Stocks at midyear: A market of two minds
Caution and daring both have managed to pay off for stock investors in 2011.
Some classic “value” stocks of blue-chip companies have revived as bargain hunters look for refuge amid a faltering economic recovery. Drug giant Pfizer Inc., for example, is up 15% this year.
At the other end of the market spectrum, economic jitters have made “growth” investors all the more hungry for the most promising up-and-coming firms, such as restaurant chain Panera Bread Co. and health-information systems developer Quality Systems Inc. Both of those stocks are up more than 30% year to date.
For U.S. equity mutual funds, the market’s diverging tastes translated this year into respectable, broad-based gains, as winners more than offset losers despite the economy’s formidable challenges.
The average domestic stock fund posted a total return of 5.4% for the six months despite slipping 0.1% in the second quarter, according to Lipper Inc. That followed a 16.2% advance for all of 2010.
Now, at the midyear point, investors again may find themselves pulled in different directions — value versus growth — if they’re thinking of putting new money to work in stocks or shifting current holdings.
The U.S. economy slowed sharply in the first six months, battered by a jump in oil prices, Japan’s devastating earthquake, Europe’s worsening debt crisis and another downturn in the housing market.
Although the mood on Wall Street brightened in the last two weeks, negativity returned Friday with the government’s dismal June employment report, which showed just 18,000 net jobs added last month.
Other recent data, including reports on June retail sales, have suggested the economy still is expanding. Nonetheless, most analysts expect the U.S. recovery to stay stuck in low gear unless hiring increases significantly.
But many investors have been unwilling to walk away from the equity market, in large part because corporate earnings have continued to advance. Second-quarter operating earnings of the Standard & Poor’s 500 companies are expected to rise 12.7% from a year earlier, according to analyst estimates tracked by FactSet Research.
The Dow Jones industrial average fell a modest 62.29 points, or 0.5%, to 12,657 on Friday despite the grim employment report. The index is off just 1.2% from its multiyear high reached April 29.
Mutual fund managers who focus on growth stocks — shares of companies whose earnings are expected to rise faster than average — say investors make a mistake if they equate a sluggish economy overall with a lack of market opportunities.
“A lot of companies aren’t just muddling along — their business is on fire,” said David Hollond, co-manager of the American Century Heritage fund in Kansas City, Mo.
His fund gained 8.7% in the first half thanks to an eclectic portfolio that includes BE Aerospace Inc., which makes airplane cabin interiors; Chipotle Mexican Grill Inc.; and online movie rental service Netflix Inc.
Hollond’s stock-picking strategy is to look for companies whose sales and earnings are accelerating, he said. What’s more, “We want to see that driven by a clearly identifiable catalyst that we think is sustainable,” he said.
For BE Aerospace, the catalyst is rising airline orders for new jets worldwide, Hollond said. The company’s first-quarter sales jumped 29% to $600 million this year; earnings surged 44%.
The stock is up 12.8% this year, beating the 10.8% gain of the Standard & Poor’s mid-cap share index.
Chipotle, spun off by McDonald’s Corp. in 2006, has become a darling of growth investors. First-quarter earnings rose 23% on a 24% jump in sales.
Hollond says the company, with 1,000 stores now, has vast expansion opportunities in the U.S. and abroad.
The stock has rocketed 53% this year.
That same hunger for growth stories is driving investor demand for the new generation of Internet-related companies. Professional networking firm LinkedIn Corp. went public at $45 a share in mid-May. The stock streaked to $94.25 on its first trading day. It fell back to $64 by late June but has since resurged, hitting a record closing high of $99.60 on Friday.
Yet LinkedIn isn’t expected to be profitable this year. And based on analysts’ consensus earnings estimate of 33 cents a share for 2012, the stock is priced at a lofty 300 times earnings, compared with an estimated 2012 price-to-earnings ratio of about 12 for the average S&P 500 stock.
The nosebleed valuations for some hot tech issues have stirred memories of the dot-com insanity of the late 1990s, which ended with a spectacular crash.
This time, a key difference is that LinkedIn and other new offerings are established businesses with huge customer bases.
Even so, some investment pros are shying away. Bert Boksen, co-manager of the Eagle Small Cap Growth fund in St. Petersburg, Fla., said he bought LinkedIn in the IPO but sold it as it soared. “I couldn’t justify owning it at those prices,” he said.
Boksen, whose fund rose 13% in the first half, said he still finds companies with sales and earnings prospects that he believes aren’t fully appreciated by most investors. “We want to be there before they wake up,” he said.
He cites Steve Madden Ltd., which makes trendy footwear for women. The stock is up 46% this year, but Boksen says he’s comfortable with the shares at 19 times estimated 2011 earnings and 16 times estimated 2012 results.
Boksen’s fund also owns chemical manufacturer Huntsman Corp., up 27% this year. “Pricing is improving for specialty chemicals, and we expect some big upside earnings coming from that whole group,” he said.
But Wall Street’s optimism about corporate earnings faces a key test in the next few weeks as second-quarter reports roll out. Disappointing numbers could quickly pull the rug out from under the stock market.
Dennis Bryan, co-manager of the FPA Capital fund in Los Angeles, believes investors are overly optimistic about future earnings given the economy’s weakened state. “We think corporate profit margins are at a peak,” he said. “Odds aren’t high that they’ll persist at these levels for long.”
Bryan said he’s keeping 31% of his fund’s assets in cash, waiting for a better opportunity to buy stocks. Even with that cash hoard his fund was up 10.9% in the first half thanks to big gains in many of its energy-related holdings.
Given the risks facing the economic recovery, value-focused investors say the environment favors their more conservative strategy.
Value always is in the eye of the beholder, but typically that label describes shares of many older or slower-growing companies that pay decent cash dividends.
One argument for value now is that the stocks have lagged behind the companies’ earnings rebound over the last two years and are bargains.
One of Wall Street’s best-known value investors is Don Yacktman, who manages the $5.5-billion Yacktman fund in Austin, Texas. His portfolio gained 8.5% in the first half as holdings including Pfizer, Viacom Inc., H&R Block Inc. and UnitedHealth Group Inc. rallied.
Many of his stocks are priced at less than 14 times this year’s estimated earnings. At those levels, Yacktman said, he is confident about the long-term payoff from price appreciation and dividends.
He’s also sticking with blue-chip stocks that have continued to disappoint investors in recent years, including Wal-Mart Stores Inc., Microsoft Corp. and Cisco Systems Inc.
The risk is that those stocks might be “value traps” — meaning that even though they’re cheap relative to earnings, they could keep getting cheaper if investors stay away because of doubts about growth.
Yacktman thinks investors focus too much on lamenting the past glories of some of the giants instead of considering their still-substantial earning power. “Forget about where a stock was,” he said. What’s important is that “at this point it’s a good deal.”
But he concedes that the value approach isn’t for everyone. “It takes people who have patience and courage,” he said. “We have a much longer time horizon than most people do.”
