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.
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.
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