by Meggan Walsh, Senior Portfolio Manager, Invesco
The ninth anniversary of the current bull market recently occurred in March — which is the second-longest period without a 20% drop in the closing price of the S&P 500 Index.1 While some market-watchers debate exactly how to measure the beginning and end of a bull market, the Invesco Diversified Dividend Fund team is focused on the profit cycle and valuation. We believe the profit cycle has moved into its latter stage and that valuations are currently extended. With this in mind, we remain focused on our fundamentally driven, bottom-up process.
Where markets are today
No one knows exactly when today’s bull market will end or when the appetite for growth and momentum stocks will abate. But we may see some key indicators that suggest growth opportunities may be harder to find. We are not macro investors, but our bottom-up research process offers insight about how the drivers of corporate earnings can change over a cycle. This profit cycle has seen the largest profit margin expansion in 50 years despite a weaker than normal economic expansion versus previous cycles.2 A key question for us is how much of the expansion is structural, due to factors like better supply chain management and reduction of fixed costs, and how much is cyclical, due to factors such as corporations benefiting from lower funding costs due to historically low interest rates.
We believe the profit cycle is in its later stages as profit margins have peaked,2 the credit cycle has troughed, sales growth remains below historical recovery period levels and wage/cost pressures are rising with a tightening labor market. Further, productivity growth has averaged 0.6% since 2010 compared to 2.1% on average for each business cycle since 1948.3 In the absence of greater topline and/or productivity gains, operating leverage will naturally decline in the latter stages of a cycle, and management teams will look for other ways to generate returns. We have seen this transpire with both share buybacks and M&A activity being consistent with prior peaks of 1999 and 2007.4 Though we generally applaud the return of capital to shareholders via buybacks, we don’t believe this is always the best use of capital, particularly when companies are repurchasing shares at expensive valuations.
How we’re positioned for tomorrow
Our goal is to build a solid foundation for investor portfolios by adding value with less risk over a full market cycle — that includes both bull and bear markets. Our process is focused on total return, seeking to provide capital appreciation, current income and capital preservation throughout the cycle.
Our process has remained the same for the past 15 years. Over the past year, we have been very focused on our downside risk analysis, stress-testing our company models to help determine how companies may perform in a less favorable environment for profits.
Overweights
Our biggest overweight versus the benchmark is in the consumer staples sector. (The fund had a 19.48% weighting in the sector versus 8.60% for the Russell 1000 Value Index as of Dec. 31, 2017.5) We have high conviction in the resilience of cash flows and earnings generated by our consumer staples holdings, particularly given efforts in recent years to improve margins by reducing costs and complexity, implementing supply chain efficiencies and optimizing brand portfolios.
Another sector in which we’re overweight is utilities. (The fund had a 15.37% weighting in the sector versus 5.91% for the Russell 1000 Value Index as of Dec. 31, 2017.5) Our utilities exposure has ranged from 3% to 15% historically, and we are now at the high end of that range. We have identified several investment opportunities in utilities in recent years based on our triangulated valuation approach as sentiment, particularly around rising interest rates, created dislocation in stock prices.
Underweights
Our biggest underweight is in financials. (The fund had a 13.90% weighting in the sector versus 26.68% for the Russell 1000 Value Index as of Dec. 31, 2017.5) We believe financials are modestly attractive today on a P/TB (price to tangible book value) basis. However, we have a more conservative view of banks’ full cycle ROA (return on assets) versus the Street. While investors were focused on the myriad of macro and regulatory headwinds from 2009 to 2011, our bottom-up research identified numerous regional banks that were attractively valued with strong deposit franchises and sound capital ratios. Though some are still reasonably attractive today, our extensive analysis indicates that the opportunity for growth in book value is currently less apparent.
We are also underweight in information technology (IT). (The fund had a 0.94% weighting in the sector versus 8.45% for the Russell 1000 Value Index as of Dec. 31, 2017.5) Most of the best performing names in 2017 were momentum-oriented, which is not a part of our investment process. Within the value universe, some companies are subject to secular risks given rapid technological change that could negatively impair their business model. Today we see IT companies with high valuations and/or business models threatened by these secular changes.
Key takeaway
The goal of our strategy has always been to provide capital appreciation with better downside preservation. This full-cycle mindset has been embedded in our investment process since the strategy’s inception. More recently, we have placed particular emphasis on managing downside risk through sensitivity analysis of our modeled assumptions, given our belief that the profit cycle appears to be waning, valuations are extended, and the narrowness of market conditions warrants focus.
Learn more about Invesco Diversified Dividend Fund.
1 Source: CNBC, “On the bull market’s ninth birthday, here’s how it stacks up against history,” March 8, 2018
2 Source: Cornerstone Macro
3 Sources: Bureau of Economic Analysis, Bureau of Labor Statistics, JP Morgan
4 Source: JP Morgan
5 Sources: Invesco, Russell. Sector weightings are subject to change. The fund holdings are organized according to the Global Industry Classification Standard, which was developed by and is the exclusive property and a service mark of MSCI Inc. For full index definition, see slide 75. An investment cannot be made directly in an index. Percentages have been rounded and may not equal 100%. Data for the fund holdings includes invested and uninvested cash.
Important information
Blog header image: Christian Mueller/Shutterstock.com
A credit cycle describes the phases of access to credit by borrowers. In earlier stages, credit is relatively easy to obtain. In later stages, the availability of funds contracts.
Operating leverage measures a firm’s reliance on fixed and variable costs.
Share buybacks refer to companies purchasing their own shares.
Valuation is how the market measures the worth of a company or investment.
Price-to-earnings (P/E) ratio measures a stock’s valuation by dividing its share price by its earnings per share.
Price-to-tangible-book value measures a company’s market price relative to what a shareholder would receive if a company were liquidated.
Return on assets (ROA) is a measure of profitability, calculated as net income as a percentage of total assets.
The Russell 1000® Value Index is an unmanaged index considered representative of large-cap value stocks. The Russell 1000 Value Index is a trademark/service mark of the Frank Russell Co. Russell® is a trademark of the Frank Russell Co. An investment cannot be made directly in an index.
Sector weightings mentioned are subject to change. Invesco Diversified Dividend Fund holdings are organized according to the Global Industry Classification Standard, which was developed by and is the exclusive property and a service mark of MSCI Inc.
Investments focused in a particular sector, such as consumer staples and utilities are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.
The profitability of businesses in the financial services sector depends on the availability and cost of money and may fluctuate significantly in response to changes in government regulation, interest rates and general economic conditions. These businesses often operate with substantial financial leverage.
Many products and services offered in technology-related industries are subject to rapid obsolescence, which may lower the value of the issuers.
Invesco Diversified Dividend Fund Risks:
The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.
The Fund is subject to certain other risks. Please see the current prospectus for more information regarding the risks associated with an investment in the Fund.
Meggan Walsh, CFA®
Senior Portfolio ManagerMeggan Walsh is a Senior Portfolio Manager and Head of the Dividend Value team for Invesco.
Ms. Walsh is the architect of Invesco’s diversified dividend investment process, established in 2002 as Invesco Diversified Dividend Fund. Her professional investment experience includes more than 10 years as a fixed income manager and more than 19 years as an equity manager.
Ms. Walsh has been in the investment business since 1987. She joined Invesco in 1991 as a trader of short-term taxable fixed income securities and was promoted to vice president and portfolio manager in the long-term fixed income area in 1992. In 1998, Ms. Walsh assumed portfolio management duties in Invesco’s equity department. She earned a promotion to senior portfolio manager in 2000.
Prior to joining Invesco, Ms. Walsh managed money market securities and conducted financial analysis for Nationale Nederlanden, N.A., a multinational financial service organization.
Ms. Walsh earned a BS degree in finance from the University of Maryland and an MBA from Loyola University Maryland. She is a Chartered Financial Analyst® (CFA) charterholder and a member of the Invesco Women’s Network management committee.
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