Investment Insights: Companies at a Crossroads
February 11, 2013
by Ron Sloan
Despite a lack of corporate earnings growth in 2012, a surge of investor confidence boosted US stocks. But we don’t believe that type of market rally is sustainable for the longer term. Looking ahead, we expect the market environment to be tougher in 2013 as companies face a crossroads: continue to hoard cash at the long-term expense of future growth, or reinvest in their business at the shorter-term expense of profit margins?
2012: The stock market gets a ‘hall pass’
The S&P 500 Index experienced almost no earnings growth in the second half of 2012. And yet, a burst of investor confidence lifted valuations and led to a market rally — the S&P 500 Index gained 16% for the year.
We believe that without a solid foundation for earnings growth, companies have gotten a hall pass from investors. In this low-growth macro environment, companies have squeezed their operating expenses in an effort to satisfy Wall Street’s demand for greater earnings. We don’t see this as a long-term strategy for success.
2013: Will businesses reinvest?
As companies have begun to report their earnings for 2012, they’ve also been quite busy lowering the bar for 2013 expectations. In general, they’re squeamish about their ability to generate top-line growth through demand for their products and services in this macro environment.
So, we’re not optimistic that companies can tighten their expenses much further to improve their margins. And we’re not optimistic about the outlook for earnings growth. All signs point to a tougher market for 2013.
But, this is only a short-term negative view.
We believe companies are at the point where they must reinvest in their business — which bodes well for long-term growth. However, investors must be prepared for the short-term ramifications. Reinvestment requires looser purse strings to pursue mergers, acquisitions and other business-building activities. And these capital expenditures will compromise margins in the short run, which can pinch valuations. In short, we believe companies that are currently hoarding cash will face future margin shortfalls, to Wall Street’s chagrin.
2013: What are we looking for?
As we evaluate the corporate landscape, there are several traits that we’re looking for in a potential investment:
- A forward-thinking view of reinvestment. We like to invest in businesses that have already taken the initiative to reinvest in themselves. These companies have laid the foundation for future growth and, therefore, have already absorbed the hit to their margins.
- Selective valuations. Valuations of small- and mid-cap companies are at generational highs relative to larger companies. Therefore, we prefer the larger end of the mid-cap market right now.
- Focused opportunities. Four years into a bull market, we are extra discerning. We are intent on finding companies that are charting their own path for growth, despite the macroeconomic fog. Some of our favorite areas include:
– Health care, notably pharmaceuticals.
– Information technology, particularly software.
Corporate America is at a crossroads of margin maintenance versus reinvestment. We are looking for companies that have made the choice to invest in their own futures and position themselves for growth. That choice may come with short-term consequences, as capital expenditures eat into profit margins. But our job is not to focus exclusively on the short term. Our job is to invest in sound businesses, at attractive valuations, with a long-term growth plan. That’s what we seek to do.
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The opinions expressed are those of the speaker, are based on current market conditions as of January 2013 and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
This does not constitute a recommendation of the suitability of any investment strategy for a particular investor.
The investment techniques and risk analysis used by the strategy may not produce the desired results.
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Past performance cannot guarantee comparable future results.
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