Look to Unloved Sectors

The idea:
For putting new money to work, I like to think about unloved sectors of the market. We are at a mature phase of growth outperforming value. Growth versus value tends to have 10-to-15 or 10-to-20 year cycles of outperformance and underperformance. Against that backdrop, I have three ideas: quality value stocks, small-caps and Japan.

The strategy:
Value means cyclical sectors like energy, financials, materials and utilities. Quality value means looking for balance sheets that aren’t overleveraged, companies that have a competitive advantage, still have earnings growth and have a dividend yield higher than that of the S&P 500, which is about 1.5%. If inflation does stick around, value should also do well.

The small-cap space is riskier than quality value. The companies are not as tested, and earnings may not have the same stability. But it’s the same general thesis — small-cap and large-cap stocks go through intense 15-year cycles, and the trend in large-cap outperforming small-cap could reverse. Valuations are at a 30-year relative low and the stocks are more closely tied to the US economy, which is doing well, and so are more insulated from geopolitics.

With Japan, it had been a deflationary world there for 30 years. Now there is inflation, but it’s the good kind of inflation. You need a little inflation because that’s what encourages companies to invest now rather than later. The other big change is that the Tokyo Stock Exchange is forcing companies to improve their capital return to shareholders, and the corporate governance model is higher-quality than it used to be. Japan has been performing very well, and I think there’s two to three years to go. 

The big picture:
Investors should feel okay about sticking with equities generally. The US economy is on pretty solid footing and has weathered higher rates pretty darn well. It’s important for investors to embrace that, and also to embrace the fact that the one tricky part in this equation is inflation. The Federal Reserve hopes it has a handle on it, and the market is anticipating that the Fed will cut interest rates. My big warning to clients is that it may not. Not that that’s a disaster in terms of investments, but it means the specter of higher inflation for longer needs to be on your radar. 

Value Plays

The idea:
At Presilium, we use a rebalancing strategy of adding funds to areas of the market that have lagged and may now present a better opportunity for clients. After rebalancing into growth in late 2022, we are now adding to value stocks and taking advantage of their attractive valuations. We rebalance client accounts every time the S&P 500 moves up or down 5% and have been very happy with the results.

The strategy:
The S&P 500 has a relatively high price-to-earnings ratio of around 23, but as of Jan. 31 the Vanguard Value ETF (VTV) and Vanguard Mid-Cap Value ETF (VOE) have a P/E of about 17, and the Vanguard Small-Cap Value ETF (VBR) P/E is around 12. We think the companies inside those ETFs are primed to be the next area that will outperform and are making investments in each of them.

The big picture:
The US unemployment rate has now been below 4% for more than two years. This means that the US workforce has had time to settle into their roles and become even more effective. Add in the rollout of AI into our everyday lives, and we will have a combination that should lead to increased productivity and profitability. We remain optimistic that this will continue to drive stock prices higher. 

Seek Long-Term Growth 

The idea:
To still be able to invest in growth stocks, even as broad industry [valuations] are stretched, we’re looking for names that are not at nose-bleed valuations, but still possess attractive earnings growth potential, strong balance sheets, and ample cash generation. 

The strategy:
As long-term investors, we are always balancing what might have upside in the short-term versus what has potential for sustained returns over a longer time period. A few examples of recent portfolio additions include:

• eBay (EBAY), an unloved growth-now-value name that trades at just 10x earnings, despite its software-like margins. The company now has an increased focus on profitability and shareholder return.
• ASE Technology Holding, a critical player in semiconductor supply chain. The Taiwanese stock has American Depositary Receipts in the US with the ticker ASX. The company provides packaging and testing services, the final step in production of semiconductors. The stock trades at just 14x forward earnings and is benefiting from the rapid recovery in semiconductor production as manufacturers sprint to supply the AI arms race.
• Applied Materials (AMAT), a reasonably valued, high-quality grower that offers attractive earnings growth while benefiting from the tailwinds of AI chip demand. AMAT is another critical player in the semiconductor supply chain and a provider of essential equipment used in the manufacturing of advanced chips. The company currently trades at a forward PE of 23, and is a capital-light business with a premium free cash flow yield and healthy 30%+ returns on invested capital.

The big picture:
In today’s market, clearly there is short-term momentum in high-flying growth and technology stocks, but valuations are becoming stretched and positioning is becoming crowded, factors that often influence medium-term returns once the momentum tide turns.

Move Into Homebuilders

The idea:
We see some interesting opportunities in homebuilders. From a valuation perspective, they are still fairly cheap and some have single-digit price-earnings ratios. 

The strategy:
Supply in the housing market is still tight. If you look at inventory, the industry is sitting at three to four months of inventory, which is very far away from the typical supply of around seven months. And the demographics remain supportive. It’s the millennials, and the record household formation rates for this cohort. Someone in their early 30s is probably getting a decent paycheck, looking to marry and start a family, wants to move out of an apartment or a parent’s house. From a demographic perspective that is a very big portion of what could drive the housing market for at least the next couple of years. Combine demand from millennials and supply that is lacking and that puts the housing market in pretty good shape.

If you look at the SPDR S&P Homebuilders ETF, where you see big names like DR Horton, Lennar, Pulte, and Toll Brothers, you have a PE of 13 times for a basket of these names. They are trading at a significant discount to the broader market, where the S&P 500 is trading at something close to a 20 times forward PE. 

The big picture:
People say housing’s “expensive,” but what matters most when you think about where the use of the word “expensive” comes in is that it’s a function of how much your monthly payment might be. It’s relative, but maybe you have to look at buying something more modest. If interest rates are high, as rates come down, you can buy more house. We think the Federal Reserve should hit the inflation target by late summer. That would allow the Fed to cut three or four times by yearend, which would help bring mortgage rates down. 

Investigate Small-Caps

The idea:
Small-cap value stocks historically tend to be the biggest gainers at this point in the cycle, so they would be a useful addition to many portfolios. But it is in smaller-cap growth where the next tier of AI beneficiaries reside that may hold the clearest winners.

The strategy:
Unquestionably, 2023 was the year for mega-cap growth stocks, as evidenced by the leadership of the Magnificent 7 (plus a few more). Their performance left the rest of the S&P 500 in the dust, and there lies the opportunity. These stocks delivered dependable earnings and more critically, investors viewed them as the go-to beneficiaries of the generative AI boom. Unfortunately, they didn’t pull their weight in terms of earnings: While the top 10 S&P stocks make up almost one third of the index, they contributed less than a quarter of the earnings.

In smaller-cap growth, software-as-a-service companies, which can dramatically improve productivity, stand out, as do companies engaged in one the most critical needs of our time: cybersecurity, a theme which, unfortunately, isn’t going away and which chief information officers are putting at the top of their priorities for the foreseeable future.

The big picture:
Historically, stock returns tend to come before earnings growth, and earnings growth before a stronger economy. At this point in the cycle, it is the small- and mid-cap stocks that are likely to lead equities, especially as we wait for stronger economic growth in late 2024 and early 2025.