Ted Thome: In the fall of 2019, we did see a rotation into cyclicals, primarily financials and industrials. And that was driven by a few factors: One is the U.S.-China trade negotiations progressed. Secondly, we saw a recovery in the U.S. economic growth. Then, lastly, we saw the yield curve steepen a little bit. So all those factors helped the cyclicals in the fall of 2019, and we think that could continue if those factors continue.
Alec Perkins: Looking over a 45-year period, it is very obvious that there is real cyclicality to the growth versus value dynamic. And growth has periods of outperformance and value has periods of outperformance. We, right now, are in the midst of one of the longest periods of outperformance for growth that we have seen in the last 45 years. And investing ahead of the rotation back to value is something we think investors should really consider.
Thome: In 2019, over 90% of the return was due to multiple expansion. So, now we have a situation where multiples are near the historic highs. And we would expect future returns to be lower, all else equal. We believe that investors would do well by being positioned and focusing more on downside risk at this point.
Perkins: Despite the high equity valuations, there are still opportunities out there to find companies trading at attractive multiples, where risk/rewards are generally in the investor’s favor. Investors can look to small banks as one area of relatively positive risk/rewards. Banks with good footprints in good economic markets still have an ability to make loans and grow over time. And the valuation and the multiples are extremely favorable in the banking sector.
Thome: Within health care, we like some of the large-cap pharmaceuticals, where the valuations have been depressed given the uncertainty around drug pricing policy and the upcoming 2020 elections. However, these companies have strong balance sheets, stable free cash flow and above-average return on capital. We also believe that these companies have a product portfolio and pipeline that will sustain their longer-term growth.
Perkins: We believe investors should look across all market caps to find good opportunities. The investable universe right now, given high equity valuations, is quite small. And so limiting yourself just to one area by definition starts to make the universe too narrow.
We are seeing very good opportunities on the small-cap side of the spectrum. We are seeing good reward to risks in that area, good balance sheets, strong free cash flow. And, historically, small caps have brought along with them more risk. But if you control for some of these variables like balance sheet, like durable competitive advantage, we believe you can actually outperform over long periods of time investing in small caps.
Thome: We would caution investors against potential value traps, where the stocks may look cheap, but the companies are being disrupted or they are facing secular headwinds. We believe investors should focus on finding value opportunities where the long-term fundamentals are intact, yet the valuations are very attractive.
Perkins: It is very difficult to time the markets. It is also very difficult to say that equities are expensive and so I am going to go away from equities. Right now, we are sitting at a time on a cyclically adjusted P/E [price-to-earnings] level that is at historic highs. At the same time, fixed income is also at historic low yields. So fixed income looks expensive, equity looks expensive and remaining nimble in an environment like that and being able to adjust your exposure between equities and fixed income is really crucial in an environment when lots of asset classes look expensive.
