By Evan Bauman, Managing Director, Portfolio Manager, ClearBridge Investments
Q: How does the equity market environment now compare to three months ago, in September?
A: It is an interesting time. Early August was a very different market environment. The S&P – pretty much all the indices – were at or close to all-time highs, and volatility was extraordinarily low. The VIX was just a hair above 10, close to the lowest in its history. It was a market having a lot of similarities to previous times in history, the most striking similarity being the year 2000.
We have managed through bull markets, bear markets and stale markets. We have always tried to be a differentiated growth manager. We buy what we consider to be durable growth franchises, sustainable growers that generate meaningful amounts of cash that are undervalued in the marketplace. We actually had years where the market was down meaningfully, and we made clients lots of money by avoiding the very speculative or crowded parts of the market.
In August, we cautioned that the Nasdaq, particularly the Nasdaq 100 and most specifically the biggest companies in terms of market cap – concentrated in technology and internet – were driving the market and index returns. The Dow was up 2-3%, the S&P up a couple of percent more, and the Nasdaq was up almost 15% – with the Nasdaq 100 up even more significantly.
Q: Since then, things obviously have changed. Do you believe they have changed meaningfully?
A: I think this is the beginning of a new reality. We saw a 10%-plus correction in the market in October, the Nasdaq has corrected over 15% and some big stocks have corrected even more. This is the beginning of new leadership. With 35 years of history to compare to, the only other time that we looked this undervalued versus the index or vis-à-vis the market was 1996-1999 – another very tech-driven, momentum-driven period, very much a speculative environment.
Valuations back then, broadly speaking, were more expensive than today, but you were not rewarded for being a contrarian. You also were not rewarded for the type of strategy we run: 96-97% active share, with more focus on earnings and free cash flow than stock price momentum. We are not just looking for restructuring or turnaround value stories. We are finding a good chunk of the growth space; companies growing faster than average, trading at massive discounts.
Q: Doesn’t health care remain controversial, with a couple of exceptions, along with energy?
A: Sentiment remains incredibly poor in health care, yet there have been significant buyback announcements from many companies. We expect that to likely accelerate the way Biogen (NASDAQ:BIIB) has repurchased their own stock, but frankly, fundamentals remain very strong. Even with Biogen’s Alzheimer’s franchise – and very encouraging early stage data – the market seems to take a negative initial view on a lot of the news. At the same time, earnings continue to grow, as does cash flow.
Historically, that often is reversed by M&A activity. Companies have been letting cash build and buying back their stock. It is likely we are getting closer and closer to a big wave of M&A activity in sectors such as health care and media. That could release some of the pressure that has kept multiples down. Operating results generally have been pretty strong in technology, media and health care.
Q: Do you find it healthy that the market is experiencing this type of meaningful correction?
A: That we are starting to see air come out of the very crowded parts of the market is healthy. For better or worse, our portfolios do not correlate with the indices. We also do not correlate with other growth managers. The best example was 2000, when the dot-com bubble burst. We feel well-positioned for a very different looking next three to five years than the last three to five.
Q: Are we at the beginning of a sector rotation? Will it begin to happen now, or could it be put off a bit by the midterm elections and any optimism that may follow?
A: There is a lot of data suggesting that post-midterm elections, the next 12 to 18 months are typically favorable, yielding about a 15% average rate of return. This could mean the beginning of a new reality, maybe new market leadership. But there is never a bell that rings. No one tells you, “OK, now switch,” although maybe there are signals of anecdotal crowding that ultimately the market is running out of steam. Eventually, you get reversion to the mean, and a rotation. Where the indices are versus where they were into August, we are starting to see that turnover.
This why we thought the midterms could be an interesting event. For example, companies in the health care space have been generating a lot of cash. Their evaluations are compressed, and they have been basically just sitting on their hands. There is $1 trillion in private equity money right now, and you have so much money out there that has been doing nothing. We ask boards, “What is holding that back?” The geopolitical environment has been a mess. There is so much noise out there that has been keeping boards from authorizing anything significant. You get buybacks, but I think everybody would rather hold cash than do something aggressive when visibility is so low.
Some companies in more cyclical parts of the market have taken down 2019 guidance because of the rising dollar or uncertainty from a trade or tariff point of view. Obviously, GDP growth is going to face some headwinds. Ironically, in that environment, investors want more defensive business models. You want to own health care. You want to own media, you want to own companies in tech that are trading at eight to 10 times earnings, not 200 times cash flow.
Q: But until recently, wasn’t the market rewarding price momentum?
A: My sense is we are in the early days of that flip-flopping. Generally, when you get a violent sell-off like the one in October – and I think it was a real traditional or presidential election correction – when the advance begins anew it tends to lead to a better environment, with different leadership. Companies start to spend on M&A and put money back into their business outside of dividends and buybacks. That could lead to a very different market environment. If it does not, watch private equity. That can be another major swing factor that starts to monetize businesses.
When it comes to M&A, look at the Comcast (NASDAQ:CMCSA) and Sky deal, where Sky went for almost double the price it was trading at publicly and was still very accretive to Comcast as the acquirer. I think you’re going to see deals, at major premiums. We have seen a couple recently in health care. Watch for private equity money to start this thing, and then the big stuff has room to come down.
Evan Bauman, Portfolio Manager at ClearBridge Investments, a subsidiary of Legg Mason. His opinions are not meant to be viewed as investment advice or a solicitation for investment.
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