ince the bottom of the U.S. financial crisis in 2009, U.S. equities have climbed – first on recognition that the worst was over, then on acceptance of a
modest recovery along with aggressive monetary policy and low inflation, and today on hopes that the recovery might gather greater steam. Along the way,
valuations have expanded and the S&P 500 now trades at a high median price-to-earnings ratio that can only be justified by the lower government bond
While PIMCO does not expect a bear market soon, there is no law that investors have to buy the entire market. In fact, as the current bull market continues
to age, the movements of individual stocks and industries within broad market indexes are diverging more often. And as correlations recede, active
investors are often more able to drive performance through a portfolio of individual stocks that represents good value, takes advantage of pockets of
growth and capitalizes on near-term tactical opportunities in certain industries.
We favor pro-cyclical companies that will likely benefit from an improving economy while also demonstrating staple-like characteristics including strong
free cash flow generation and attractive returns on invested capital. These businesses should better withstand macroeconomic risks and potentially dampen
portfolio downside. In addition, we are focused on finding select mispriced, idiosyncratic opportunities that offer attractive upside potential. Within the
PIMCO Long/Short Equity Strategy, we are emphasizing U.S.-centric companies in an effort to reduce currency risk and sensitivity to slowing global growth.
Capturing consumer demand
Lower oil prices and a strong dollar have been a drag on corporate profits, but they also benefit the U.S. consumer through increased buying power and
lower gas prices. This trend, combined with stable jobs growth and rising consumer confidence, makes U.S. consumer stocks attractive. Arguably a primary
beneficiary is lower income consumers and, by extension, dollar stores – which, even with the recent run in consumer discretionary names, we still believe
have upside to come. Dollar stores remain one of the few retail sectors that are still expanding their store footprint materially.
We believe affordable luxury is on the rise as U.S. consumers look to splurge … a little. Companies offering premium brands and services at reasonable
prices, or the ability to dine out, both as a treat and a necessary convenience, should capture market share as the consumer recovery continues. Quality
apparel and shoes, dining out and travel are now luxuries that consumers seek at affordable prices. We are seeing consumer demand for more casual and
athletic footwear and a shift toward “athleisure” apparel, which combines sporting performance with style for everyday wear. We own a mall-based athletic
retailer that is well positioned to benefit from these trends. We have also found value in an apparel company that can offer products at multiple price
points through its diversified portfolio of well established brands.
We view the U.S. consumer as a source of strength, but are selective because we see both headwinds and tailwinds for consumer company earnings. A stronger
dollar benefits consumers, but it’s a headwind for companies with significant overseas operations. We have focused our investments in U.S.-centric
companies to avoid the drag of foreign exchange on U.S. dollar earnings. The market has also been skeptical of multinational consumer stocks (see Figure
Underappreciated healthcare businesses
The effects of an aging population and healthcare reform will be long-term growth drivers in the healthcare sector. We favor select outpatient services
that may benefit from secular demographic trends. We own one of the largest drug distributors based on our view that the company should benefit from
industry dynamics including brand-to-generic conversions and favorable drug pricing.
Though their business is more directly affected by health reform, hospitals may ultimately have significant upside as either the U.S. Supreme Court
reaffirms current laws or, if not, Republicans in Congress offer replacements that preserve large portions of what already exists. While a Supreme Court
decision may drive volatility among hospitals, it will also likely bring some clarity.
We believe select bank stocks offer attractive upside as fundamentals are strong and improving, while valuations continue to reflect legacy litigation and
regulatory fines. While bank restructurings continue, we believe select banks are now well-capitalized and therefore able to make attractive payouts to
shareholders. We believe the heavy regulation that U.S. banks currently face, while capping return on equity, may also help cap volatility of earnings. To
the extent banks can begin to get beyond fines and charges that have become regular events post-crisis and begin to report consistently clean earnings and
focus on capital return, some of the largest banks with the lowest valuations may see their prices grow as their valuations inch up and book values
increase consistently. If that pans out slowly over time, investors may begin to look at banks somewhat less as high-risk ventures reaching for the highest
return possible and a little more like utilities or staples that deliver slow but consistent growth and return excess capital through dividends and
buybacks. It’s not as exciting as reaching for high return, but there are plenty of investors who would find that kind of investment attractive.
Finding these stories is a rigorous process. For the PIMCO 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, consider every name in the space as a candidate for
further research. The process is as exhaustive as it is exhausting. However, being thorough enables us to identify themes and one-off company ideas that we
would never have found using shortcuts.
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 new management 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.
Another interesting idiosyncratic find is a wholesale vehicle auction service. The company provides auction services for sellers of used and salvage
vehicles through both physical locations and websites. As a market leader in vehicle auction services in North America, the company is well positioned to
benefit from the recovery in car auction volumes, in our view. There is a delay from when a car is sold (leased) new and when it ultimately could end up at
a car auction (Figure 2). As new car sales (including leases) have been strong and accelerating, visibility on volumes is high over the next few years.
Typically a car lease is three years, so in 2015, the company will benefit from 2012 leases that have been turned back into the dealer.
On the short side, we believe in a highly selective, stock-specific approach. We aim short positions at generating returns rather than simply hedging
volatility. We are finding opportunities in companies that are sensitive to rising interest rates, such as utilities, REITs and telecom. These sectors have
benefitted from low interest rates and investor demand for dividends. We believe select interest-rate-sensitive stocks are richly priced and these
companies will suffer when rates eventually rise. We have also taken short positions in industrial stocks that are sensitive to slowing global growth and
select oil service companies that we expect will struggle amid low oil prices.
Take advantage of market volatility
While equity markets have trended upward, investors remain concerned about corporate profits and a pending Federal Reserve interest rate hike. We expect
the U.S. monetary normalization process could result in some short-term market volatility. The PIMCO Long/Short team will be actively looking to take
advantage of market volatility, searching for growth opportunities at attractive price points.
We believe a selective, high-conviction approach is one of the best ways to generate attractive risk-adjusted returns today.