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Federated Investors’ Stephen F. Auth expects technology stocks like Broadcom to lead a market rally next year.
‘Tis the season for investors to start looking ahead to 2011 and beyond. For that purpose, Barron’s called on Stephen F. Auth, chief investment officer, equity, at Federated Investors, a large money manager headquartered in Pittsburgh. A seasoned investor who has been with Federated for a decade, Auth turned bullish on stocks in the spring of 2009. Since then, with the nearly $30 billion of equity assets he oversees at Federated, he has had his ups and downs with that call.
When we spoke with him last August in New York, where he is based, the market was struggling with concerns about an impending double-dip recession, among other worries. “I was long and wrong,” Auth recently recalled. His upbeat call is turning out to be on the mark, as stocks finish the year in a nice upswing. Auth, 54 years old, possesses a keen mind, more than 25 years of experience, and an ability to boil down complex financial and economic matters. We interviewed him by phone last week.’Tis the season for investors to start looking ahead to 2011 and beyond. For that purpose, Barron’s called on Stephen F. Auth, chief investment officer, equity, at Federated Investors, a large money manager headquartered in Pittsburgh. A seasoned investor who has been with Federated for a decade, Auth turned bullish on stocks in the spring of 2009. Since then, with the nearly $30 billion of equity assets he oversees at Federated, he has had his ups and downs with that call.
Barron’s: What’s your macro view?
Auth: We expect real gross domestic product growth next year will be probably 3.5% or higher, with better growth outside the U.S. That’s a little ahead of the consensus. We’re thinking the Standard & Poor’s 500 can pretty easily get above 1400 by the end of next year, versus 1245 recently. So we’re constructive, and we’ve been constructive. Certainly, we have had a nice a little run here at the end of the year, and I wouldn’t be surprised to see a little bit of a consolidation. But over the next 12 months, we are pretty happy about equities.
You’ve maintained that the consensus is too gloomy about the economy and the market. What is that view overlooking?
We came through such a searing experience in 2008 and the first quarter of 2009, and everyone is still recovering. But that is what has presented the opportunity in equities. Our S&P 500 earnings forecast for next year is around $95 or $96 [a share], which isn’t that far ahead of consensus — although I don’t think anyone actually believes the consensus number. But the S&P, even if it goes to 1400, is still well below its peak, even though we are going to go past peak earnings on the S&P, probably sometime next quarter. So the market hasn’t been able to get back to where it was, because everyone believes that the world has changed fundamentally and that we’re in a new normal, with a low-growth, misery-forever environment. That’s the wall of worry preventing equities from going higher.
So what’s being overlooked?
First of all, we concur that things are not perfect. But consider deleveraging. It is used as one of the key arguments that the world is going to be terrible forever. We’ve done a lot of work on this, and we think that if you look at household debt to disposable income, which compares apples to apples, we’re currently running at about 120%, down substantially from the peak. In our view, we are about halfway back to where people need to be. But based on analysis of other deleveraging scenarios around the world, typically the economy starts to reaccelerate and consumption really starts to come back stronger about halfway through the deleveraging process. So we aren’t saying that deleveraging isn’t going on, but a lot of it has already occurred—and now it’s time to start getting back to purchasing again.
In any particular parts of the economy?
There are two big sectors that are important, but are effectively running at zero right now. The first is autos. We are clawing our way back from selling five million units of production to 10 million to 12 million annually—but we were up at 18 million for a long time. But 10 million to 12 million units, against a fleet of 220 million units, just barely replaces the autos that are literally dying each year. So there has really been no discretionary spending there. Housing is the same way. Housing starts are running at 500,000 to 600,000 units a year. The ongoing trend demand in housing is roughly 1.4 million units a year; that’s a combination of household formation growth of 1.1 million, and 300,000 houses fall down each year. So, again, we are underproducing. and living off excess inventory, but that can only go on so long.
Looking ahead to 2011, there’s concern about slowing corporate profit growth. What’s your view on that?
First, we look at gross domestic product for the U.S., and we are at 3.5%; it could even be 4% in real terms next year and probably 5% in nominal terms. Global GDP growth is going to be higher than that. And so if you just take a normal multiple of GDP growth for sales, it probably gets you to sales growth on the S&P of maybe 7%, 8% next year, which would be pretty good. So you can get to 15% earnings growth next year, which, again, gets you up to, say, $95, $96 of EPS [earnings per share], which would be a record high for S&P earnings.
We have the S&P 500 trading at 12 to 13 times next year’s earnings. The bears want to see a single-digit [price/earnings ratio]. They say all bear markets end in single-digit P/Es. But all previous bear markets where we had single-digit P/Es either had the absolute bottom falling out of the economy or inflation running at double digits, but we are not in either scenario. Relative to their absolute historical levels, stocks are inexpensive. And relative to bonds, whose yields are almost unfathomably low, stocks are even cheaper, perhaps extraordinarily so. The yield on the S&P is still almost 2%, which, again, relative to the past 10 years, is very attractive, particularly given the growth in dividends that’s likely at this stage of the cycle.
Big changes are afoot in Washington, owing to last month’s election. How is that impacting stocks?
That’s important. Last summer, we were pulling our hair out because we were long and wrong. And one of the things that we were arguing at that time was that we were in a soft patch, not a double dip. And we thought the soft patch was being caused by corporations and even individuals throwing up the caution flag, as you had three of the largest sectors of the U.S. economy simultaneously being regulated or restructured: health care, energy and financial services. You had the Obama administration really coming out with a lot of anti-business rhetoric. You had the tax law, which was supposed to be resolved by then, being left wide open, so people didn’t want to invest. And you had Europe looking like it might be Lehman Brothers, Part II.
So what’s changed since the summer?
For one thing, all of those uncertainties I just outlined are gradually coming off the table. Europe is still crawling along, but it looks like it is moving in the right direction. The election was a vote for more private- sector involvement and less government interference in the economy. The administration has backed off a lot of its anti-business rhetoric. It looks like this tax deal will get done, which is very important. The key element of our forecast is that job creation starts to re-accelerate. We’ve gone from 700,000 jobs a month being lost to a three-month trailing average of 120,000 to 130,000 being created a month. We need to get north of 200,000 a month for our forecast to be right. And we’d like to be at 300,000 by June, which is ahead of the consensus.
What about the argument that the housing overhang will be with us for many years, constricting any economic recovery?
We have probably eaten through two to three million units over the past two to three years, although the net burn is closer to one million as more foreclosed homes come up for sale. Ongoing inventory issues in markets like California and Nevada are a reason we aren’t likely to get back to the annual 1.4 million trend demand next year, but in some submarkets, housing inventories are already getting tight. So a 50% increase in housing starts, to 750,000 or 800,000, is pretty doable.
Let’s hear about your sector weightings.
Going into 2011, we still like the consumer space, including restaurants, autos and housing. We see tech as a sector that is going to lead this bull market, similar to the way it did in the 1990s. We also like dividend-paying stocks. We like financials, selectively, and we like selective international markets. In Europe, we like the north, where balance sheets are better and they are more in control of their destiny. That includes Germany, Norway and Denmark. In Asia, we like countries tied to the global cycle, including South Korea and Taiwan.
What do you like about technology?
Tech stocks were the leaders in the 1990s. Then they were in the doghouse for 10 years. They had to rebuild their balance sheets, and they didn’t participate in the big bubble that went on earlier in this decade. Typically, when you come out of the bottom after a bubble, a different sector leads the market. Tech is a perfect candidate for that leadership position, because the balance sheets are a lot better. And they are right in the heart of this whole convergence of technology in the consumer space, including wireless and broadband. The evolution of the technology sector has led it, in reality, to become a consumer product as much as a corporate one. And many tech companies are also very, very big in international and emerging markets. A lot of their revenue base is out there. So there are a lot of things that tech stocks have going for them.
One tech name we like is Broadcom (NASDAQ: BRCM – News), and it is a good example of why we like the sector. It has a pristine balance sheet. Terrific market position in chips for the communications business, with half their revenue coming from wireless and mobile. Over half their revenue is from growing overseas markets. And it has a reasonable multiple at 16 times next year’s earnings.
What is your weighting for the financials?
We have an overweighting for two reasons. One, on the banking side we think the credit cycle has turned, so we like it that earnings are going to start to improve as write-offs decline. We also see the consumer starting to turn. The financial-regulatory bill is behind us. Not perfect, but at least investors know the landscape. And, importantly, we see dividends coming back big next year. We’d be selective in the financials, but one stock we like a lot is JPMorgan Chase (NYSE: JPM – News), which probably has the best balance sheet in the group. They will probably be one of the first banks with a dividend increase. They have deposits overseas, which we like. And they’ve got one of the highest Tier 1 capital ratios among U.S. banks.
What about JPMorgan’s exposure to the consumer, credit cards and mortgages?
Because their balance sheet is stronger, they have been able to get ahead of the write-off cycle. Again, we are looking for consumer exposure, so we like that. Another thing we like about JPMorgan is that during the financial crisis, they were able to buy assets for nothing and, really, without issuing equity. The bears point out that the stock is trading at virtually the same level as it was just before Lehman went bust. But JPMorgan now has Washington Mutual, which they acquired in 2008. They’ve got Bear Stearns, which they also acquired in 2008, and those earnings bases are going to help them get to earnings of something like $6 a share in a couple of years, compared with the $3.86 a share they are expected to earn this year. So the stock is pretty cheap.
What other stocks do you like?
The housing space is probably one of our more outlandish calls, but as I said, we think starts can rise at least 50% next year. We prefer some of the more levered players, because they will be the first to benefit from any signs of a recovery. We like Lennar (NYSE: LEN – News), which is trading at about 1.3 times book value. It has a strong position in some of the markets that are more likely to recover quicker, such as Texas, which didn’t really have the big overbuild.
We also like restaurants, where the consumer is starting to come back. A conservative play would be McDonald’s (NYSE: MCD – News), which gets two-thirds of its revenue overseas. And it has a 3% dividend yield, which is pretty attractive. As I said earlier, we like autos. That includes Johnson Controls (NYSE: JCI – News), which has a big auto business, especially in lithium-ion batteries. It trades at a P/E of about 15 on September 2011 profit estimates. We think it can grow its earnings at a 20% annual clip over the next two or three years, and it gets 60% of its revenue from overseas. So it really benefits from the global auto recovery, which is happening not just in the U.S., but particularly in places like China.
Another stock we really like is Daimler (DAI.DE – News). It is a luxury-brand company, and luxury will recover quicker on the consumer side. It is really growing rapidly in China, which is going to be a huge market. It’s also trading at a very attractive multiple, about 10½ times next year’s earnings. A little high for an auto company, but it should be able to grow by 16% next year. And don’t forget Daimler’s big trucking business. It is actually the world’s largest truck manufacturer. And if you like the global cycle, that business is just going to start to roar in 2011.
Tags: Autos, equity, financials, housing