More than two years into a robust bull market for stocks, buy-low opportunities may be hard to find. But contrarian investors can unearth some relatively low-risk opportunities — including a few that may be hiding in plain sight.
"The U.S. dollar ... is more likely to go up than down," says Rob Stein, senior managing director at Astor Asset Management in Chicago, when asked about out-of-favor investments. Reasons for fluctuations in the value of the dollar are widely misunderstood, Stein says.
"Some people point to QE2, economic stimulus and bailouts as probable causes for dollar weakness," he explains. "In truth, the dollar fell more sharply in the middle of the last decade than it did during the financial crisis a few years later."
In Stein's view, the value of the dollar is determined by three factors: interest rate differentials, trade flows and pure supply and demand for various currencies. All factored in, he sees the dollar appreciating at least 6% and perhaps as much as 10% by year-end. Continued economic growth and rising interest rates may put more bang into the buck. Stein argues that investment opportunities include dollar ETFs such as PowerShares DB US Dollar Index Bullish, net importers such as chipmakers and travel-related industries.
Stein also expects the S&P 500 and the Dow to reach new peaks in the next 18 months. "GDP and personal income are at all-time highs," he notes. "There are a lot of good things happening that are not getting much notice."
As of the end of May, the S&P 500 was about 16% lower than its 2007 peak, so domestic large-cap stocks would have to surge through the end of 2012 to fulfill Stein's forecast. Those equities, in fact, may be considered laggards, despite the hefty gains of the past two years. Morningstar reports that large-cap stock funds, through April, have annualized gains of around 3% for the past 10 years, trailing the broad category of domestic equity funds (up 4.5% a year) and well behind international equity funds (7.5% a year).
If large-cap domestic stocks have lagged for the past decade, are they likely to catch up in the coming years? Stein believes there may be opportunities among large-cap industrials, which will benefit from a growing economy, as well as the importers that stand to gain from a stronger dollar.
Ethan Anderson, senior portfolio manager at Rehmann Financial in Grand Rapids, Mich., is also upbeat on U.S. blue chips. "Large-caps are valued very attractively versus small-caps," he says. Anderson notes that the Russell 2000 small-cap index recently was 2.37 times more expensive than the Russell 1000 large-cap index. Historically, this spread is closer to 1.58, so large-caps appear to offer a more attractive risk-reward proposition.
Large-caps have other merits as well, according to Anderson. "From a qualitative standpoint, large-caps have more global reach and easier access to financing," he says. "Therefore, they have an advantage in today's marketplace." Anderson notes that small-caps may continue to prosper in a growing economy, but they could underperform in a slowdown or dreaded double-dip.
Mark Luschini, chief investment strategist at Janney Montgomery Scott in Philadelphia, agrees. "U.S. large-caps have largely cleaned up their balance sheets," he says. "They have lots of cash, and they stand to benefit from global growth. Those positive aspects are not reflected in current valuations." As the recovery moves to modest expansion, investors may put a premium on sustained steady profits, he adds. "This recovery is now in its third year, which often has been the time when large-caps move up."
RISING ... OR SETTING?
While large-caps have lagged other asset classes in the past decade, some investment classes have trailed even those 3% annualized gains. Japanese stock funds are at the bottom of the list of what's considered mainstream mutual fund categories, losing 3.7% per year. (Bear market funds managed to lose 10% per year during the turbulent past decade.)
Sentiment about Japan's future is mixed. "Japan is cheap, especially small-cap Japanese companies, which I own," says Jeff Saut, managing director of Raymond James & Associates in St. Petersburg, Fla. "Those stocks generally trade at less than book value, with single-digit price/earnings ratios."
Luschini also sees possibilities there. "By any measure — price to earnings or book value or free cash flow — Japan is the cheapest or among the cheapest of the world's major markets," he says. "Massive stimulus to help rebuilding after the recent disasters may help profits, and Japan's exporters will benefit from global growth."
Others remain cautious. "Japan has been an island unto itself for quite some time," Anderson says. "We don't see a lot of correlation in regard to valuation and market performance compared with other countries. Perhaps it has something to do with an aging demographic or the culture's propensity to save. In any case, we generally stay away."
Ted Wright, director of portfolio management at Genworth Financial Asset Management in Encino, Calif., is also in no hurry to buy Japanese stocks. "After all the devastation in Japan, I'd want to see more data before I'd look for a bounce-back."
The only other major fund category showing negative returns was communications funds, down 1.3% per year for the last 10 years. On the surface, the result is surprising given the explosion in wireless communications.
Morningstar analyst Janet Yang explains that this is a very small category, and the results were skewed by one fund. As of late May, ProFunds UltraSector Mobile Telecommunications had tortured investors with an annualized loss of nearly 25% for the last 10 years.
Even if you exclude this leveraged fund, the category still lagged, Yang says. "There has been a huge change in the past 10 years as the companies have gone from a regulated industry to a very competitive landscape." Increased competition often meant lower revenues, profits and stock prices. There might be brighter times ahead for certain communications funds. "Some are holding more tech stocks, and some are going abroad to the emerging markets, where there may be more opportunities for wireless companies," Yang says.
Saut concurs that some wireless companies could prosper beyond the borders of developed nations. "When I travel in emerging and frontier markets, I see tremendous use of the Internet. But many people don't have tablets or notebooks. Often, they use smart-phones for uplinks to the Internet." Saut is upbeat on companies that provide wireless connectivity in such markets, including NII Holdings, which operates in Latin American, and Millicom International Cellular, which serves Africa and other emerging markets.
Some funds barely made it into positive territory in the past decade. Through April, both technology and financial funds posted 10-year annualized returns of just 1.3%.
The scant results for tech partially reflects the crash of 2000-02. Even after a stellar 2009 and strong performance in 2010, the tech sector still may offer good value, analysts say. Global growth may spur demand for state-of-the-art technology, and the timing could be right.
"I'm back in technology," says Darrell Hoff, a financial planner in Cupertino, Calif. "My usual strategy is to wait for a full business cycle before investing in sectors that have collapsed. Now that we're through the 2008 recession, it has been a full business cycle since the dot-com bust. To participate, I'm investing in PowerShares QQQ, an ETF that tracks the Nasdaq 100 index, which is heavily weighted to technology stocks."
To Luschini, businesses are underinvested in technology these days. "It's probably time for investment to pick up as economies improve," he says. "Some major technology companies trade at modest price/earnings multiples."
While tech funds were pounded in this century's first stock market crash, financials performed relatively well. But financial funds were hammered by the last crash, in 2008-09. The category's weakness started earlier and continues, with financial funds trailing domestic equity funds in total returns for the last four calendar years as well as this year through the end of May.
Even as Hoff feels it's time to venture back into technology one full business cycle after the tech bust, he also feels it's too early to invest in financials. "If you wait, there'll still be lots of time to find good opportunities," he says.
Others echo the caution. "Financials are still laggards," Wright says. "It's a function of time before they can become more attractive. An improving economy will help."
Luschini agrees that financials will probably lag for a while. "Some of the businesses that generated profits are gone, and leverage is not as available," he says. "More stringent regulation has made the industry more conservative. Financial stocks may be becoming a nice dividend story, like utilities."
Saut is staying away from major banks, but finds some smaller firms attractive. "Iberia Bank, for example, is making acquisitions and will become a factor in its region," he says. The Lafayette, La., company has few construction loans in its portfolio, which is unusual for a bank in the Southeast. Iberia is a derivative play on energy because it lends to local companies in that industry.
He's also upbeat on People's United Financial in Connecticut, which he sees as a well-run bank in an area with a "wealthy footprint." The bottom line is that some financials may be good investments now, but stock selection is critical.
Bonds have generally had such a good run for so many years that prices are high, yields are low and investors face the risk that rising interest rates will devalue fixed-income assets. In this environment, are there any overlooked but viable opportunities?
Wright likes mortgage REITs. "They typically borrow short and lend long, so they like a steep yield curve." With two-year Treasuries yielding nearly 0.5% and the 10-year Treasury paying about 3%, the yield curve may be sufficiently steep for mortgage REITs to post profits.
This sector was "destroyed in 2008," Wright says, as mortgage woes triggered the financial crisis. There are still credit and liquidity problems, he acknowledges, while housing market fundamentals are "not much better" than they were a few years ago.
Nevertheless, those difficulties and more may be priced into mortgage REITs now. The FTSE NAREIT Mortgage REIT index, which peaked at 28.14 in March 2004, was at 6.88 at the end of April, up only slightly from the February 2009 low of 5.15. There is ample opportunity for a rebound, bulls say.
In addition, Wright thinks sentiment could improve, strengthening the housing market and bolstering mortgage REITs. "The labor market is improving," he says. "If that keeps up, we could see an increase in confidence, more buyers and less housing inventory."
A lot of companies in the sector have gone out of business, and the survivors are generally in better financial shape. "Today's mortgage REITs are pretty solid from a credit perspective," Wright says. "Their underlying assets are not bad and their dividends are high. Investors are getting paid to wait for a turnaround in housing." Overall, mortgage REITs now yield an eye-catching 13%. Wright invests through an index ETF, iShares FTSE NAREIT Mortgage Plus Capped Index Fund, which recently offered a double-digit yield.
Anderson also says bank/senior loan funds look attractive now; the average payout is 4.5%. "While many people may shy away from them because of their junk status, their high position in a firm's debt structure provides better protection against bankruptcy than the same firm's traditional debt," he says. Interest rates on these loans typically reset every 60 to 90 days, making them appealing in a rising rate environment.
Bank loan funds trailed all taxable income funds amid the turmoil of 2008, losing nearly 30% on average, and their 10-year returns also are at the rear of the pack. Nonetheless, in a healthier economy, yesterday's losers could turn out to be tomorrow's pacesetters.
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