Quite Contrary
Investors have shunned cyclical stocks in favor of utilities and Internet stocks. Time to bet on global growth.
Never before has contrarian investing been so, well, contrarian.
For months, strategists and economists have been in near-agreement on the rosy outlook for the global economy. For the first time in five years, the U.S., Japan, and Europe are all poised for economic growth. And yet the majority of mutual fund managers have taken contrarian tacks, pouring money into companies that aren't dependent on economic growth, and instead focusing on biotechnology, social media, and electric utilities, none of which are likely to benefit further as the economy improves.
So when everyone appears to be a contrarian, what's a stockpicker to do? Perversely: Follow the consensus view. While strategists have been recommending economically sensitive stocks on expectations of better global economic growth, fund managers quite literally haven't bought the argument, eschewing cyclical stocks, which rise and fall with economic cycles. Indeed, cyclicals make up the smallest portion of actively managed fund portfolios since the financial crisis, according to Bank of America Merrill Lynch U.S. equity strategist Savita Subramanian. She recommends that investors seek out some of the less-popular areas of the market, most notably the global companies that are tied to economic growth, including technology, energy, industrials, and financials. "There's not going to be a better opportunity to buy these cheaper cyclical names than now," she says.
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Illo: Scott Pollack for Barron's
Going against the crowd can be lonely, but that's how you want to be positioned when the market turns -- and it's turning right now. The most crowded stocks in the Standard & Poor's 500 underperformed the most underowned stocks by four percentage points in the second quarter. Granted, the global recovery is uneven, and some caution is warranted, especially as many of these cyclical stocks have started to rise. But it doesn't take much to sustain modest growth in the early stages after a downturn, says Strategas chief economist Don Rissmiller. That's especially true for Europe, which is at an even earlier stage of recovery than the U.S.
What's more, he thinks China will dodge another hard landing, and its moves to keep its economy chugging along should help emerging markets shore up their own growth. Japan's new sales tax is creating some messy economic data, he says, but its recent monetary and fiscal reforms should underpin growth.
Within the U.S., cyclical stocks offer better dividend growth and cheaper valuations than utility stocks, where investors have fled for yield. And the unpopularity of cyclicals also could mean less selling pressure if the market pulls back, says Subramanian.
As a result, you should look for companies and sectors that have been largely ignored. Today, that means technology, energy, industrials, and financial services. Barron's identified six relatively cheap stocks that should benefit from the global recovery.
Technology
While Internet stocks have captured the market's attention, up 97% over the past three years, other technology stocks have largely been overlooked. The group's price/earnings and price/cash-flow ratios are at the lowest level in 25 years, relative to the S&P 500, notes Leuthold Chief Investment Officer Doug Ramsey.
One reason for the discount is that companies are still tightfisted with their information-technology budgets, especially on big projects. That has hurt companies like Teradata (TDC), a leader in helping businesses make sense of the digital data gathered from the Internet, mobile devices, and elsewhere, with large-scale data analysis.
Teradata's shares have slipped 8% this year on concerns about competition and a slowdown in revenue. Sales are expected to rise 3% this year, to $2.8 billion, a big drop from its midteens rate of 2010 through 2012.
Potential competition from start-ups with cheaper products has weighed on the stock, but first-quarter results suggest it isn't having the impact some had feared. Teradata also saw a record number of new customer sign-ups in the first quarter, and strong growth from its smaller customers. Teradata also stands to benefit from increased sales in Europe, as customers there are in the early stages of adopting data-analytics software.
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First Eagle Global co-manager Abhay Deshpande says Teradata is well positioned to benefit as companies collect even more data and try to capitalize on it over the longer term. He thinks the company should be able to generate stable 5% to 7% growth and rich free cash flow -- $527 million over the past 12 months. "Teradata's stable long-term growth and cash flow are more valuable than those of temporarily higher-growth companies that the market has been flocking to lately," he says, adding that the stock, now $42, is worth at least $50.
Energy
Energy stocks have been out of favor for nearly four years, but lately they've begun to attract attention, rising 12% so far this year. Chesapeake Energy (CHK) is up less than half that. Almost 1½ years after co-founder and CEO Aubrey McClendon was forced out over questions about his mingling personal expenses with those of the company, Chesapeake is still struggling to regain confidence with investors.
The firm's aggressive spending also raised concerns. Its willingness to take risks and invest big helped Chesapeake become one of the most active gas drillers and a poster child for the domestic oil boom, but it also dented its cash flow and left a wave of concerns about its corporate governance. New management is focusing on spending in areas that produce returns, rather than just acquiring more acreage, which should be good for future production growth. Already, the company has doubled its 2015 production forecast from earlier in the year, and is now expecting 7% to 10% production growth.
Earnings are expected to rise 24% this year, to $1.4 billion, or $2.05 a share. Some of Chesapeake's investments are also beginning to pay off. And the recent spinoff of its services business removed $1 billion of debt, improving its balance sheet.
Those moves should help Chesapeake stock, which trades at an enterprise value to Ebitda ratio of 5.5 -- well below the industry's historical average of seven. (Ebitda stands for earnings before interest, taxes, depreciation, and amortization.)
"In this market, it's almost impossible to find anything cheaper," says Charlie Bobrinskoy, director of research at Ariel Investments and manager of the firm's Focus fund. "Chesapeake's name has been tainted, but it still has spectacular horizontal-drilling and fracking technology." He thinks the stock is worth in the mid- to high-$30 range, or at least 30% higher than its current $27.
Industrials
The U.S. manufacturing renaissance has helped industrial stocks fare a bit better than energy. The biggest opportunities, then, are in more global-oriented companies that have been out of favor amid concerns over China's economic slowdown.
Take Caterpillar (CAT), whose stock was essentially stuck in the mud for two years amid the downturn in mining and slowing growth in China.
But as expectations for a stronger global economy emerged, Caterpillar's stock rose 20% this year. At 17.6 times this year's estimated earnings of $6.18 a share, it's now a bit pricier than the broad market. But industrials tend to trade at high P/Es toward the bottom of an economic cycle, and by historical standards, this is a relatively low multiple. In the trough of the downturns in 2003 and 2009, its shares traded at a P/E of 25 or higher. The stock, now $109, could rise another 15%, to $125, if the cyclical recovery is on.
There is more than hope at work. The pace of decline in Caterpillar's mining business has slowed, and construction and highway activity have picked up. The company also has cleared the excess inventory of mining equipment it was stuck with when orders dried up. "If you get just a little bit of a recovery in emerging markets and mining spending over the next two years, it will show up in earnings quickly," says Laton Spahr, manager of the $2.4 billion Oppenheimer Value fund. "They fixed their house."
At 13 times forward earnings, industrial toolmaker Kennametal (KMT) is a cheaper way to play similar trends; the tools it sells are used by Caterpillar as well as by auto makers and in engineering projects. Its cutting tools employ a specialized technology that allows metals to withstand corrosive and high-temperature conditions.
That edge hasn't protected it from slowing demand, particularly in coal production in Appalachia and China. Analysts expect earnings for the year that ended in June to slip 3%, to $197 million, on sales of $2.9 billion. But Kennametal has seen a pickup in orders in its industrial business over the past few quarters, with growth especially strong in Asia and Europe, and a stabilization in its infrastructure business that includes energy, road construction, and mining.
Since Kennametal doesn't sell big-ticket equipment, it sees a pickup in spending more quickly than those that do. The steps it took during the downturn, including cost-cutting and acquisitions, should boost profitability once spending returns. More credit from the market would help it trade in line with peers at 17 times forward earnings, boosting shares to the mid-$50s from $45.
Financials
Financial firms are still one of the cheapest parts of the market, plagued as they are by regulatory concerns and low interest rates. Capital One Financial (COF) has transformed itself with acquisitions, like ING's online-banking business, which gave it low-cost deposits that should power profits over time, and its purchase of HSBC's U.S. lending business. The latter deal gave the company entrée to the lucrative private-label credit-card business, but also created its own share of headaches. Not long after the deal, Capital One decided to unload a chunk of what it had just bought -- saying that it wasn't a good fit -- a move that hurt earnings and raised concerns about the transaction and its growth prospects.
Now the fourth-largest U.S. credit-card firm, Capital One has worked through most of the kinks. The missing ingredient: Customers are still reluctant to rack up additional credit-card debt. But its second-quarter results, out last week, showed glimpses of loan growth.
For 2014, analysts expect net income at Capital One to rise 3%, to $4.3 billion, or $7.55 a share, as revenue slips 2%, to $21.9 billion. Based on cost-cutting and other moves, Wasatch Advisors founder Sam Stewart thinks the stock should fetch a valuation closer to that of average regional banks, which trade at 13.5 times forward earnings compared with Capital One's 11 times. That translates to 20% upside, or a price of $99 from its current $82.
While Capital One waits on its missing ingredient to make a full transition, T. Rowe Price Group (TROW) has been hit because of a coming transition. This underowned stock fell 5% in the month after the asset manager said its chairman, veteran investor (and Barron's Roundtable member) Brian Rogers, would relinquish his money-management duties on the $31 billion T. Rowe Price Equity Income fund next year. Analysts think the selloff is overdone, especially since the firm has long been known for having a team orientation and a deep bench of managers.
The company benefits as the economy improves and people invest more. T. Rowe is one of the major 401(k) players, which helps drive inflows to its funds. And with a firm foothold in the target-date fund business, retirement assets will continue to grow.
Analysts expect earnings to increase 19%, to $1.2 billion, as revenue rises 15%, to $4 billion. Yet, at 16.6 times forward earnings, the stock is trading 15% below its 19.8 average over the past decade, giving investors an opportunity to buy a high-quality stock just as some strategists expect these types of stocks to outperform. The shares, now $80, could rise 15%, to $92.