of the financial services industry, of seeing the economic storm brewing and reducing costs. Once the recession hit, they cut labor expenses by letting people go, outsourced as many fixed costs as possible, and reduced overhead across the board.
But here’s the first misunderstanding about improved profit margins. When a company outsources costs such as payroll, data centers, and call centers, they reduce fixed costs while increasing variable costs because most outsourcing contracts are priced on volume assumptions. As business increases because of the economic recovery, so too will many of these new variable costs companies thought they had eliminated.
Improved margins over the past two years have also been helped by low interest rates and a benign labor market. But, over the last quarter of the year, rates started to raise—a trend we see continuing. Additionally, we have begun to hear grumblings by labor wanting to share in their companies’ newfound prosperity—though this will not mean immediate renegotiated labor contracts given the high unemployment rate, it does point to margin pressure in the not-too-distant future. Though we do not see margins collapsing any time soon, we remain skeptical that margins will increase meaningfully from current levels. The most likely scenario is that the US and other economies continue to improve but that certain companies fail to meet investor expectations due to margins being at a peak.
(c) Granite Investment Advisors