Over the last several weeks, there’s been a sell-off in commodities, due mainly to falling oil prices.
The upside is that’s “presented an opportunity to increase exposure at the margin to certain integrated oil companies,” says Peter Hardy, vice president and client portfolio manager at American Century Investments in Kansas City, Missouri. His firm manages the Renaissance U.S. Equity Income Fund.
He suggests investors focus on “large diversified business models [that] cut their capital expenditures earlier in the year. They’ve already been doing things [to] generate greater free cash flow.”
Before investing, he adds, the key is to look at the earnings power of businesses rather than at commodity prices. Take Total E&P Canada, a French intergradient oil and gas company, which “basically has a 5% dividend yield. It’s still selling at six times EBITDA, so is an attractive name for us in the current environment.”
Also, keep an eye on whether the results of the upcoming OPEC meeting in Vienna impact markets, and pay attention to the discussion between Iran and the P5+1 (a group that includes the U.S., Russia, China, U.K., France and Germany) regarding sanctions tied to Iran’s oil production, and nuclear program.
Taking a global view
Commodity markets aside, stocks have largely shrugged off concerns over global tensions, says Hardy.
In fact, “we’ve hit new highs on the S&P 500 [recently], and securities continue to be overvalued…So, as an advisor, I think you have to prepare clients for a lower return market environment” in coming years.
“I would have believed that we would have been in a low-return environment already,” he adds. But “if you look at 2013, the S&P 500 had basically 6% increases in operating earnings, and was up about 30%.”
However, “with interest rates at [essentially] 0% in the United States, and with stock markets at all-time highs, it’s very difficult to see asset prices going up substantially. So adopting [a] low-volatility strategy will be beneficial,” especially if clients are worried about market risks impacting stocks.
Looking forward, he suggests, “your starting point for expected returns should be short-term interest rates, which are currently at zero.” That’s because QE is ending in the U.S., and people’s focus will shift to predictions of when rates will rise.
As such, “your expected return on fixed income should be the yield to maturity of your fixed income portfolio,” says Hardy, “while your expected return on equities could be [calculated through looking at] inflation plus operating earnings, or dividend growth plus operating earnings.”
He expects the S&P 500 will only rise between 6% and 8% going forward, “until higher yields or higher interest rates, or even higher expected earnings growth, comes out of the economy.”