After a dramatic few months, stocks may be more fairly valued.
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Paul Roukis, portfolio manager of the large cap value strategy at Rothschild.

So the question always comes about, about valuation, and are stocks overpriced or underpriced at these levels. At this point I would say neither. I believe stocks are pretty much fairly valued for the current backdrop, and that’s usually the case for the overall market over time, excluding some of those extreme market conditions. You know, when you assume about $175 of earnings power by S&P 500 companies in 2019, and again, that’s kind of the consensus, or right around the consensus, the implied forward-looking PE multiple would be around 15, 15 and a half times, which is well within reason for the risk return and earnings growth profiles of corporate America at this point.

For comparison, the long term median is about 15 times, although the market tends to over- and undershoot the median over time. Just remember, we started a year ago, about 2018, at roughly 18 times. So U.S. stocks have already de-rated to some degree on more subdued growth assumptions. Quite frankly, you know, as an organization we don’t spend much time trying to time the market based on our views of valuation and investor sentiment. To us that seems like a random outcome; you get it right 50% of the times.

Our strength is to identify individual stocks that we find mispriced in the market relative to peers and then to build diversified portfolios around those individual stocks. So the question always comes up about certain areas of the market that we may find either attractively valued or less attractively valued. So we do see areas in the market that are less attractively valued at this point. We’ve recently reduced our exposure to the regulated utility sector, or in the utility sector on valuation. Utility stocks have been the beneficiaries of a lot of this market uncertainty in recent months.

What’s unusual about this cycle is that the regulated utilities have outperformed during a period of rising interest rates. This is somewhat perverse, but it speaks loudly about the fears that investors have of being late cycle. The utility sector trades at a multiple of between 18 and 19 times the consensus estimates for 2019, which seems expensive relative to the broader market at that 15, 15 and a half times. While I would agree that the rate-based backdrop looks constructive as the infrastructure is in need of modernization, and there is a broader push to cleaner fuel sources, these trends seem adequately recognized by investors in my view.

We recently sold our position in New Jersey based Public Service Enterprise Group, as we thought that company’s high-teens earnings multiple adequately discounted the company’s hybrid business model and near-term growth prospects.

So, one of the questions we also get is what stocks look inexpensive at face value to you. Within the universe of large capitalization value stocks—and I stress value here, since that is the strategy I co-manage with my partner, so I’m excluding growth stocks—then many of the cyclical sectors look inexpensive to us if you believe the earnings projections for 2019. The housing, auto, industrial and bank stocks all look discounted following significant underperformance in recent months. Many of these stocks traded single-digit PE multiples with relatively strong free cash flow profiles. But as you may notice, really the big question is do you believe the denominator in this PE equation, and that is earnings.

As we talked about earlier, there are a number of binary events that could influence the outcome, such as the Fed and trade policy, among other things. The consensus is that we are at the tail end of the cycle, and it’s only a matter of time before the U.S. enters a recession. To me it just seems premature to talk of an imminent recession when the economy may well add about two million jobs in the next twelve months. With that said, the probability of recession is not zero. And what we should have learned from past cycles is that often times it’s an exogenous event or events that acts as a trigger.

So Marathon Petroleum is a $44-billion market cap energy company that focuses on refining, marketing and transporting crude oil and refined products such as gasoline and diesel. The company recently closed on its acquisition of Andeavor, which is formerly Tesoro, and is now the largest refiner of crude in the U.S., with roughly three million barrels per day of capacity spread throughout the U.S.

One of the things that attracted us: shares have retreated about 25% over the past three months, driven by the selloff in the energy sector and the market in general, as well as weaker refining margins, which tend to drive profitability. We think the stock looks attractive at these levels for a few other reasons. You know, first as I mentioned with valuations shares trade at a roughly 25% discount to the peer group on a cash flow basis. And by that I mean enterprise value to EBITDA, and an even bigger discount when you’re looking at the two biggest peers, Valero and Phillips 66. This discount comes despite having a more defensive business model than Valero in particular. From a stability standpoint, while Marathon is the biggest refiner in the U.S., refining makes up only 50% of cash flow, with the balance split between the more stable midstream and retail businesses.

These businesses leave more resilience to lower oil prices than many of the other energy companies, and actually retail actually benefits when oil falls, and this helps to generate free cash flow. Marathon currently has a 3% dividend yield, with targeted dividend growth at 10% annually alongside a buyback program that could see at least 2.5 billion of shares repurchased annually.

When I mentioned about company-specific issues, we see synergies from this acquisition that they made of Andeavor, and the company just hosted an analyst day and expects to realize synergies from the acquisition of about $1.4 billion. That’s up about 40% from original expectations. So there’s a potential margin story here beyond just the general macro trends.

And then two other things to mention on differentials. Marathon is a big beneficiary of the growth in U.S. and Canadian crude production as they benefit from an ability to run cheaper, locally produced crudes in places like the Permian basin, Bakken and Western Canada.

Finally the one thing I’d want to mention is IMO 2020 [Editor’s note: Roukis is referring to the International Maritime Organization rules on sulfur that come into effect in 2020], that’s one of the biggest potential benefits for Marathon, and all refiners in general, and because of that it’s really the forthcoming International Maritime Organization rules that is set to require lower sulfur fuel oil in all ships. So that, you know, the end result is that could significantly tighten the global diesel market, which should result in higher spreads for the refiners and weaken the market for heavy crude, which Marathon uses as an input.

Renaissance U.S. Equity Value Fund
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