Unemployment continues to fall. Inflation and wage growth have finally started picking up. The bull market is in year seven. To many investors, the message is clear: Signs of the late stage of the business cycle have been rising.
That’s not necessarily a bad thing. “When people think late cycle, they often think recession,” notes Lisa Emsbo-Mattingly, director of research for Fidelity’s Global Asset Allocation Group. “But they’re not the same thing at all.”
Stocks have historically delivered gains on average in the late cycle, even as GDP growth slows, earnings come under pressure, and credit tightens. But investment performance is more mixed than in the early or mid stages of the cycle—so which sectors of the market you favor can make a big difference.
A key driver of the turn to the late cycle is the rise of inflation. The energy and materials sectors, whose fate is closely tied to the prices of raw materials, have historically done well.
Health care and consumer staples have also seen positive relative performance in the late cycle, but for a different reason. As investors grow concerned about an economic slowdown, they may be drawn to companies whose revenues are tied more to basic needs.
With that backdrop in mind, Viewpoints spoke with fund managers focused on materials, commodities, health care, and consumer staples, and asked them how they are positioning their funds to try to capitalize on some of today’s brightest opportunities. (For a deeper dive on energy, read Viewpoints: "Time for oil stocks").
Materials: a late housing cycle and defense in defense
Investing in the late cycle is partly about being risk-aware, says Tobias Welo, manager of Fidelity Select Materials Portfolio (FSDPX) and Fidelity Select Industrials Portfolio (FCYIX). “What comes after the late part of the cycle is recession,” he says. “In the late cycle there are great opportunities to earn excess return, but there’s also increased risk. So I look for subsectors that haven’t yet peaked or offer some protection against a downturn."
Construction still has room to run, according to Welo, who notes that first-time home purchases, a large piece of the residential housing market, have picked up in the past 12 months in their first substantive move since the financial crisis.
“Housing traditionally has peaked earlier in the cycle, but because of the bubble, it looks like a late-cycle sector this time,” he says. “Construction-linked businesses are benefiting from increasing volumes and pricing power.”
Welo says there are a range of opportunities connected to construction, from the chemical companies that produce paint, to building products firms that produce air conditioners. Welo cites water-heater maker A.O. Smith (AOS) as a beneficiary of construction growth that also offers some protection against an eventual downturn. He notes that while new construction boosts water-heater sales, 80% of the market comes from replacements in existing homes. “People get used to hot showers,” he says, “so they replace their water heaters almost no matter what the economy does.” The firm is also a leader in China, where the market for water heaters is growing in double digits annually.
I think defense stocks offer less risk than some other parts of the market. “These stocks went through their recession when the federal budget sequester happened in 2013,” says Welo, who notes that this year marks the first defense budget increase in years. “If we have a recession tomorrow, defense companies should still have a tailwind through 2017."
One of the companies Welo’s fund has invested in is General Dynamics (GD). He points out that the company offers a measure of exposure to economic growth through its commercial jets business, as well as a lower valuation than its peer average.
Commodities: the upside of inflation
Rising inflation is often a key part of the late cycle environment. For many companies, that is a headwind as labor and input prices rise. But commodity producers may actually benefit—as the raw materials they produce sell for higher prices.
Joe Wickwire, manager of the Fidelity® Global Commodity Stock Fund (FFGCX), says many commodity companies benefited from inflation during the 1970s, and that has broadly been the case over the past fifteen years. He also thinks the positive relationship between commodity companies and inflation could continue should we see an uptick in inflation as a result of all the reflationary policy that has been inserted into global markets.
Wickwire looks for inefficiencies and disconnects between how the market is pricing stocks and Fidelity’s view of supply and demand for individual commodities and companies. “With market downturns in August, the fourth quarter, and in early January, we’ve seen attractive areas being dismissed by investors,” he says.
Recently, he’s seen attractive risk-reward opportunities among shares of agriculture and U.S. oil and gas companies.
In agriculture, he’s focused on makers of fertilizers and manufacturers of farm equipment. Wickwire thinks the market is discounting the cash flows of fertilizer producers based on short-term considerations like a four-year run of good weather in the U.S., which has boosted crop production and put downward pressure on prices and the earnings of agriculture companies. Longer term, he sees the potential for improving prices, strong free cash flow generation, and improved shareholder returns driving higher valuations, dividends, and share buybacks. An additional benefit across selected agriculture names is the lower relative level of volatility versus other subsectors in the global commodity equity universe, which could potentially enhance the space’s risk–reward profile for investors.
“Fertilizer is a classic example of a space that hasn’t worked, and a lot of people have left it because it hasn’t worked,” he says. “We think it’s going to work—and when it does, it could have outsized benefits for investors.”
Wickwire sees farm equipment manufacturers as potential beneficiaries of negative sentiment about agriculture in general—and as having potential for M&A. Wickwire’s fund has invested in Deere & Co. (DE), which makes the John Deere brand of equipment, and he says it is a victim of negative sentiment despite its solid product mix, strong balance sheet, and dominant market position. Meanwhile, his fund has invested in AGCO Corp. (AGCO), which also has strong fundamentals.
With regard to energy, Wickwire is looking beyond the current slump. “I want the survivors and the thrivers that are going to come out the other side of this period, in which production is shrinking, to align with a global economy that is not as robust as it was,” he says. In his view, the exploration-and-production companies that are best positioned are those with the bulk of their activity in the United States or other countries with “certainty around the rule of law,” which helps protect their business models. Anadarko (APC), for example, has a strong management team, with an investor mindset that Wickwire appreciates.
Health care: increased usage and innovation
While health care may be less affected by the business cycle than some other sectors, it’s not completely isolated, says Eddie Yoon, manager of the Fidelity® Select Health Care Portfolio (FSPHX). As the overall stock market has risen over the last several years, he’s sold riskier holdings and added to existing stable large-cap positions. In addition, low unemployment levels in this business cycle phase have provided some tailwinds for certain health care companies, as the newly employed begin to make use of their company-sponsored health benefits and increased consumer confidence leads to more elective procedures.
At the same time, the market’s recent volatility has created some opportunities for individual stocks that fell along with their sector. “For the last six months, the baby’s been thrown out with the bathwater in biotech stocks,” Yoon says. “We’ve been able to take advantage of that downdraft to buy some of the higher-quality companies I see out there.”
Broadly speaking, Yoon sees an acceleration of innovation across the sector. He has been focusing on large pharmaceutical companies and makers of medical devices. Bristol-Myers Squibb (BMY), for example, is a leader in development of drugs that stimulate the immune system to fight cancer. There’s similar innovation with medications for heart disease and diabetes, Yoon says.
If the innovations lead to positive clinical trials and strong product launches, he expects dramatic earnings growth over the next several years. “Many of these companies have already expensed most of the R&D related to these products, and now these companies have some of the dynamics you might associate with regulated monopolies protected by strong intellectual property,” he says.
Innovation in cardiology is also having an impact on medical devices, such as heart valves that had required invasive procedures being replaced someday by ones implanted through catheters. Edwards Lifesciences (EW) is a leader in the field, while Medtronic (MDT) is the No. 2 player, and Boston Scientific (BSX) has announced plans to enter the U.S. market within a few years.
Health care also gets a boost from emerging markets, which are still in the early stages of adopting health care products and services. Emerging markets might account for just 10%–15% of revenue for many medical equipment and devices firms, compared with 30% or 40% for consumer staples companies. Yoon thinks health care companies can still expect strong revenue growth from emerging markets, even with the broad economic slowdown in countries like Brazil and China. “You really haven’t seen that impact health care,” Yoon says. “I think that’s because it’s still so early in the investment cycle.”
Compared with the 3,000 largest stocks in the U.S., health care valuations are well below the long-term average, Yoon says.
After delivering the best annualized five-year performance of any sector through 2015, health care has seen a big correction, and lags the market overall through the first quarter of 2016. The reversal largely has been driven by concern over the sustainability of drug prices, an issue aggravated by the current presidential election, according to Yoon. Going forward, Yoon expects that manufacturers both of new drugs and of new devices are going to be under increasing scrutiny to economically justify the price of their products. While this is not new to the industry, the level of publicity tends to rise in election years.
“This is a topic that we talk about, but in the long run, I think the economic model of the sector is going to be very much unchanged,” he says. “Over time, companies have demonstrated they can deliver value to society and human health in the long term.”
Consumer staples: downside protection
When economic growth slows or disappears altogether, the appeal of consumer staples stocks is stability. The staples sector is generally cycle-agnostic, according to Robert Lee, manager of the Fidelity Select Consumer Staples Portfolio (FDFAX). “People are going to buy roughly the same amount of toothpaste and toilet paper and yogurt regardless of where we are in the economic cycle,” he says. The sector tends to perform best relative to the broad market in the late stage of the business cycle and into any ensuing downturn.
Staples have been particularly important for downside protection, Lee says, noting that the S&P 500’s peak-to-trough loss in the last two bear markets has averaged 50%, while consumer staples have lost only 25%, on average. “It’s not a happy outcome overall, but in relative terms it’s better,” he says.
Lee’s general strategy is to own companies with earnings growth rates above the sector average and valuations below the average valuations. For example, he looks for firms that are well positioned for growth thanks to opportunities in emerging markets. “Procter & Gamble (PG) and British American Tobacco (BTI) have strong brands and strong distribution in many of the large emerging markets,” he says. “They’re positioned to be there as consumers increase their spending on staples over time.”
Lee also seeks companies that can grow market share and earnings. For example, CVS (CVS) is integrating its chain of retail stores with Caremark, which helps health insurers and employers manage prescription benefits. The approach gives the company insight into doctors’ prescription writing for health plan participants and allows it to steer the participants to CVS for fulfillment. Even in a slowing economy, people continue to get sick and consume health care services, benefiting pharmaceutical and drug companies in all stages of an economic cycle. The stock’s valuation is below average for the sector, Lee says.
A third approach is to find companies with more pricing power than is typically found in the sector. Lee focuses on two sources of such power: products to which buyers might feel an emotional attachment, and those that present high barriers to entry. Baby food falls into the first category. Lee likes baby food manufacturer Mead Johnson (MJN); currently its valuation is slightly above the sector average.
- See where Fidelity’s Asset Allocation Research Team thinks we are in the business cycle and our latest views on sectors.
- Fidelity® Select Materials Portfolio (FSDPX), Fidelity® Select Industrials Portfolio (FCYIX), Fidelity® Select Consumer Staples Portfolio (FDFAX), Fidelity® Global Commodity Stock Fund (FFGCX), and Fidelity® Select Health Care Portfolio (FSPHX)
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