Wed, 30/06/2010 - 06:00
Mary Chris Gay (pictured), portfolio manager of the Legg Mason US Equity Fund, explains how low inflation rates, slack in the economy and continuing high rates of unemployment have put the US in a ‘sweet spot’ of the equity investment cycle…
Whilst we don’t believe the US will necessarily lead the global recovery, what is certain is that it has moved from recession to recovery and there is little evidence that the US will slip back into recession. The balance of the economic reports in the US have been positive and we believe the market is underestimating the powerful cyclical recovery potential of the US economy and its leverage effect on the recovery in corporate earnings.
Corporate earnings are also now improving as a result of companies’ making steep cuts in costs. At the end of April, 83% of S&P 500 companies reported earnings that had surprised on the upside, with an average surprise of more than 50% in the financials sector. Valuations among the biggest names in the index are among the most attractive they have been in 20 years.”
The ultimate strength and sustainability of the recovery are important considerations but we believe that the evidence supports the view that the recovery will be stronger than most observers expect and investors generally do not fully appreciate the power of the recovery underway in earnings. With the exception of the six month period after the collapse in Lehman, the US market is trading at the lowest valuation level since 1990.
We believe that the pullback in the US market has created an exceptional buying opportunity for long-term investors. With the historically low valuations, continued strength in corporate profitability, stimulative fiscal and monetary policy and low core inflation, we believe the backdrop for positive returns for US large cap equities is quite compelling.
Legg Mason Capital Management also believes that inventory restocking still has a part to play in driving the US recovery as it really only started to kick-in during the first quarter of this year (2010). Inventories are now in positive territory and should continue to increase given demand did not decline as much as most businesses feared it would.
Anecdotal evidence shows that most investors remain very nervous about the market’s recovery and are broadly staying overweight in bonds and underweight in US equities. We would encourage investors to re-consider their position on bonds, as we don’t believe this overweight allocation is sustainable; there’s little return from many money market funds and rates are likely to rise over time in the US and result in bond prices in the US declining.
The Legg Mason US Equity Fund is currently overweight IT, financials and consumer discretionary and is underweight consumer staples, energy and industrials. As of 24 May 2010, the Fund has returned 80% compared to 63% returned by its benchmark since the low reached on March 9, 2009 and it is up 44% for the one year period through the end of April 2010 versus 39% for the S&P 500. In the first quarter of 2010, only one new position was added to the portfolio.
We added Citigroup to the fund because despite the stock’s 14% gains so far this year, the market is still not discounting the bank’s operational improvements, abating credit costs and global deposit franchise. We think Citigroup’s normalised earnings power is close to $0.65 to $0.70 a share, implying a fair value for the company at roughly 8-10x that run rate, or considerably above where the market currently has it valued.
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