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Paul Roukis, portfolio manager of the large-cap value strategy at Rothschild & Co.
With markets up about 30% in 2019, I guess one of the big questions is how much upside is there to further stock gains? When we think about the market, it’s trading at roughly an 18 forward PE multiple. The market enters 2020 a few multiple points higher than it did at this time last year. Eighteen time is above the historical median, and certainly at the higher end of the longterm valuation range. I would argue, however, that evaluation multiple of 18 times is not out of the realm of reason when balanced against the tepid inflation backdrop. Also, stocks still look relatively attractive versus other asset classes such as bonds, in my view. The bigger picture, it helps that the Fed and most of the other global central banks are supportive through accommodative monetary policies.
Even so, I believe further stock market gains are likely not to come as easy as they did in 2019, as people are thinking about 2020. To me, what was interesting about the rally in stocks last year was that it was fuelled exclusively by multiple expansion, which is unusual against the backdrop of nearly flat corporate profit growth — say about 1% that was generated or expected to be generated in 2019. Typically stocks get their direction from corporate profit trends, which was not the case in 2019. The expectations for corporate profit growth are relatively high in 2020, coming off a disappointing year in 2019, where growth looks to be coming in at about 1%. This is particularly disturbing when you consider that the hundreds of billions of dollars in share buybacks by companies last year contributed about 2% to EPS growth.
Just by doing the math, in essence, operating profits likely to decline modestly, led by those of the cyclical sectors. Think of sectors like basic materials, energy and the industrials. For 2020, the expectation for profit growth is about 9%, driven by 5% sales growth, capital management actions, which would include share buybacks, and some modest margin expansion. Nine percent year-over-year growth is not a low bar, in my view, particularly given some of the overhangs we have to deal with this year. The key to corporate profits will be whether or not the cyclical companies are able to see profits recover to the degree that investors expect. Remember, there is optimism around the effects of last year’s Fed easing, which historically supported growth on a lag basis. Also, since this easing cycle is occurring at other central banks as well, not just the Fed, there’s optimism for a more coordinated global economic rebound.
When we look at stocks at the portfolio level, the stock that we remain relatively constructive on is defence contractor Northrop Grumman. Northrop is one of the largest defence contractors in the U.S., with a market capitalization of about 60 billion. But the story doesn’t revolve around just size and scale. The attraction here is the company is well positioned, given its exposure to some of the vital modernization programs going on at the Department of Defence. For example, the F-35 fighter program, the B-21 long-range bomber program, and the ground-based strategic deterrent system, in which Northrop is the sole bidder. The latter two of these programs could each be worth upwards of $100 billion over many years, assuming Northrop is the winner on the missile system.
Obviously, when buying defence contractors, there is headline risks associated with the budget, which every investor should be aware of. Considering the potential constraints on defence spending against the backdrop of sizeable federal budget deficits, our thesis here doesn’t include much change in future spending plans. So we have the defence budget growing at maybe low single digits at best. However, by the same token, we’re reminded with the Iranian incident that the world remains unstable, and we’re probably not at risk of peace breaking out anytime soon. To us, Northrop is a good hedge in the portfolio to such macro uncertainty. In terms of valuation, stock trades at a roughly 10% discount to the broader market. So, roughly 16 times forward earnings versus 18 times for the S&P 500. Even though the company is set that deliver EPS growth of about 15% in 2020, or about 50% higher than the broader markets 9% to 10% expected growth rate.
Keep in mind, the stock received a bounce following the Iranian incident, so it may see some reversion or weakness in the near- term, absent further escalation in the middle East. Even so, we think the story’s intact, that makes a good holding in a diversified portfolio. Also, defence stocks have tended to perform well during election years. In terms of the portfolio, we recently sold our position in Alexandria Real Estate. This is an office rate with a market capitalization of about 20 billion, and whose real estate properties are clustered around research/ healthcare centers around the country. Cities like San Diego, Boston, San Francisco, New York, Seattle, Maryland, and the research triangle in North Carolina. This is the case of Alexandria being a very good company, if not a great company, but a not so great stock in our view, given the premium valuation it gets in the market.
The price to FFO of multiple, which is a common valuation metric for rates moved up to over 23 times, which we thought largely discounted the favorable growth outlook we had for the company. One of the attractions to Alexandria is the robust development pipeline that the company has. What we’ve seen with employment trends in the U.S. is a matter of cities becoming haves and have nots, depending on end markets and education levels. Alexandria caters to much of the newer economy, where capital is being invested. While Alexandria has had its wind at its back for many years now, as capital has moved to those new era end markets and companies, the comps are likely to get tougher from here in our view. As I mentioned that one of the attractions to the story is the company’s robust development pipeline. That also represents one of the biggest risks to the company if market conditions deteriorate.
All in all, we think the secular growth story in Alexandria looks pretty attractive, just not the valuation. My views expressed today are my current opinion, and not an indication of the fund’s intention to trade or hold a position. I would also like to highlight that my opinion may change in the future, and it should not be viewed as investment advice.