October 6, 2003Through much of 2003, the best performing strategy has been one focusing on companies with high market exposure (or beta), no earnings and no dividends – a strategy that is contrary to the investing disciplines Westwood follows. The most fundamentally strong companies, those that generate significant amounts of free cash flow and shareholder value, posted only modest gains throughout the year. These companies have not yet been rewarded by the market, despite the recent changes in tax laws that favor dividend income.
While the increased appetite for speculative securities and risk has contributed substantially to the market’s rise, we feel that real fundamental improvements are needed in the quarterly earnings reports of those companies for the outsized returns to be justified. What has been seen year-to-date however is that fundamental improvement has not taken place. Earnings growth in the second quarter was less than 12%, using Standard & Poor’s operating EPS numbers, which is clearly lower than in recent quarters. (See chart below.)
Despite the lower rate of earnings growth, there are segments of the market showing strength. So where are the real fundamental improvements taking place? First, if we were to break down the earnings growth from the quarter, one would find that the larger companies are actually posting better earnings growth than the small companies. This is in direct opposition to where price performance has come from this year. In a recent study by Merrill Lynch[1], the fifty largest companies in the S&P 500 posted earnings growth 40% above all others in the index. When quarterly earnings are broken down by sector classifications (see below), the best performing group, Technology, reported only average earnings growth. Average earnings performance does not seem to validate the lofty expectations of the markets as evidenced by the large relative out performance of technology stocks. Conversely, the best group in terms of earnings growth, Energy, is among the lowest performing sectors this year and it appears that the markets have relatively low expectations for the group.
The prevailing view of 2003 has been that economic growth will strengthen causing GDP to finish this year above 5% and next year above 4%. Along with the economic growth, market participants are anticipating profit growth in select sectors to follow that same trajectory and to not only finish the year strongly but to continue on at that same rate. The out performance of sectors most leveraged to economic growth reflects this consensus view.
We disagree. While we believe that the prospects for longer-term economic expansion remain solid and there will be continued growth in corporate profits, we do not expect the level of growth that is currently priced in to the speculative parts of the market. We see moderate economic growth, at an uneven rate, throughout this year and into 2004. And, although corporate fundamentals will be improving, the gains could be overshadowed by a return of high-risk aversion and low confidence as the market begins to discount, and fear the implications of, an economy that is not growing at the robust pace it once anticipated. Government spending should continue to grow and support the economy, but renewed risk aversion could limit consumer and business spending and cause a strong preference for safety and liquidity.
Investing in such an environment requires a pre-determination of risk levels. We believe that this type of environment requires a strategy that focuses on companies with strong fundamental growth, an emphasis on free cash flow and yield. Our strategy of focusing on the long-term fundamental strength of a company has consistently led to areas of undiscovered value where real improvements are already in place. The holdings in our portfolios today have shown fundamental strength, the ability to generate free cash flow and increase shareholder value. The market has begun to realize that the gains anticipated by price moves this year have not been validated through fundamental earnings growth. As the market begins to search for those areas of real fundamental improvement, our portfolios will be well positioned to benefit from this search for real value.
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[1] Merrill Lynch Quantitative Viewpoint 09/18/2003
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