Large and mega-cap stocks: Look for opportunities in financials and energy
Large and mega-cap stocks produced strong returns through mid-December of 2014 and portfolio manager Matt Fruhan expects the biggest stocks to continue posting solid returns in 2015, based on a foundation of healthy balance sheets, profits, cash flow and revenue diversification, as well as attractive yields.
While large stocks lead other parts of the market in 2014, Fruhan says they are still relatively cheap compared with other parts of the market. “The S&P 100 is trading at about 15 times earnings, which is by no means expensive historically,” he says.
According to Fruhan, the major risk heading into 2015, is Federal Reserve policy. He expects the Fed to move short-term rates higher if employment continues to strengthen. “The question is, what happens to P/E ratios in a rising-rate environment?” he explains. “If global bond investors see relative value in U.S. bonds, this demand could continue to hold yields down at the long end of the curve. But everybody should be aware of the potential for the Federal Reserve to raise short-term interest rates and the pressures that will put on stock valuations.”
As a result, Fruhan expects an uptick in volatility and is being cautious about companies trading at premium valuations that have been propelled by short-term earnings growth. Instead, he is focusing on more reasonably valued companies with long-term earnings growth upside and exposure to the recovering economy.
What kinds of companies might win in an environment of rising rates and an expanding economy? Fruhan points to financials companies. Rising rates, he argues, would likely increase financials’ earning power by increasing their net interest income and net interest margins.
He is also watching energy stocks, searching for opportunities that may appear as other investors flee the sector. Oil prices declined sharply in the second half of the year due to both oversupply and declining global demand. “When there’s a supply/demand adjustment, there’s usually a shakeout, and that creates pretty good buying opportunities,” he notes.
Fruhan is taking a cautious approach to health care and utilities in light of his expectations for higher interest rates, especially following the sectors’ strong performance in 2014. “If we do get into a rising rate environment, I think the most fixed income–like pieces of the equity market—REITs, utilities, and some pieces of the health care sector, like pharmaceuticals—might see some valuation pressure,” he says.