As markets shift, value investors keep tabs on how the names in their portfolios are affected.
To achieve this, Paul Roukis, managing director and portfolio manager at Rothschild Asset Management in New York, analyzes factors as diverse as corporate earnings trends and macroeconomic factors. “One of the questions we often get is, ‘What seems constructive at this point?’ Conversely, [we’re asked,] ‘What stocks have you sold and what industries are you more concerned about?’”
Roukis offers insight on U.S. hits and misses for 2018.
A stock to watch
“One stock that we remain positive on, and that happens to be the largest absolute weight in our large-cap value strategy, is New York-based JPMorgan Chase & Co.,” says Roukis, whose firm manages the Renaissance U.S. Equity Value Fund.
The bank has caught his eye for several reasons.
First, it has “a nearly US$400-billion market cap, and the stock very much aligns with our investment philosophy, which [focuses on] attractive valuation at 13 times 2018 earnings, and less than 12 times 2019 earnings,” he says.
He also forecasts that the bank’s earnings “have a strong probability to continue exceeding census expectations, which the company has done for 12 quarters now.” In January, JPMorgan announced that its fourth-quarter results fell 37% from a year ago—but attributed that to a one-time hit from President Trump’s tax bill. Excluding that US$2.4-billion charge, the bank indeed beat estimates.
As Roukis explains, it’s “a diversified bank” that collects approximately half of its earnings from consumer and community banking, while the other half “is spread across corporate and investment banking, asset management and commercial banking. This is a company that grew its franchise rather substantially during the credit crisis.” In 2008, JPMorgan scooped up both Bear Stearns and Washington Mutual.
So, “[the bank] has a number of levers to pull to generate strong earnings growth in coming years,” says Roukis.
Looking through the macroeconomic lens, you’ll find JPMorgan is “levered to the U.S. economy as well as to the global economy, and should benefit from tax reform in a material way. Tax reform alone will likely add US$3 billion to US$4 billion to the bottom line in 2018,” says Roukis. (In its Q4 results release, the bank said its effective corporate tax rate will now be roughly 20%, down from 31.9% in 2017 and 28.4% in 2016.)
This potential gain is “gross of reinvestment, and JPMorgan has made it clear that they will pursue investment to grow their franchise,” he adds. Roukis expects the bank will gain share in core lending areas and says, “[It’s] well-positioned from a balance sheet perspective to benefit from higher interest rates in the U.S., particularly at the short end of the curve. Credit remains stable and operating efficiency seems likely […].”
Across the financial sector, Roukis finds many big banks are well-positioned. “They’re sitting on excess capital—and high-quality capital, at that—and [they’re] generating significantly more through earnings,” he says. “Financial reform, which is gaining steam in Washington, could be added to that capital equation.”
Still, shareholders will be happy with JPMorgan in particular, says Roukis, who’s calling for “capital returns to shareholders increase at a pretty healthy pace in coming years,” through both share buybacks and dividend increases.
If markets look as if they’ll correct, he won’t worry. “JPMorgan has demonstrated superior risk management capabilities in past cycles. […] Management is attuned to what can go wrong” just as much as they’re focusing on what’s going right.
Case in point: the stock (NYSE:JPM) dropped from a close of US$116.42 on Feb. 1 to a close of US$108.82 on Feb. 9, but it was trading above US$118 as of Feb. 27. While this was a short-term recovery, Roukis expects that “JPM’s resiliency will show in the next economic downturn,” truly showcasing its strength relative to its peers.
A stock to avoid (for now)
Roukis became cautious on homebuilders last year following the significant market rally.
One casualty of his change in sentiment was Pulte Homes, part of Atlanta, Ga.-based PulteGroup. Roukis dropped PulteGroup’s stock (NYSE:PHM) in late 2017, when it was trading above US$30—leading up to the fall, it had traded below that level but steadily climbed.
Roukis concedes he sold too early. Still, he says, “The basis of the sale was relevant. The stock advanced over 80% in 2017, and we believed that adequately [reflected] the meaningful transformation that the company went through in recent years. It also reflected the constructive housing backdrop in the U.S.”
Pulte Homes, one of the largest homebuilders in the U.S., has a US$10-billion market cap, says Roukis. He originally invested because “it has a diversified presence across the housing segments; if you think about that, the company serves first-time homebuyers [as well as] move-ups through Pulte Homes, and the active adult market [adults aged 55+] through its Del Webb operations.”
The company is also well-diversified geographically, “with large exposures to the southeast in Florida, and it’s also represented in other areas like the Northeast, Midwest and West,” says Roukis.
At the time he invested, he found “Pulte [had] made significant progress in recent years, through more efficient capital allocation, higher returns [and] higher profitability.” The company also continues to focus on shareholders.
Nonetheless, Roukis was skeptical that the recent surge in first-time U.S. homebuyers was sustainable.
“How much better can it get? And, what was already being discounted in the valuation [at that time]?” Pulte Homes was expected to benefit from “pretty sizable growth that also included favourable tax benefits,” says Roukis, but that wasn’t enough.
“From our standpoint, there were concerns tied to affordability given the price appreciation that had occurred in the housing market,” he explains. “Homebuilders are raising prices at rates that are higher than wage growth, and that’s occurring at a time when mortgage rates are increasing.”
As such, “There were no signs of consumer pushback [in late 2017, but] it was a question of when and not if.”
Roukis’ decision to sell PulteGroup was also reflective of his views on the rising cost of land, labour and materials. Builders are holding less land, says Roukis, so that meant “buying land at higher prices as the cycle goes on.”
While Pulte Homes “has a larger supply of land than most,” Roukis still expected the company to face challenges, and he decided to let it go.
Following the market correction, his view on the company’s valuation hadn’t changed. On Feb. 26, he said, “We do not own PHM,” and he had no plans to repurchase it. Says Roukis: “All in all, we think profitability at the margin could be more difficult to come by going into the back half of 2018.”
PulteGroup closed at US$29.34 on Feb. 26, after trading above US$35 throughout January.
This article is part of the AdvisorToGo program, powered by CIBC. It was written without input from the sponsor.