Charlie Dreifus: Margin Levels Look Safe Despite Tepid Economic Growth by Royce Funds
Portfolio Manager Charlie Dreifus comments on the Fed’s March statements and the first quarter’s economic lull, discusses why dividend-paying stocks remain an attractive investment option, and makes a case for risk management in the current climate.
What do you make of Fed Chair Janet Yellen’s remarks in March—do you see the Fed as growing more hawkish or remaining dovish?
The Fed’s meeting in March largely confirmed what I have been expecting, which is that we will not see a rate hike before September—if we see one at all in 2015.
So I still see the Fed as essentially dovish, primarily because of their lower economic growth and inflation outlooks.
Rates will obviously rise at some point, and that’s a good thing, especially as it indicates that the Fed is taking the economy off life support and putting it on a road to recovery. And the central bank’s recent actions confirm that we will not see a repeat of 1937 or a short-circuiting of the long, slow economic recovery.
Are you concerned about the soft patch that hit the U.S. economy in the first quarter of 2015?
I think we’ll all be monitoring second-quarter data even more closely for signs that the first quarter’s soft patch was transitory. We’re all hoping that the cold weather, the West Coast port strike, and other developments that hindered growth all turn out to be non-recurring events.
The soft patch certainly got the Fed’s attention. One bit of good news is that ISI data released in late March looked encouraging. My own view is that the economy will keep growing though perhaps not at the robust pace some have been predicting.
Do you think most companies remain in sound shape in spite of the recent soft patch?
Company guidance has been downbeat since before the winter set in, but the practice of keeping expectations low for the purpose of “beating” them later has become more and more common.
Of course, share buybacks are another way businesses can meet or exceed E.P.S., so it’s not surprising that February saw the highest dollar value of share buyback authorizations ever.
Stock prices have come a long way since the bottom on March 9, 2009, but so have earnings. Operating margins have more than doubled since that bottom, up 106%, and there has been accompanying share shrinkage. Yet according to Strategas, sales per share are up only 11.8%.
Leaner and meaner business practices, robotics, and lower break-even points have all allowed for margin expansion with comparatively little sales growth. And I still believe that current margin levels are not at risk of falling much.
I have observed substantial incremental expansion from many companies, often with little or no sales growth. As long as the economy is growing—even at a tepid pace—I expect more businesses to experience additional incremental margin expansion.
Why do you think dividend-paying stocks remain an attractive investment option?
Over the last 80-plus years, 46% of an equity investor’s total return came from dividends. That’s one reason I’ve always focused on dividend-paying companies.
The combination of a competitive return, a reasonable valuation, and continued dividend growth—preferably annually—represents to me a very attractive mix of attributes. As Albert Einstein said, “Compound interest is the eighth wonder of the world.”
How would you describe your outlook on the market?
I would not say that stocks are inexpensive because that’s simply not the case. However, the context of the current climate is important.
The bears who trot out graphs of valuations relative to GDP or sales seem to me to be missing one very critical fact—namely that corporate profitability is way up, which means that it is indeed different this time.
No doubt the bears would respond that these profit levels are unsustainable, but I would counter that they’re overstating the case. I think that’s one reason why Fed Vice Chair Stan Fischer has been relatively quiet despite his focus on financial stability risks and bubbles. The T.I.N.A. Principle—”There Is No Alternative“—for equities remains alive and well and is expanding abroad.
What is the case for a risk-conscious, active approach like yours in the current market climate?
Increasingly, I believe the market requires more granular attention, which should favor active managers and other stock pickers. We all certainly hope our turn has arrived.
What’s received little mention in these discussions is the fact that earnings multiple dispersion is beginning to look extended. Make no mistake—problems still exist, from ISIS to income inequality to debt and productivity issues.
A potential surprise could still be higher earnings resulting from higher organic revenues (even those attained gradually) that will allow the latent incremental margins to kick in.
I still believe that for those investors who want exposure to U.S. equities but are concerned about the degree to which the market has risen, a proven, time-tested, and disciplined approach remains attractive.
