Portfolio manager John Stephenson has concerns that peaking earnings, economic growth, rising inflation, a flattening yield curve, and a maturing business cycle are weighing on stocks. Despite investor angst, fundamentals remain very solid for stocks in the technology, financial and consumer discretionary sectors. He picks three global giants to buy now.
With the majority of S&P 500 companies having reported earnings, investors for the most part seem surprisingly unimpressed. This despite the fact that the first quarter results have come in extraordinarily strong, with the majority of the reporting companies beating the consensus earnings per share growth rates of 24 per cent. Companies that have beaten on both the top- and bottom-lines have outperformed the market by just 1.1 per cent this earnings season as compared to a historical average of 2.0 per cent.
This equity bull market, the most hated bull market of all time, has lost none of its ability to both repulse fresh capital and still live to fight another day. Investors have pulled nearly $11 billion out of US equity funds in the first quarter of this year, and $205.6 billion over the past 12 months, according to Morningstar. Meanwhile, taxable bond mutual funds took in $9 billion in the first three months, and $170.1 billion during the past year.
Stock bulls wonder why more people haven’t bought in, and that skepticism has prevented a full-out fervor that typically leads to a bear market.
Investor interest has continued to be strong this year for bond funds, even though returns have been muted during a run when the S&P 500 has soared about 300 per cent since its March 2009 lows. This year’s wild stock market swings have proven to be a friend to bonds and have thwarted multiple predictions that 2018 finally would end the more than 30-year bond bull.
Policy uncertainty and no strong direction
The trouble for investors this year is that most asset classes have moved little in either direction, though there are opportunities in stock selection and in individual commodities. In that environment, money has moved to cash and its equivalents and away from risk assets, particularly in US assets. Cash has risen to 16.6 per cent of investor portfolios, the largest share since May 2017, according to the American Association of Individual Investors.
At the same time, there’s a good deal of policy uncertainty. The Federal Reserve is on track to raise interest rates three or four times this year, and the Trump administration is threatening broad-based tariffs that many investors fear could start a trade war and fuel inflation. Taken together, it’s made for an environment friendly to safe-haven bonds.
In the latest trade salvo, US allies are breathing a sigh of relief after President Donald Trump’s last-minute decision to postpone tariffs on imports of steel and aluminum from some of Washington’s closest partners, helping to avoid a trade war but leaving many questions about what comes next.
In a response to this latest development the European Commission, the European Union’s (EU) executive arm, said: “The US decision prolongs market uncertainty, which is already affecting business decisions. The EU should be fully and permanently exempted from these measures, as they cannot be justified on the grounds of national security.”
What I recommend
Despite investor angst, the fundamentals remain very solid for stocks. In particular, investors should look toward the technology, financial and consumer discretionary sectors for outperforming investment ideas. The telecom, REITs and utilities sectors should be avoided, as interest rates have doubled since mid-2016, resulting in the underperformance of bond proxies.
Even though the technology sector suffered a recent pullback, it has been one of the top-performing sectors throughout the nine-year recovery, driven by superior fundamentals. Since mid-2016, the sector has delivered more than twice the market’s return, with all sub-groups outperforming.
While the price-to-earnings ratios for the sector are still above the market, technology stocks remain attractive on a free cash flow basis.
Old technology companies (hardware and semiconductors) are currently trading at a discount to the S&P 500. Technology remains my favorite sector of the market and a must-own sector for investors.
Since mid-2016, only technology has delivered stronger returns than the financial sector. This strong performance by the financial sector is the result of an improving economic backdrop, rising interest rates, a decreased regulatory burden, and strong credit performance. These trends should continue throughout 2018.
All sub-groups of the financial sector are expected to deliver 2018 earnings growth above the market, while valuations remain attractive relative to the benchmark.
Netflix faces least regulatory risk of the FANGs
The consumer discretionary sector is attractive. However, its market-like performance since mid-2016 is deceiving, with internet retail (approximately 30 per cent of the sector) up 112 per cent, and the remainder of the group lagging. Within the consumer discretionary sector, internet retailers should be the focus of investors.
Growth and revisions for internet retail continue to be extremely strong, although valuations are quite extended compared to the benchmark and technology stocks.
One stock I really like is Netflix, Inc. (NASDAQ—NFLX). Netflix is an online entertainment subscription business that has approximately 125 million streaming subscribers globally. For an approximate price of $8 to $14 per month subscribers receive unlimited access to curated TV shows and movies.
The company is the leading streaming service, with about six times as many subscribers as its next closest competitor. I believe that streaming video has many years of premium growth ahead given its superior value proposition (anywhere, anytime at reasonable prices) especially compared to broadcast TV.
There are approximately one billion cable TV subscribers worldwide and about 175 million streaming video paid subscribers worldwide, suggesting a long-growth runway for Netflix.
As well, Netflix may face the least regulatory risk of the FANGs (Facebook, Amazon, Netflix and Google (now Alphabet, Inc.) since it is not an ad-supported business.
Expedia reaches both consumer and business markets
With more and more people opting to spend their money on experiences rather than other consumer purchases, a stock I really like is Expedia Inc. (NASDAQ—EXPE). Expedia is a leading online travel company, providing both leisure and business travelers with tools to research, plan, and book travel. The various sites under the Expedia umbrella offer access to traveler reviews and advice, flights, hotels, car rentals and cruises, as well as vacation packages and other activities. The portfolio of brands spans the globe and includes Expedia.com, Hotels.com, Hotwire.com and Egencia.com, among others.
Expedia has re-accelerated bookings growth on the back of a platform upgrade and improved execution. Faster-growing international markets have become a significant driver for the company. Integration of additional inventory from numerous acquisitions has opened up new opportunities across the globe. I believe online travel can continue to grow solidly in the double-digit range for the foreseeable future.
Visa should see both growth and higher margins
Another solid company that I like is Visa Inc. (NYSE—V). Visa operates the world’s largest retail electronic payments network and manages the world’s leading electronic payments brand. Through a series of brands including Visa, Visa Electron, PLUS and Interlink, which are licensed to financial institutions, and multiple payment card types, including credit, debit, prepaid, and commercial payments, Visa enables global commerce.
Visa remains one of my best ideas in the space, given our belief that investors should look to long-term secular-driven stocks that should provide solid organic growth with opportunities for margin expansion. In the near term, Visa faces some cyclical but abating regulatory pressure. In addition, I believe that longer-term the company will begin to optimize its capital structure, which should provide additional growth. Visa’s fundamentals (high-single to low-double digit organic revenue growth, 60 per cent operating margins, potential for close to mid-teens plus earnings per share growth, and significant free cash flow generation) rank it among a select group of companies.
Despite strong earnings, limited recessionary risks, and reasonable valuations, the market has declined 1 per cent year-to-date. Concerns surrounding peaking earnings per share and economic growth, rising inflation rates, a flattening yield curve, and a maturing business cycle are weighing on stocks. While each issue has merit, I believe investors are under-estimating the market’s potential upside, and over-estimating risks. As Warren Buffett once famously commented: “Be fearful when others are greedy and greedy when others are fearful.”
John Stephenson is an award-winning portfolio manager and the President and CEO of Stephenson & Company Capital Management Inc. in Toronto. He is the author of “The Little Book of Commodity Investing” and “Shell Shocked: How Canadians Can Invest After the Collapse.” He is also the publisher of Strategic Investor (www.StephensonFiles.com). He can be reached at (647) 775-8360 or (844) 208-8817, or email@example.com.
This is an edited version of an article that was originally published for subscribers in the May 2018/First Report of The MoneyLetter . You can profit from the award-winning advice subscribers receive regularly in The MoneyLetter. 
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