History suggests that the stock market leadership of this year is likely to give way to a new crop of outperformers in 2010. There is no doubt that the energy, materials, industrial machinery and equipment, and transportation sectors, which have been the leaders since the March lows, will continue to do well next year, as revenues begin to accelerate and profit margins increase, leading to well above average earnings gains. That said, investors need to recognize that the strong performance of these groups since the market lows has already discounted some of that expected profit performance over the next year or two.
However, it is becoming more evident that economic growth next year, and perhaps beyond, will be below potential, notwithstanding the expected strength from inventory rebuilding, exports and the remainder of the Government’s stimulus program. Overall, corporate profits will rise much more than a sluggish domestic recovery would indicate because of the deep cost cuts that have been enacted as well as the increasing proportion of profits derived from exports and foreign demand, as the emerging economies have been expanding much more rapidly than those in the developed world.
Nonetheless, the job of the investment manager is to outperform his benchmark, in our case the Standard & Poors 500 Index. To do that consistently requires periodic reorientation of the portfolio in order to maintain an overweight in industries and companies whose profit growth potential has not yet been fully recognized by the stock market. While we continue to maintain most of our positions in this year’s leaders and are likely to do so at least into the first quarter of 2010, we see new opportunities arising among a diverse mix of companies, all of which appear to us to have dependable growth characteristics.In addition to being characterized by stable and moderately growing demand, all of these companies are statistically cheap in both absolute P/E terms and relative to the overall market. In addition, they all appear to have the potential for worthwhile profit gains next year and in some cases have achieved significantly higher earnings in prior years, which may again be achieved in time. Most of them are also generating substantial free cash flow, and many have significant foreign source earnings. All have underperformed the approximately 65% rally in the S&P 500 since the March low.
The new companies in our portfolios include consumer staples, pharma and healthcare services, miscellaneous financial services and defense contractors. Over the past few weeks, as the S&P has struggled to move above 1100, many of these companies have tacked on 5%-10% gains but still remain laggards for the year as a whole. Recognizing that most institutional portfolios are nowhere near as concentrated as ours, indeed most are too broadly diversified in our view, we anticipate that as 2010 unfolds and economic growth remains lackluster, perhaps even with fears of a double dip recession, which we discount, many large institutional portfolios will seek safety in these dependable growers and in doing so will bid their share prices up to full value.
This publication is for information purposes only. Past performance is no guarantee of future results. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate, and it should not be relied on as such. Any opinions expressed are current only as of the time made and are subject to change without notice. We assume no duty to update any such statements. The views expressed herein are solely those of the author. This report may include estimates, projections and other "forward-looking statements." Due to numerous factors, actual events may differ substantially from those presented. This publication is not to be used or considered as an offer to sell, or a solicitation or an offer to buy, any security. Our officers may have positions in securities or investments mentioned in this publication, which positions may change at any time, without notice.
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