U.S. equities have surged to record highs this year on signs of economic recovery and continued aggressive monetary policy. With today’s higher earnings multiples, many investors have bid up stocks anticipating that future earnings growth will ultimately justify current valuations (Figure 1). For the market to move meaningfully higher from here, we would need to see multiples continue to expand or economic fundamentals surprise to the upside. We are skeptical of either scenario, and so we are wary of simply buying the broad market.
At the same time, however, economic growth has improved, central banks have been working to mitigate the risk of a left-tail event, and inflation and interest rates are low. In this environment, we believe equities are investable. But you need to pick your spots.
For us, this means finding stocks with industry- or company-specific tailwinds and catalysts. We are finding companies benefitting from favorable dynamics in the energy, airline, insurance and healthcare sectors. Our bottom-up research has also uncovered interesting companies, sometimes in slower growth industries, that we believe are mispriced by the market. Equities have had a strong run, but we think investors have the potential to earn attractive returns by being selective.
U.S. energy independence
The U.S. energy story is one of the great ones of this decade. PIMCO’s credit experts, including Mark Kiesel, have been writing about this; recently, John Devir wrote a piece for Institutional Investor, “Little Shale on the Prairie: Energy Independence in the U.S.” That title says it all. America is trending toward energy independence as oil production rapidly grows in places such as the Eagle Ford in Texas and the Bakken Shale in North Dakota.
One way for investors to approach this theme is via the pipeline infrastructure that is critical to moving oil from the fields to the refineries and beyond. This goes beyond mere pipes. Barge transport companies that carry oil along the Mississippi River and the Gulf of Mexico will benefit from ongoing growth in U.S. oil and gas production, and they have greater flexibility than physical pipelines or rail to adapt to changing circumstances. The industry likewise benefits from the Jones Act, which dictates that vessels that transport goods between U.S. ports must be U.S. made, U.S. licensed and U.S. crewed.
Since the economic downturn, not enough of these ships have been built to offset the increasing flow of oil out of the South Central region. This gives certain shipping companies pricing power.
Tactical positions in mid-continent refineries
While some companies are benefitting from the shale gas boom, other companies in the energy sector may face headwinds. Our mandate in the Long/Short Equity Strategy enables us to take advantage of stocks that may face near-term weakness by taking company-specific short positions. One such short theme has been driven by PIMCO’s Commodities team and their views on the spread between crude oil benchmarks.
Specifically, the increased mid-continent oil production discussed earlier at times temporarily depresses the price of West Texas Intermediate (WTI) oil below that of the global benchmark North Sea Brent oil. This can create an opportunity to short mid-continent refineries if they are earning excess profits by virtue of their easy access to this temporarily cheap crude. Since, theoretically, there is one global market for oil, the prices tend to converge over time, meaning the WTI benchmark will rise to meet the Brent index, and this occurs as the capacity to ship the continental oil expands. Hence, the mid-continent refiners lose their temporary edge. Through bottom-up analysis, we have identified several stocks that are levered to changing spreads between WTI and Brent, with an eye to opportunistically taking both long and short positions as crude oil prices change.
Of course, short positions can expose investors to significant risks – in this case, the prices in either oil market could move sharply in an unexpected direction.
Airline industry consolidation
The airline industry may make some investors nervous as companies pop in and out of bankruptcy and pilots go on strike. But it has been a strong performer this year and is poised to do well over a cyclical horizon. Passenger demand remains stable, and the industry is benefitting from consolidation of the mainline carriers, which keeps supply growth limited and pricing firm to rising.
We pay particular attention to the discount carriers, which are well positioned for an economy that is still recovering as customers continue to demand low fares. Further, discount airlines are benefitting from legacy carrier consolidation – the low cost structure of discount airlines enables them to enter networks that large carriers no longer find profitable.
One example is one of two ultra-low-cost carriers here in the U.S. This carrier offers bare-bones service, which in turn allows for very low-priced tickets that have seen consistent demand in both up and down economies.
Undervalued insurance companies
The insurance industry is in the midst of a cyclical recovery that has generally improved pricing on policies just as many of them begin to benefit from higher income on their bond portfolios as rates rise, which PIMCO expects will occur very gradually over several years. While our review of the insurance industry as a whole suggests that the rate at which premiums are rising is slowing (though continuing to grow) and valuations are fair, there are individual companies that have yet to fully recover. We tend to focus on life and casualty insurers with exposure to longer-duration securities and room to cut costs, improve claims management and increase policy rates. Also, we believe some companies can improve their bottom line if they no longer need to take additional reserves for poorly written past business.
Healthcare companies with tailwinds
In our view, healthcare pharmaceutical and service companies are worthy of consideration, as they often represent steady businesses that can potentially perform well in a slow growth environment; they are also likely to experience at least a small tailwind if the Affordable Healthcare Act is implemented as planned in 2014, and a longer tailwind from the aging population. For pharmaceuticals, we focus on companies with lower patent risk and international exposure.
Finding these stories is a rigorous process. For the Long/Short Equity Strategy, twice a year we review all stocks that trade in the U.S. above a certain market capitalization. This forces us to stop and assess every industry and, if only briefly, to consider every name in the space as a candidate for further research. The process is as exhaustive as it is exhausting. However, the thoroughness of the process regularly enables us to identify themes and one-off company ideas that we would never have found using other short-cut methods to screen for ideas.
Among the more idiosyncratic names we’ve discovered is a mini-conglomerate that owns several businesses, such as shareowner recordkeeping, output solutions, healthcare processing and asset servicing. Our view is that the company’s previous CEO was an empire builder and used the company’s cash flow to make investments in other public companies, real estate, private equity and other unrelated businesses. Our thesis is that the new management team will likely monetize these non-core assets and return value to shareholders. In a slow-growth environment, companies that have the potential to unlock the value of existing assets may offer attractive upside potential to investors in almost any environment.
Pick your spots
Over the past 18 months, equities in general have benefitted primarily from multiples expansion. While multiples may expand marginally from here, we don’t think the market can move much higher without an optimistic outlook for future earnings. The outlook for equities is mixed: Valuations are neither cheap nor expensive, we expect the economy to continue growing slowly, the Fed remains accommodative, inflation is benign and interest rates remain low. In this environment, we think equities are investable, but investors should pick their spots. We believe a stock-specific approach to equity investing is the best way to seek attractive returns today.