Equity Investment Outlook
Osterweis Capital Management
During the first quarter of 2011, the stock market, as measured by the S&P 500 Index, enjoyed a total return of 5.9%. This was on top of a 15.1% gain in 2010 and a 26.5% gain in 2009. Interestingly, the Russell 2000 Index, which represents small cap stocks, did even better, gaining 7.9% in the first quarter of this year, 26.9% in 2010 and 27.2% in 2009. On the other hand, while the Dow Jones Industrial Average, which represents 30 large cap stocks, also beat the S&P 500 Index in the first quarter, gaining 7.1%, it seriously lagged in 2010 and 2009 when it posted gains of only 14.1% and 22.7%, respectively. This bifurcation of the market, with small caps outperforming large caps, has led to a valuation disparity between overvalued small caps and undervalued large caps, which we believe can be profitably exploited. We, and others, have observed for some time that many excellent, growing large cap stocks are quite cheap relative to both the overall market and to more richly priced smaller companies. We expect that, over time, more investors will agree and large cap stocks may then begin to outperform the general market, as they have to a modest extent this year.
As we wrote in last quarter’s Investment Outlook, it appears that the U.S. economy has turned the corner from mere recovery to sustained expansion. Nonetheless, the word “anemic” still applies as the economy faces several longer term challenges. First, housing remains under severe pressure from the huge inventory of foreclosed homes that weighs down prices and obviates the need for much new construction. Second, persistently high unemployment levels and the consumer’s continuing need to deleverage combine to limit consumer spending, particularly among the less affluent. The high-end consumer has benefitted disproportionally from the stock market recovery and has thus been able to spend more freely. Lastly, even the modest growth now evident in the U.S. economy is dependent upon ongoing massive government spending. Premature withdrawal of this support could lead the recovery to falter.
For those lower down on the economic ladder, life has been more challenging with the recent surge in oil, gasoline and food prices. Not only are jobs and credit scarce, but the cost of essential goods and services continues to rise at an alarming rate. Prices for food, energy, clothing, health care and education continue to outstrip the official inflation number. These rising prices act as a tax on the consumer, forcing cut backs in other areas of spending and, as a result, often tend to be more deflationary than inflationary.
The recent popular uprisings in the Middle East and North Africa have underscored the potential instability of the region and the possibility of a serious disruption of our oil supply. We generally take the view that whoever ultimately wields power in the Middle East will want to sell oil and, therefore, we tend not to be alarmists regarding turmoil in that region. Nonetheless, we are not blind to the possibility of material short-term supply disruptions.
Likewise, we believe that natural disasters, such as the horrific earthquake and tsunami in Japan, typically do not have a lasting effect on economic trends. Clearly, they have short-term impacts but not lasting ones. The obvious concern about the recent disaster in Japan is the extent of the nuclear accidents and their potential to wreak long-term damage.
Returning to the U.S. economy, what has been most surprising about the current recovery/expansion is the extent to which corporate profits surged. The Bank Credit Analyst explains it succinctly, “While real GDP surpassed its pre-recession peak in Q4 of 2010, total employment still remains 7.7 million below its pre-recession levels. No wonder firms have been able to boost productivity and profit margins in this environment!”1 From The Economist magazine, “In America total real wages have risen by $168 billion since the recovery began, but that has been far outstripped by a $528 billion jump in profits. Dhaval Joshi of BCA Research reckons that this is the first time profits have outperformed wages in absolute terms in 50 years.”2
Not only are corporate profits quite robust, but corporate balance sheets are in exceptionally good shape. This suggests that even with a modest pace of economic expansion, corporations could generally do well, potentially enjoying strong profits and generating unusual amounts of free cash flow. Some of this cash may then find its way into increased capital investment, higher dividends and share repurchases, and greater merger and acquisition activity. All this could make equities more attractive over the foreseeable future.
Lest we end on too happy a note, we will reiterate our concern about the looming problems of government deficits at the local, state and Federal levels. Many state and local budgets are in shambles, which will force municipalities and states to cut back services and employment. Since much of the problem can be traced to overly generous retirement and health care benefits, we think it is inevitable that such benefits will either be curtailed or that more of their cost will be shifted to employees. Layoffs will contribute to high unemployment levels and cost shifting will mean less spending ability by the affected workers.
At the Federal level, the combination of budget deficits and stimulative monetary policy poses a risk of inflation. We are clearly seeing significant commodity inflation, but slack in the labor markets has not allowed inflation to spillover into wages. Perhaps the biggest challenge the Federal Reserve faces is how long it can keep monetary policy loose to support the economic recovery without triggering an inflationary spiral. This is something the markets will be watching very carefully.
1 Berezin, Peter, “A Huge Hole to Fill”, The Bank Credit Analyst March 2011: 4.
2 Buttonwood, Marx, Mervyn or Mario?, economist.com 3/24/11.
Past performance is no guarantee of future results. This commentary contains the current opinions of the author as of the date above, which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
The S&P 500 is a market-capitalization weighted index of five hundred unmanaged common stocks and is widely recognized as representative of the equity market in general. The Russell 2000 Index is an index measuring the performance of the 2,000 smallest companies in the Russell 3000 Index, which is made up of 3,000 of the biggest U.S. stocks. The Russell 2000 serves as a benchmark for small cap stocks in the United States. The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq. The indices include reinvestment of dividends. The indices do not incur expenses and are not available for investment.
Free cash flow represents the cash that a company is able to generate after laying out the money required to maintain and expand the company’s asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value.
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