In the first six weeks of 2016, investors grew increasingly concerned about the possibility of a U.S. recession. Their fears were not driven by weakening consumer demand at home, but instead from the spillover of slowing growth abroad as well as lower oil prices which could propagate through the banking system via a cascade of energy-related defaults. High yield debt spreads widened to levels which are typically indicative of recession. It appeared that the Federal Reserve was blind to these issues, as the median projection of its Open Markets Committee was to hike interest rates four times in 2016, perhaps starting as soon as March. We believe that this would have likely strengthened the U.S. dollar, making American exports less competitive and weakening the U.S. economy.
As often happens in the capital markets, these fears were overblown. Aided by some coordination among key foreign producers, oil prices rebounded off their lows, as did the share prices of bank stocks, a group that had been among the hardest hit. Borrowing rates for highly indebted companies fell from their highs as default fears waned. China and Europe announced accommodative monetary policy actions, supporting the outlook for global growth. The Federal Reserve recently reduced its median projection to just two interest rate increases, weakening the U.S. dollar. Strong employment data as well as the latest regional Fed surveys confirmed that U.S. economic growth is likely accelerating this quarter, rather than falling into recession. In our view, this narrative points to a more favorable environment for value stocks than we have seen in several years.
When the economy is growing slowly, investors typically attribute a valuation premium to growth stocks as well as stable businesses, such as consumer packaged goods and regulated utilities. In that environment, investors generally view growth and stability as scarce and bid up those shares relative to companies with more cyclical or volatile earnings streams. However, when broad-based economic growth returns, growth stocks and stable businesses typically lose some of their valuation premium. At these times, investors no longer perceive growth as scarce, and relatively cheaper value companies seem more attractive than before.
Over the past month, value has outperformed growth, and along the way we have repositioned our client portfolios accordingly. Looking ahead, we expect the shift to continue. In addition to support from economic growth and the valuation disparity, historically a trend reversal of the magnitude experienced in the last month tends to persist for several more quarters, as the outperformance of growth stocks over the last five years that brought the discrepancy to its peak in mid-February cannot be unwound in just one month.
Going forward we expect to continue to increase the mix of value stocks in our client portfolios, with a focus on those companies with high and sustainable free cash flow generation and strong management teams, where superior business performance has perhaps been masked by macroeconomic headwinds. In ordinary circumstances, free cash flow is a key determinant of a company’s intrinsic worth. We rely on sensible management teams to either invest this profit wisely or else prudently return it to shareholders, so that capital markets properly recognize the company’s value.
We continue to seek strong investment opportunities regardless of the market environment. As always, our benchmark agnostic approach gives us the flexibility to pursue the best opportunities we identify, regardless of style, size, or country of domicile.
This information is intended solely to report on investment strategies and opportunities identified by Roosevelt. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell any financial instrument. References to specific securities and their issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Please contact us at 646-452-6700 if there is any change in your financial situation, needs, goals or objectives, or if you wish to initiate any restrictions on the management of the account or modify existing restrictions, or if you would like to request a copy of our Code of Ethics. Our current disclosure statement is set forth on our Form ADV Part II, available for your review upon request, and on our website, www.rooseveltinvestments.com.