Large Cap Commentary-April 2019
The month of April was a good one for the market, as the S&P 500® Index hit record levels, closing in on the psychologically important level of 3,000. The results that companies posted for the first quarter of 2019, results that were released during the month of April, were one of the drivers for the move in the S&P. Per FactSet, a data provider we and many investors use, of the 78% of S&P 500 companies that reported earnings, 76% reported earnings that were better than expected. In addition, positive sales surprises are also tracking above FactSet’s five year average. Better than expected earnings and better than expected sales logically implies markets should rise and that is what we have seen on a year-to-date basis.
As the chart below illustrates, when we look at the Rule of 20, which says the forward Price/Earnings (P/E) ratio of the market should be 20 minus the yield on the 10 Year Treasury Bond (currently 2.45%), we see that the S&P 500 Index P/E ratio for the beginning of May is near 16.5 while the Rule of 20 P/E is near 17.5. Thus, one could conclude that the S&P forward P/E ratio is roughly five percent below fair value. As we have noted before, however, the performance of certain sectors or pieces of the market, have diverged from other sectors and it is in that divergence that we find more compelling value. We have talked before about the recent dichotomy between Defensive stocks and Cyclical stocks. As a reminder, Defensive stocks are those that are less affected by the economy – think, for instance, of a food manufacturer or an electric company. Likely your demand for food does not vary considerably when the economy is doing well or doing poorly. Put simply, you gotta eat. Cyclical companies, on the other hand, produce goods and service that are much more discretionary. Here, think cars, boats or homes, for example.
Recently, as investors became more sanguine with regard to their outlook on the U.S. economy, Cyclical companies have shown some better performance relative to Defensive companies. Although price performance has improved some, there remains a wide valuation gap between Cyclicals and Defensives, with Defensives looking much more expensive than Cyclicals. One of the key aspects of the way we invest at Argent is consideration of valuation, in other words, how much are we are forced to pay for expected earnings in the future. We are always inclined to pay as little as possible for expected future earnings and that bias has us leaning to more cyclical companies today.
One of the recent additions to the Large Cap strategy fits in well with this narrative. That stock is DR Horton (DHI), a home builder. As I have mentioned above, the home building industry certainly falls into the more cyclical group of stocks. With interest rates low and demand for housing stable to good, DR Horton’s end market – home sales – has been positive. One unique aspect to DR Horton is that the company is moving away from owning land. Land ownership causes volatility in results as land prices rise and fall. Instead, DR Horton is focusing on building homes. We think this change by management is a positive for shareholders and differentiates the company from other home builders.
For as long as there is a significant valuation discrepancy between economically sensitive cyclical companies and defensive companies with the backdrop of a supportive U.S. economy, expect that we at Argent will be taking a closer look at more cyclical companies for our clients. We have four successful equity strategies – Large Cap, Small Cap, Dividend Select and Mid Cap. If you have questions on any of these options, please call us.
Senior Portfolio Manager