Ailing economy clips wings of us funds

The question facing investors in US equities is not whether the economy will slow, but how fast will be the contraction. Some economists even believe the US economy has already entered into a recession, with falls in earnings, profits and house prices. In the third quarter of 2007, for example, S&P 500 companies had their fifth worst quarterly decline in earnings since 1945, and house prices have fallen an average of more than 5 per cent from their peak. Some economists have estimated they will drop by between 10 and 15 per cent. Also in the third quarter of 2007, corporate profits fell 1 per cent, while the decline was 6 per cent for financial companies. In December 2007, unemployment rose to a seven-year high of 5 per cent. The second half of 2007, of course, was dominated by the sub-prime crisis and credit crunch. This featured a rise in the number of homeowners defaulting on their mortgages. The concern is that all these factors will lead to a significant fall in business investment and consumer spending. In an attempt to ward off a recession, the Federal Reserve has reduced interest rates. The ability of the Federal Reserve to continue reducing rates to stimulate the economy, however, may be constrained by inflationary pressures, notably the oil price touching $100 (?67) a barrel at the start of 2008, and rising food prices. These negative trends have been partly offset by the boost to exports from the weakening dollar. The currency has fallen 23 per cent in real terms since February 2002. The weaker economic growth has been reflected in the volatility in US stock markets. In the 12 months to 3 December 2007, for example, the S&P 500 index lost 1.86 per cent, according to Morningstar. The economic environment may have weakened, but Diane Jaffee, manager of the SGAM Fund Equity US Relative Value fund, says the US is still enjoying economic growth and the consensus is for it to have reached 1-1.5 per cent in the fourth quarter of 2007.

‘There have never been two consecutive years of negative returns’ - Mary Chris Gay, Legg Mason

Ms Jaffee believes the economic outlook will improve after the first few months of 2008 as long as the effects of the credit crunch are not worse than anticipated. This is partly because of the liquidity being created through reduced Federal rates. She says equities are generally reasonably priced and more attractively priced than property and fixed income. “Equities should do well in the third quarter of 2008 because of the comparison with the third quarter of 2007. “At some point, financial stocks will become attractive again. We sold Capital One after a review, but we have added to Fannie Mae and Citicorp. Fannie Mae has a strong underwriting capability and exposure of less than 5 per cent to sub-prime and 10 per cent exposure to All Day, which is not as low quality as sub-prime mortgages.” Ms Jaffee says the SGAM Equity US Relative Value fund is investing in companies that can benefit from the weak dollar. She points to Avon as an example, as 80 per cent of its revenues come from overseas. “Large-cap technology companies have an average of 50-65 per cent of their revenue from overseas,” says Ms Jaffee, with industrials such as Boeing, Honeywell and General Electric also benefiting. The boost to exports from a weakening dollar is also a boon to the US stock market as a whole, says Ms Jaffee. Financial services is the largest sector in the S&P 500, at around 20 per cent. But technology accounts for around 17 per cent, industrials are around 10 per cent and consumer staples are 5 per cent. This means 32 per cent of the index at least will benefit from the weak dollar, believes Ms Jaffee. Surprises in store Hubert Goyé, head of international equities at BNP Paribas Asset Management and manager of the Parvest USA fund, is cautiously optimistic about equities. “Before the credit crisis started, we were confident the US economy was strong and growth was likely to surprise people on the upside. Our quantitative model pushed us to hold strong overweight positions in technology, consumer discretionary and financials, especially investment banks.

‘We have focused on stocks that can do well during periods of volatility’ - Hubert Goyé, BNP Paribas

“The scenario appeared to be right because the GDP figures in the third quarter of 2007 were strong. The problem is that the credit crunch has caused a loss in confidence. “We have reduced our exposure to investment banks but have increased our allocation to other financial stocks. We have focused on stocks that can do well during periods of volatility, such as Nasdaq and Nymex. “Even within investment banks, we have done relatively well through stock picking. For example, we held Goldman Sachs, which has not been badly affected, and JP Morgan, which is well diversified. Lehmans has underperformed but has reported results better than was expected. “We have reduced our exposure to consumer discretionary stocks, and part of the proceeds was reallocated to consumer staples, whose growth should be more resilient. We have also added some healthcare stocks.” Mr Goyé says his cautious optimism is based on the fact that fundamental factors are still positive. “The Fed rate is moving in the right direction. The weak dollar is boosting US exports. Unemployment has risen, but is still low. Consumer spending may slow, but it will not be as bad as if unemployment were rising. We expect consumer confidence to rise and economic growth of between 1.5 per cent and 2 per cent in 2008.” Mary Chris Gay, manager of the Legg Mason value fund, says she has reviewed every stock in the portfolio since the start of the credit crunch.

‘At some point, financial stocks will become ­attractive again’ - Diane Jaffee, SGAM

She says a number of changes were made to the portfolio in the last few months of 2007. Ms Chris Gay says the portfolio’s exposure has been widened across sectors, with the fund having expanded into financials and consumer stocks. “From the end of the third quarter, however, we were hit by share price falls. Two areas that significantly led to losses were financials and consumers,” admits Ms Chris Gay. “The financial sector suffered the greatest negative returns in 2007. We believe, however, that this sector offers more attractive valuation opportunities than ever.” She derives optimism from the fact that when financials suffer negative returns, the next year they have historically delivered positive returns. “There have never been two consecutive years of negative returns. Over the past 50 years, the year after a negative year for the top 50 banks is followed by a positive return.” According to Legg Mason figures, in 2002, financial stocks were down an average of 2.2 per cent but were up 28 per cent in 2003. In 1994, they were down less than 2 per cent but rose 49 per cent in 1995, and they were down 14.2 per cent in 1999 and up 26 per cent in 2000. “In 1990, financial stocks were down an average of 24.3 per cent, while in 1991 they were up an average of 59.12 per cent. From the start of 2007 to 17 December, financial stocks were down an average of 18.9 per cent,” she adds. Ms Chris Gay says the fund has suffered from extreme valuations in the market. “In 2007, the cheapest quintile of the value stocks fell 5 per cent, while the stocks in the most expensive quintile rose 15 per cent. This is a net spread of 20 per cent and means the cheapest stocks are even cheaper and the more expensive stocks are even more expensive. “Furthermore, commodities are at a 50-year high in their relative price to financial stocks. We are confident because we believe stocks in our portfolio offer value. We estimate that our portfolio is 50 per cent below fair value.” Ms Chris Gay says there are several similarities between the current economic and market environment and 1990. Interestingly, 1989 and 1990 were the last times the US version of the Legg Mason Value fund suffered two consecutive years of negative returns. “In 1990, the downturn was prompted by problems in the junk bond market, while this time it has been sparked by the sub-prime market,” says Ms Chris Gay. “There was a war in the Middle East in 1990 following Saddam Hussein’s invasion of Kuwait. This led to a rise in the oil price.” She says share prices started rising in 1991 even before the economic down turn came to an end. This was in anticipation of the improved economic environment. Ms Chris Gay says it is worth remembering that over the past 17 years, there have been only two recessions in the US, which have lasted just eight or nine months each. She adds: “We believe the economy will slow, but it will avoid a recession. Even if there is a recession, it is likely to last a short period.” “Inflation is not a big concern. Interestingly, Bill Gross is concerned about deflation rather than inflation. If there is an economic slow down in emerging markets along with develop­ed countries, then inflation will ease as oil and commodity prices come down.” Health scare It has traditionally been difficult for active fund managers to consistently outperform the S&P 500 index. The SGAM Fund Equity US Relative fund has underperformed the market over the past year. Ms Jaffee says the fund found the environment challenging over the second half of 2007. But she says it is not the stocks people might expect that have suffered negative returns. “We have taken comfort from the fact we have had zero exposure to house builders and financial stocks have delivered a net return to performance,” says Ms Jaffee. The biggest negative return came from Tenet Healthcare. “This loss has come from what is called Bad Debt in the US,” says Ms Jaffee. “These are people who do not have health insurance, but the hospital has to see them if they are an emergency case. This hits the hospital’s costs and therefore its profits.” Ms Jaffee says the fund reviews stocks if they underperform the market by 10-15 per cent. Three out of five times the stock will be sold after such a review. This is because the market gives Ms Jaffee and the team information on why the stock should be sold. But the fund retained its holding in Tenet Healthcare. Tenet Healthcare delivered its third quarter figures on 6 November 2007, which included positive cash flow and operating margins. Ms Jaffee says the share price rose more than 55 per cent in November. One stock that was sold after a review was Office Depot. Ms Jaffee says its share price fell after the fund sold the company in August 2007 from the mid-$20s to $14. Mr Goyé says the Parvest USA fund uses both a quantitative and qualitative approach. “We have a proprietary quantitative model that screens around 500 stocks. About 400 of these are in the S&P 500 index. “To be included in the universe, stocks have to have a sufficient number of analysts watching the stock, and enough liquidity. “The stocks are analysed by the model using five factors. First, we look at trends in corporate earnings and consensus forecasts for the next 12 months of earnings. We are looking for momentum and changes in earnings. Second, we look at analysts’ forecasts for five-year profit growth. “Two more factors are the price/earnings to growth ratio and price to earnings adjusted for the sector and industry the stock belongs to. “The fifth factor is if a stock reports above expected earnings. This is a more marginal factor because it provides a small advantage for a couple of weeks.” Mr Goyé says the 500 stocks are ranked according to the scores from these five factors. The top 5 per cent of stocks on the ranking are on the buy list. Mr Goyé and his analysts review these stocks once a month to evaluate whether they should be added to the portfolio. But new stocks can only be bought if existing stocks are sold from the portfolio, which happens when they fall to the bottom 30 per cent of the model’s ranking. Stocks that come between the top 25 stocks and the bottom 150 companies cannot to be bought or sold from the portfolio. Each stock within the portfolio has an equal weighting of 2 per cent. The fund allows the weighting to move up or down by between 0.35 1.65 per cent and 2.35 per cent before the portfolio is rebalanced. Investors will be hoping the US stock market will rebalance to more stable returns after the volatility of the past six months.