It seems like a world away, but it was just four years ago, in early March 2009, that the S&P 500 index bottomed out before starting a powerful multiyear ascent. Since then, the index has more than doubled, even as the U.S. economy has grown at a snail’s pace, consumers have reined in spending and Congress has thrashed out remedies to a yawning budget deficit.
At this point, David Giroux, the 37-year-old manager of the $13.7 billion T. Rowe Price Capital Appreciation Fund, believes that it may be time for investors to take a reality check. He says that while the stock market still has some room to grow, there are fewer compelling values to be had than in recent years past.
“Four years into the economic expansion and long stock market rally, we’re not that excited about the equity markets relative to a year ago,” he says. “In 2012, we had a number of names in the portfolio where we could see upside of 50%. Now, we’re seeing maybe 20% upside on fewer stocks.” The prospects for stocks’ modest earnings growth in the low single digits this year could also rein in returns.
Giroux’s portfolio aims to offer equity-like returns over a multiyear period with less price volatility by investing in a range of stocks, convertible bonds, debt and cash. His sentiments about muted future returns are reflected in the multi-asset class fund’s current 60% stake in stocks, which Giroux says reflects a “neutral” stance. The fund typically keeps between 55% and 70% of its assets in stocks, and had as much as 72% of assets in them during 2011.
Yet even with such subdued expectations for stocks, Giroux says they’re a better bet than bonds over the next few years. “I don’t know if interest rates are going to go up this year or not,” he says. “But I do know that the risk-reward profile of bonds is heavily skewed against investors. If rates fall a little more, there is not a lot of money to be made. But if the rate on a 10-year Treasury moves back up to 4%, there is a lot of money to be lost.”
Keeping the possibility of higher rates in mind, Giroux focuses the fixed-income side of the portfolio on securities with floating rates, as well as those with very short durations. About one-third of fixed-income assets are devoted to leveraged loans. These floating-rate loans made by banks to below-investment-grade companies are senior in the capital structure both to other types of debt and to equity, providing a measure of safety to investors. “Even in a bad environment, a company would have to eat through its capital structure to impinge on its leveraged loans,” says Giroux.
His other investments on the fixed-income side include short-term corporate notes and Ginnie Mae bonds with average durations of less than two years. For much of his seven-year tenure, Giroux has favored convertible bonds, but he’s cut back in that area substantially because prices are too high.
Giroux has ample motivation not to lose money for shareholders: He personally has more than $1 million in the fund.
While the fund diversifies across asset classes, it holds a fairly concentrated portfolio of fewer than 70 stocks. Most of them are mid- to large-cap names that are out of favor with investors when he buys them, but they have the potential for appreciation once their value is recognized. “There are inefficiencies in the market that create opportunity for those who are willing to walk into uncertainty,” he says. “It’s how you gain an edge.”
If performance is any indication, Giroux has been effectively maintaining that edge since he began managing the fund in 2006 at age 32. At the time, he faced the daunting task of taking over the only fund among domestic equity and balanced funds to provide a gain in all of the previous 16 calendar years. “My goal is to be around another 25 years, so I wouldn’t be surprised if I’m the one to end the streak at some point,” he told Financial Advisor in a 2007 interview.
That point came more quickly than Giroux or anyone else expected when stocks, bonds and just about everything else nosedived in the bear market running from October 2007 to March 2009. But the fund rebounded sharply in 2009 as Giroux stuck with stocks he had picked up on the cheap as others were fleeing the market. His focus on higher quality companies in 2010 and 2011 kept the Capital Appreciation fund ahead of other asset allocation funds, and in 2012 the fund continued to beat the pack as Giroux’s stock picks such as TRW, Delphi, Disney and Cooper Industries forged ahead. The bank loan portion of the portfolio also gained ground as investors sought higher yields from his floating-rate debt instruments.
Since Giroux joined the fund in 2006, it has beaten 97% of its moderate-allocation peers, delivering top-decile risk-adjusted returns. The fund also has an expense ratio of 0.71%, which is below average for the category. Those attributes, along with the fund’s performance (it has consistently beaten the stock market with lower volatility), helped Giroux garner Morningstar’s 2012 Manager of the Year Award in the asset allocation category.
“I’m humbled by the award, but there should be 50 names on the trophy instead of just one,” he says, referring to associate portfolio manager Steven Krichbaum and the broad team of analysts they work with.
Positioning For A Tough Market
Giroux and his team face ample challenges as slow economic growth and the threat of rising interest rates collide with a long bull market that has stretched valuations. While the fund still has a strong presence in leveraged loans, Giroux isn’t adding much money to that area. The popularity of higher-quality loans has soared over the last year, which means the yields on them have fallen from the 5%-6% range to the 4%-5% range. Meanwhile, many banks no longer attach the strong covenants to those loans that would protect investors. “When investor appetite for risk increases, investors are willing to waive credit protection for higher yield,” Krichbaum observes.
Since the managers can’t find attractive options in the bond markets, their cash levels have inched up to the 12% to 13% range. Given the low interest rates, Giroux believes the opportunity cost of holding cash right now is very low. Those holdings are both a way to preserve capital and maintain a war chest should the right buying opportunity present itself.
In the equity markets, such opportunities often come from companies facing stress or short-term challenges; perhaps it’s a firm that just missed its earnings numbers or made an unpopular acquisition, or perhaps it operates in a sector fallen out of favor.
Right now, Giroux sees the most compelling values in well-run companies whose industries tend to perk up in the later stages of an economic upturn. He also sees value in those companies that could benefit from rising interest rates.
In the former group is United Technologies, whose business units include Pratt & Whitney, which designs and manufactures aircraft engines and industrial gas turbines. Also in this group is Otis, the leading name in elevators and escalators. Giroux likes Otis’ strong free cash flow, and the stock’s cheap valuation of 12 to 13 times free cash flow.
Several financial institution holdings could profit from rising interest rates, which widen the spread between the lower rate they pay for deposits and the higher rate they make on loans or investments. TD Ameritrade, which derives much of its revenue from such spreads, would be one beneficiary of higher rates. Another would be State Street Corporation, which began buying back its stock over a year ago and has implemented cost-cutting measures that should improve its profitability.
Mutual fund company Invesco, another Giroux holding in this sector, has a well-regarded stable of equity funds but a much smaller footprint in the bond fund space. Giroux believes the firm could see more flows into its stock funds if rising rates and deteriorating share values prompt bond investors to migrate. “People have a false sense of security that they can’t lose money in bond funds, but that could easily change if they start seeing deteriorating values,” he says. “And more likely than not, rates will be higher over the next three to five years than they are now.”
Uncertainty about the health-care front has held down some stocks in the sector, including UnitedHealth Group, one of Giroux’s fund holdings. He believes the stock price already reflects bad news, and that the company’s active stock buyback program and its solid dividends are a draw for shareholders. And while cost-cutting has hurt HMOs, United derives a much smaller portion of its revenues from that part of its business than other publicly traded health-care providers.