Shares digital

The US economy may be down but it’s not out, so now could be a good time to pick up some nuggets on the cheap. David Burrows goes hunting

Every cloud has a silver lining apparently, but when you look at the ominous clouds over the US economy you do start to question the wisdom of this saying. Recent data releases have shown that the US economic backdrop is deteriorating, with unemployment hitting 5% and the closely watched Institute for Supply Management (ISM) Manufacturing Report on Business falling to 47.7. Readings of below 50 imply negative overall business sentiment.

This news has led the US equity market to record its weakest start to a trading year since 1932, causing some commentators to question the investment case for US stocks. Thankfully there are a few optimists around who refuse to subscribe to the doomsday scenario.

Bill Miller, the respected manager of the Legg Mason US Value Trust, questions why, regardless of market conditions, an investor would ignore the world’s largest economy. Given the breadth of the US market there are always opportunities, it is just that sometimes they might prove a little harder to find. More than ever it is a stock-picker’s world and Miller should know more about this than most – he is one of the very few US fund managers to have beaten the S&P 500 consistently.

Mike Lenhoff, chief strategist and head of research at Brewin Dolphin, thinks Miller talks sense. ‘I can see where Miller is coming from and I agree that there are always opportunities in US equities. The question for investors should be: do they want to be in equities full stop? If you don’t hold expectations that the US will recover then there isn’t much hope for any global stock market. Even taking into account the Asian decoupling, countries such as China still take their leads from Wall Street.’

Lenhoff is not, though, in the pessimists’ camp when it comes to the US market. ‘We are in a period of weak growth but will this lead into a recession? I don’t think so. Manufacturing is certainly not in recession. Also, if you strip out the financials from the S&P 500, the results really aren’t that bad. Average earnings growth was about 10% for the final quarter of last year, which is reasonable.’ He adds: ‘A lot depends on the Fed’s action, with interest rates down, and valuations starting to look far better as they build in risk premium, I would argue that the stage is set for a rebound, maybe in the summer.’

Cormac Weldon, head of US equities at Threadneedle Investments, follows a similar line of thought. ‘There are undeniable problems in the US economy, and we do think that consensus earnings growth forecasts are still too high,’ he says. ‘But those numbers are for the whole market. There are certainly plenty of companies that can deliver good levels of growth, with valuations that leave scope for useful share price rises.’

Through 2007, Threadneedle’s US team has sustained a high conviction, underweight in financials, adding significant value. Weldon is still cautious on the sector but he is starting to see some opportunities: ‘We are just starting the reporting season and there are going to be some big writedowns from the banks,’ he admits. ‘It is still too early to

start buying the sector indiscriminately, but there are some instances where all of the possible bad news and more is reflected in prices, and we have been taking advantage of those. The result is a reduction in our underweight in recent weeks.’

HGrowth opportunities

In a climate of slow economic growth, Weldon has placed an emphasis on companies able to deliver sustainable earnings growth via niche products or exposure to international demand. Technology holdings such as Apple, Google and Electronic Arts all served portfolios well in 2007. But technology is not the only sector to offer non-cyclical growth opportunities.

‘Our healthcare analyst has generated some good ideas and we have added stocks such as Inverness Medical and Schering Plough to the funds in recent months,’ explains Weldon.

Despite the short-term difficulties facing the market, Weldon is bullish about the prospects for the whole year. ‘Interest rates are falling and we are finding lots of companies with strong balance sheets and healthy cashflows that are well positioned to weather the tighter credit conditions we are witnessing,’ he says. ‘Idea generation in the team has never been better and that gives us a great chance to outperform in 2008.’

Aled Smith, manager of the M&G American fund, says the best approach to US equity investing is to look beyond macroeconomic concerns and focus on companies improving their returns. ‘I like to look beyond the market noise created by changes in investor sentiment. American companies have solid balance sheets and there is ongoing M&A activity in the market, showing that the corporate sector as a whole is healthy.

‘I believe US equities remain attractive as an asset class and I can see many investment opportunities at the moment. Cashflow valuations relative to the rest of the world are at lower levels than they have been for several years.

Smith argues that many companies in the US were improving their returns on capital, following periods of restructuring and investment in order to improve operating efficiency. ‘Most importantly, this often happens independently of the economic environment.’

H Key drivers

Smith, focuses on bottom-up stock selection rather than sector bets. His investment process centres on four key drivers of return on capital within companies – internal change, external change, R&D/innovation and undervalued business franchises.’

‘Given the current economic slowdown in the US and the global credit crunch, investors have been risk-averse. As a result, they have tended to sell out of areas of the market that are perceived to be risky, moving instead to companies with high returns that can deliver more reliable sources of return – such as mega caps.’

But of course, as Smith points out, many large caps are also well-researched by the market and it can therefore be more difficult to find mispriced opportunities in this area.

As far as Smith is concerned it is a case of being resolute and sticking to fundamental analysis – taking a longer-term view rather than being distracted by short-term periods of market volatility. He name-checks a few of his current favoured stocks and explains why he bought in.

Hess Corp – ‘After significant management changes, the integrated oil & gas company has transformed itself from a collection of mature, low-quality assets into a more focused business with exposure to longer-life, higher-returning projects. The share price has performed strongly as higher oil prices and increased production enabled the company to report earnings ahead of expectations, and I believe the company is on track to generate returns in excess of the cost of capital as well as delivering reasonable growth.’

Archer Daniels Midland – ‘As a result of increasing demand in the agricultural processing market, especially from China, and the lack of investment by the industry in the 1990s, I believe the company is well placed to increase its return on capital. The company, which is also a market leader in ethanol and biofuels, reported earnings that beat expectations and I continue to believe the company will benefit from favourable supply-and-demand dynamics.’

Bio-Rad Laboratories – ‘The biotechnology company has an excellent track record in exploiting R&D for commercial use, and this focus on profitable innovation was apparent in the company’s third-quarter earnings, which were well received by investors. I believe the company has good growth prospects in medical diagnostics and scope to improve its operational efficiency, which continues to lag its peers.’

FMC Corp – ‘The chemicals company operates in a number of areas where the supply and demand background is favourable (such as soda ash and lithium) and has a management team focused on the efficient allocation of capital. The recent earnings report showed demand continues to be strong and I believe that the market expectations for returns and growth are too pessimistic.’

H Focus points

There are inevitably reservations on any companies reliant on US consumer spending but there are no doubt specific themes worth pursuing. The US government has placed a huge emphasis on alternative energy development (ethanol production) hence the interest in companies in line to benefit such as agrochemical giant Monsanto and tractor manufacturer John Deer.

An investor’s basket of US stocks should typically have a broad spread across a number of sectors. Arguably some sectors should always have some representation regardless – oil being the obvious example. As one US fund manager so succinctly put it: ‘All you need is one missile attack in the Middle East and oil goes up to $120 a barrel, so you want to be invested there.’

Lenhoff concedes that there will be some sectors for which investors will just not have the stomach, but others, he argues, remain very strong. ‘You won’t get much interest in the financials sector, in the auto sector nor in consumer discretionary – most US retailers are having a hard time of things. But you have areas such as aerospace and defence where companies have solid earnings backed up by long-term contracts. At some point you have to look at some of the unloved sectors too and decide: as a longer-term investment, do they stack up?’

For the bold investor there is always the temptation to buy when stocks have been hammered and can arguably only go up. It is a very dangerous game of course because there are enough stories of companies going into freefall and investors licking some pretty nasty wounds. In the US, house builders have come in for some heavy treatment, and the question is: are the valuations now tempting enough to attract investors in for a longer-term play?

David Nelson, chairman, of Legg Mason Investment Policy Committee gives his view. ‘The panic in CDOs and sub-prime loans has put renewed pressures on the battered home building industry, pushing down the shares of companies such as Pulte Home and Centex by more than 17%, below their previous lows (reached in the summer of 2006 and the spring of 2007). The double-digit annual declines in housing starts and widespread house price weakness also did little to engender investor confidence. None of these concerns is new to the market. In fact, the home builder stocks are now trading near their underlying asset values, implying that the market is ascribing little if any value to their cash-generating abilities as going concerns. With such low expectations, we believe the odds are clearly in favour of long-term investors.’

As far as Lenhoff is concerned the sensible course of action is to wait for genuine signs of recovery. ‘The problem with bottom feeding is that you don’t know the full risk. Most people wait for the start of a recovery, they don’t want to be catching a falling knife. If a share price falls by 60% (and in the US house building sectors there were falls that severe), why not wait until the stock is up, say, 5% before you buy?’