The U.S. stock market is in positive territory for the year, but you wouldn’t know it by the looks of investor sentiment.
Confidence remains visibly shaken and a lackluster recovery is cause for concern, but piling into Treasuries that yield less than inflation will only handicap investors’ potential, says Ben Fischer, NFJ founder and portfolio manager.
With interest rates expected to hover at historical lows until the end of 2014, the Federal Reserve is pointing investors toward risky assets, specifically stocks. However, anxiety has been too high for low rates to coax them off the sidelines. That’s why the Fed will wield one of its policy tools to boost confidence and spur a “risk-on” environment, Fischer says.
In the following interview, Fischer discusses recent performance of the Allianz NFJ Dividend Value Fund and the Allianz NFJ International Value Fund, challenges and opportunities in today’s markets and what he expects from the Fed in the coming weeks. He also explains why he likes Cisco, toy maker Mattel, German industrial giant Siemens and Japan’s Komatsu, a mining-equipment manufacturer.
In the face of heightened volatility in recent months, how have the Allianz NFJ Dividend Value Fund and Allianz NFJ International Value Fund held up?
Fischer: On an absolute-return basis, performance has been fairly similar: the Allianz NFJ Dividend Value Fund has returned 7.62% and the Allianz NFJ International Value Fund has returned 8.84%, year-to-date through July 31 (I shares net of fees.) On a relative net basis, Dividend Value is trailing its benchmark, the Russell 1000 Value Index, by 2.18%, while International Value is ahead of the MSCI All-Country World ex-U.S. Index by 4.62% year-to-date. For context, the S&P 500 is up 11% year-to-date.
What is driving the disparity between the funds’ relative performance?
Fischer: Relative to its benchmark, Dividend Value has been less “defensively” positioned and more cyclically tilted than International Value. Other dividend players are more defensively positioned, which typically means they have higher P/E ratios. This positioning was more pronounced in the second quarter when the “risk-off” trade returned after two consecutive risk-on quarters, fueled by data showing the economy had slowed. Investors have been drawn to defensive, high-yielding companies in sectors such as telecom and utilities. Dividend Value has been underweight these areas, while International Value has been overweight. In the United States, stocks in these sectors have gotten expensive as investors bid them up in pursuit of higher returns in the face of low yields. Indeed, 10-year Treasuries are offering negative real yields.
While overweight positions in energy and materials have detracted from both funds’ performance, Dividend Value’s larger overweights to these more cyclical, economically sensitive areas of the market had a greater impact. Commodity prices (specifically industrial commodities) have gotten hit by continued slowing global growth and fears of a hard landing in places like China and Brazil. Mining company Freeport-McMoRan struggled in this environment after being one of our best performers in 2011. Like most U.S. stocks, shares of companies in these sectors did better, on average, in the U.S. than overseas, but they still have been clear laggards. International Value has also had positive effects from currency moves.
How has an underweight position in financials impacted performance?
Fischer: Financials have been among the best-performing stocks across all indices, likely driven by optimism for added government stimulus and relief over the Moody’s downgrade of global trading banks. But we remain cautious on financials because there is not enough clarity on their balance sheets and their key drivers of future earnings growth in the wake of the 2008 financial crisis. Our larger relative underweight in financials in Dividend Value meant a bigger hit to relative returns, however. Stock selection within financials has also made a difference: International Value got a big boost in relative returns from avoiding European financials altogether, and got strong performance out of Asian banks that have low exposure to Europe.
Which sectors in the Dividend Value portfolio have helped performance?
Fischer: Our stock selection in consumer staples helped. Wal-Mart was up after reporting its best same-store sales numbers in years. Kimberly-Clark did well following a positive earnings surprise, which it attributed to higher prices and volume maintenance. Whirlpool is up over 50% year-to-date, benefiting from a stabilizing U.S. housing market. The company recently renewed exclusive appliance partnerships with Beazer Homes and Meritage Homes—two top-10 homebuilders in the U.S.—which will allow it to continue to participate in the recovery. Earlier this year, the company announced a strategic alliance with Suning, the No. 1 appliance retailer in China, which will allow it to advance its emerging markets growth strategy. The stock is trading at 10.8 times forward earnings and provides a 2.8% dividend yield.
Another bright spot is Mattel, which reported strong year-over -year earnings (up 20%) and exceeded Wall Street expectations. The company is benefiting from successful price increases, which is helping to maintain margins, as well as strong sales from several product lines. These include the popular Batman “The Dark Knight Rises” toys, inspired by the summer blockbuster. Mattel has a 16% share of the global toy market and has a more diversified geographic revenue stream than its competitors. The stock is yielding 3.5%. The company also raised its dividend 35% earlier this year and has been buying back shares.
How should investors put the market and recent Dividend Value performance in perspective?
Fischer: U.S. equity markets are in positive territory year-to-date, but it feels like things have been worse because of the never-ending spate of negative headlines. Investors are bracing for a depression and a big downward move in the markets. With no identifiable catalyst for organic growth, everything hinges on the Fed and central banks around the world. With political paralysis in the U.S. and Europe, fiscal policy changes are unlikely to have much of an impact. However, monetary policy tools can boost investor confidence and keep the economy from falling off a cliff. Without Fed intervention, we’re headed for a recession.
Ultimately, the Fed will do what is necessary, which could include injecting liquidity through QE3. In fact, a September move from the Fed is likely. Any stimulus would have to be more than $500 billion to move the needle. Investors would then follow suit by taking on more risk rather than paying the government to hold their money—which is exactly what they’re doing by accepting 1.5% yields from Treasuries with 2% inflation. In a risk-on environment, our less defensive, more cyclically tilted portfolios are poised to take advantage.
NFJ sticks to a disciplined investment process through different market environments. What are the long-term benefits of such an acute focus on dividends and valuation?
Fischer: The powerful thing about combining dividend payers with a low-P/E value strategy is that you get paid to wait for the market to realize that these companies are undervalued. Legendary value investor John Neff once observed that with dividends you get to “snack on hors d’oeuvres while waiting for the main course” of P/E-multiple expansion. Of course dividends add far more value than that by helping preserve principal in downturns, and they have shown strong performance on their own over the past several decades.
We’ve been through this type of market before and survived. We’re not sector rotators trying to zig and zag with the market. We buy stocks that pose attractive opportunities from a valuation and yield perspective, particularly companies that have strong balance sheets and cash flows. Right now, that is leading us toward cyclical companies and away from more defensive areas of the economy. Balancing low valuation with dividend yield is a very powerful combination over full market cycles. In the long run, we’re confident that our style and philosophy will serve clients well.
Where is NFJ finding “cheap” names in the U.S. and across the globe?
Fischer: In the U.S., we’ve been trading down in valuation—and up in dividend yield—within industries. In tech, we bought software company CA Technologies, Inc. to replace Microsoft and we bought Cisco Systems to replace IBM in the Dividend Value portfolio. We also swapped out Merck for GlaxoSmithKline in the drug sector. We believe Europe is going to bottom, so we’re taking baby steps into such stocks as Siemens, which has been down for quite a while. Other opportunities we’ve seen recently are in health care, like AstraZeneca. Health care is a positive long-term theme that’s been handed to us on a platter, with stocks that are trading at less than 10 times earnings and have solid dividend yields. We are overweight versus the benchmark in Japan, where companies such as Komatsu and Fuji Heavy Industries should benefit from increased global activity.
Share