Savita Subramanian is Head of Equity and Quantitative Strategy at BofA Securities. Read on as we ask Subramanian to find opportunities in this volatile market, as well as his position on tech stocks and dividend payers.
Back when everyone was bullish and the market was making new highs, you had a disappointing outlook for stocks. How do you think this year will go? It’s going to be a volatile year – oh boy, huh! A lot has already happened.
Our year-end target for the S&P 500 is 4,600. When we released this in November, we looked bearish, but that’s basically bullish from where we are today. [4,329 on March 4]. But our goal could be reached several times this year; a straight at 4,600 is not our call. We will see steep declines and steep increases over the course of the year.
Based on our economic forecast for interest rates and inflation, fair market value is lower than it is today.
Investors have been focusing on geopolitics lately, but what else do you see in the market? The market is absorbing the idea that the Federal Reserve is backtracking on stimulus through lower interest rates, as well as through its bond-buying program.
We have also reached the peak of globalization. Over the past 20 years, there has been a huge expansion in profit margins thanks to lower labor costs, lower raw material costs, and lower taxes realized by moving outside the United States. Now we’re moving from free trade and open borders to more offshoring, with companies focusing a bit more on the domestic market, partly because of geopolitical friction, partly because of chain risk supply we’ve seen during the pandemic.
In addition, given the attention that companies pay to the environment, it is incumbent on them to set up shop locally rather than importing raw materials and exporting goods abroad to be processed – that’s a lot of carbon emissions. They’re also redefining business partners based on shared values, seeking the same kinds of corporate governance, transparency, and regulatory practices instead of just finding the cheapest areas to produce widgets.
How do investors position their portfolios on these themes? There is a risk to profit margins in the short term, as at least half of all this expansion over the past 20 years has been driven by globalization. This is one reason why we are less bullish on S&P 500 stocks relative to more domestically focused small cap stocks.
But this is going to be a year where choosing your spots is important. You want to research businesses that can benefit from the reopening and continued strength of the US economy.
On the negative side, we have already seen a significant pullback in high-growth stocks that benefit from low interest rates – companies that may not be generating a lot of cash flow today but promise great growth in the future. .
Where are the opportunities in this volatile market? When sifting through the rubble of the market today, the key factor to focus on is generating and preserving free cash flow. [cash profits left after investing to maintain or expand the business].
Think about supply and demand. Free cash flow is becoming scarcer and gaining in value: rates are a bit higher, so companies are paying more to borrow; they bear the higher costs of inflation; and if our call is correct and the Fed raises short-term interest rates seven times this year, cash will go from worthless to yielding near 2%. It doesn’t seem like much, but in a world where we don’t expect big jolts from stocks, 2% is remarkable.
Which pockets of the market do you like now? Healthcare is one area of the market that can continue to maintain pricing power, where you’ve seen the preservation of profit margins. And the importance of health care has been underscored by the global pandemic.
I like small caps because they are very cheap, and they always trade at a 26% discount to large caps – historically they have traded at an average premium of 2%. They are also surprisingly good in economic upturns and in times of inflation, and even during times of protectionism, which fits with our global to local theme. The risk is that if Fed tightening or geopolitical conflict catapults us into recession, small caps will not fare well.
In terms of market sentiment, which is a contrarian indicator, much of the world is still underweight energy and financial stocks. This makes these areas more interesting.
What’s your take on tech stocks? We had what seemed like a heartbreaking sale. Is it time to buy tech in bulk? No. Typically, sectors don’t hit rock bottom until everyone forgets about them. But there are plenty of companies whose prices have dropped so much that this could be a good entry point.
You really want to look for free cash flow rather than other things that sound more exciting, like strong growth or surprising earnings. I’m really focused on a pretty boring mantra: free cash flow is king.
In the longer term, what is your vision of equities? We are past the point of heady comebacks. Our valuation model, which isn’t that predictive in the short term but is a very powerful signal to think about how much money you’re going to make over the next 10 years, suggests that the annualized returns for the S&P 500 are going to be significantly lower over the next 10 years than this model was telling us in 2010 and 2011, when valuations were much more attractive. We expect returns in the low single digits.
What role will dividends play? Historically, a fairly large portion of total returns has come from dividends – 40%, if you think back to the creation of the S&P 500 data. Today, if we are looking for paltry or negative price returns, those dividends will contribute a greater proportion of your portfolio returns.
Look for companies with safe, stable and growing dividends – those that can increase dividends with inflation, rather than being compromised by the inflation cycle.
Where do you find good dividend payers? S&P 500 companies at all levels are more likely to increase their dividends. Last year, S&P earnings growth was 49%, dividend growth only about 20%. There is some catch-up in dividend growth that has already happened this year and will likely continue.
We see that many of the classic dividend-yielding sectors – consumer staples, for example – may not be the best places to get yield today. We favor energy companies. They are still relatively inexpensive, they strive to reduce their issuance risk, and they have become disciplined in capital management. We love finances – they have been forced to shore up their balance sheets, there is ample room to increase dividends and they are focusing more on their engagement with shareholders via dividends rather than share buybacks.
What would you say to novice investors to persevere for the long term? I have this conversation with my kids all the time. Here is my advice. It’s great that investing has gone mainstream and not just for the elite. I’m super happy with it. But there is a difference between trading and investing.
Look at the numbers: if you bought and sold the S&P 500 daily, you would stand a chance of making money. But if you buy and hold over a 10-year horizon, your risk of losing money is closer to just 5%.
Simply expanding your time horizon is a recipe for returns. When it comes to investing in stocks, you want to take a long-term view.
