Stock investors had reasons to smile as 2013 came to an end, with the S&P 500® Index (.SPX) up nearly 30% and a four-year bull market continuing to run. But with valuations up and corporate profit margins near record highs, where can investors look for opportunities as 2014 begins?
Viewpoints caught up with Will Danoff, manager of the $108 billion Fidelity® Contrafund® (FCNTX), to get his take. He says fewer stocks look appealing after the market run, as valuations and expectations have risen. Still, he thinks equities are relatively attractively valued, and investors have opportunities targeting best-of-breed companies. In particular, he is concentrating on innovators in the tech space and consumer companies selling to growing customer populations around the world, while being more cautious in energy and utilities.
Stocks had a great year last year, but have prices gotten ahead of fundamentals?
Danoff: The stock-picking opportunities in the market are sparser than they have been in the last few years. The S&P 500® Index rose 16% in 2012 and appreciated another 30% in 2013, outpacing the 8%–10% expected earnings growth for 2013 and 2014. Slowing economic growth in the emerging markets has removed an important tailwind for earnings momentum at many global companies in the last year. European growth is barely positive but is stabilizing. And U.S. growth is bifurcated, with the high-end consumer spending, while most Americans feel squeezed. The U.S. housing market recovery has stalled, with higher mortgage rates and higher home prices causing buyers to pause. Yet, the U.S. economy has generated, on average, 200,000 jobs a month for the last few months of 2013—a healthy level.
With this stable but sluggish economic backdrop, with inflation staying low, and with the nomination of dovish Federal Reserve Chair Janet Yellen, I expect interest rates to remain low. The persistence of low interest rates should help stock prices generally and growth stock prices specifically. If a company can grow earnings more than 10% in this environment, its stock price should perform relatively well this year.
Do you think stocks can continue to run from here?
Danoff: The bull case on the market is that the S&P 500® Index trades at only 14 times the 2014 earnings estimate of $121 per share. This P/E ratio seems reasonable, even if the S&P 500® Index’s earnings growth rate is only 7%–10%, considering that the reported U.S. inflation rate is only 1.5% and interest rates are at historic low levels. In addition, the United States is the leader in many important global markets such as computer software, Internet commerce, media, and biotechnology. The emergence of domestic shale gas and oil production also should help the U.S. economy sustain better growth than the pessimists fear.
The bears are worried about the historically high corporate profit margins, but I don’t agree. In response to the sluggish macroeconomic environment, the gridlock in Washington, and the political uncertainties in many other parts of the world, U.S. companies are doing an excellent job controlling capital spending and working capital, and cutting expenses. Technology has also made companies more efficient than in the past. And the expansion in the emerging markets has created billions of new consumers for many multinational corporations, allowing these companies to leverage their overhead more effectively. Thus, profit margins and free cash flow yields are higher than in the past, but I think they are sustainable for the foreseeable future.
What investment opportunities have you been seeing?
Danoff: I have positioned Fidelity® Contrafund® (FCNTX) with big commitments to two sectors: consumer discretionary and technology. These sectors have been large and profitable, and therefore tend to be fertile ground for stock picking. In the consumer discretionary sector, the fund is focused on companies with strong brands, good business models, and the ability to expand overseas, and companies that are gaining market share and growing earnings. At the last date of Contrafund's (FCNTX) disclosed holdings, top positions in this sector included TJX Companies, the off-price retailer that has more than tripled its earnings per share since 2006; Disney, which has more than doubled EPS since 2006; and Discovery Communications, which has quadrupled earnings in the past five years.* In addition, the fund has very large positions in Starbucks, Nike, and Estee Lauder, all of which have increased EPS by more than 2.5 times in the last seven years.*
Technology is another huge growing market, but tech companies have been more vulnerable to new competition and disruptive technologies. As in the consumer discretionary sector, the fund has favored growing companies with strong brands and sustainable business models, and those companies that have shown evidence they can migrate profitably to the mobile Web world. Google, Amazon, and Facebook have all been very large positions in the fund.*
The large number of initial public offerings in technology indicates that sentiment may be too optimistic in the short term. But over the long-term I think we will see some compelling investments in the industry. The fund's big commitment to Yahoo differed somewhat from most of its other growth-oriented tech investments. Yahoo has been a cheap turnaround story led by new CEO Marissa Mayer. The company performed well in the past year, as the market realized that its holdings in Yahoo Japan and Alibaba were very valuable, and usage on Yahoo's Web sites grew nicely.
Another large opportunity in technology is in the exploding area of enterprise software. The last big shift in enterprise software came 20 years ago during the move to client-server architecture. Now, corporations are rapidly adopting the software-as-a-service (SaaS) model. With SaaS, corporate customers effectively "rent" the latest software, which is automatically updated so all users are on the latest release and customers can run the software in the SaaS vendor's data centers if they want. Therefore, the SaaS solution is cheaper, more effective, and easier to manage than the old client-server product. As of the last date of disclosure, the fund owned SaaS players such as salesforce.com, Workday, NetSuite, Concur Technologies, and ServiceNow, and does not own any client-server dominated companies such as Oracle or SAP. SaaS valuations are high, but I am confident in the growth outlook.
What areas are you concerned about?
Danoff: I remain concerned about the energy industry. Companies have been spending aggressively to find new reserves all over the world. This new supply will probably put pressure on the prices of oil and natural gas. Large new reserves are being found in jurisdictions such as Russia and Brazil, which can be hostile to foreign oil companies or lack existing significant infrastructure. I believe this shift away from safe jurisdictions may ultimately hurt returns on capital. In addition, the market may be underestimating the considerable efforts by consumers, corporations, and governments to reduce their use of oil, natural gas, and electricity.
I also have very little exposure to the telecommunications or utility sectors. These sectors also are capital intensive and regulated—a combination that I believe generally produces poor returns for shareholders over time.
Are you looking at more companies abroad?
Danoff: My exposure to foreign markets has been reduced, as growth in Europe and the emerging markets slowed. I continue to look for industry-leading, best-of-breed companies or good turnaround stories that happen to be based overseas. Examples here that the fund owned include Canadian Pacific Railway, a top railroad in North America, and Bayer, a leading German science-based company run by Marijn Dekkers, an excellent executive who successfully turned around Thermo Electron five years ago.*
How will you approach 2014?
Danoff: I am going to stay flexible, as the global markets will be volatile and create opportunities in the coming year. More than $1 trillion dollars rushed into bonds in the aftermath of the Lehman crisis, and much of it fled the U.S. stock market. I am surprised that many investors are still fighting the Lehman crisis battle, and I expect much of this money will ultimately find its way back into the stock market.
One thing I am watching is the economic recovery. If the economy strengthens sharply and interest rates rise, upward pressure on rates could contract P/E multiples and traditional growth stocks could struggle. If that scenario plays out, earnings growth revisions could be very favorable for cyclical groups such as industrials and energy.
- Will Danoff manages Fidelity® Contrafund® (FCNTX) and Fidelity Advisor® New Insights Fund (FNIAX).
|Top ten holdings (% of Net)|
|Company||as of 11/29/2013|
|Google, Inc. Class A||(7.0%)|
|Berkshire Hathaway, Inc. Class A||(4.1%)|
|Wells Fargo & Co.||(2.8%)|
|Biogen Idec, Inc.||(2.4%)|
|TJX Companies, Inc.||(2.4%)|
|Noble Energy, Inc.||(2.3%)|
|Visa, Inc. Class A||(1.9%)|
|The Walt Disney Co.||(1.9%)|
Discovery Communications, Inc. Class A (1.167%)
Yahoo!, Inc. (1.382%)
Starbucks Corp. (1.184%)
NIKE, Inc. Class B (1.938%)
Estee Lauder Companies, Inc. Class A (1.075%)
salesforce.com, Inc. (0.825%)
NetSuite, Inc. (0.357%)
Concur Technologies, Inc. (0.342%)
ServiceNow, Inc. (0.334%)
Workday, Inc. Class A (0.363%)