Month: November 2015

Market Perspective: Stronger U.S. Dollar Weighs on Commodities & Foreign Stocks

Equities rebounded over the past month, approaching 2015 highs, as Internet companies led the Nasdaq 100 to a new record. Strong jobs data from October and Federal Reserve assertions reversed interest rate expectations ahead of the December hike now predicted by many market analysts. In turn, the bounce pushed the U.S. dollar even higher. Contrary to gains in the dollar, commodity prices fell. Oil, copper, gold and iron ore all suffered declines, coinciding with weak Chinese economic data and its slowing economy.

The U.S. labor market saw 276,000 new jobs added in October, exceeding expectations and lowering the unemployment rate to 5 percent. The Federal Reserve considers this full employment, lending strength to the data supporting a rate hike. This puts even more pressure on the Fed to raise interest rates.

In addition to jobs data, incoming economic data has been quite positive. Wholesale inventory data for September was stronger than expected, and is one of the most significant data points affecting GDP revisions. Third-quarter GDP was 1.5 percent as of the first estimate, but the second estimate at the end of November should be higher due to larger inventories. As for the current quarter, the Atlanta Federal Reserve’s GDP Now model currently forecasts 2.3 percent growth in response to a projected increase in consumer spending and fixed asset investment.

Earnings season has been mixed for stocks. Of the approximately 90 percent of companies that have reported thus far, 74 percent have exceeded earnings estimates, although only 46 percent have beaten their revenue estimates.

With economic data supporting rate hikes and investors adjusting their expectations accordingly, the financial sector started leading the market in November, while rate-sensitive sectors, such utilities and real estate, have lost ground. The S&P 500 Index was originally forecast to see earnings fall 5.2 percent, but the decline has shrunk to only 2.2 percent thus far. Pulling earnings higher was healthcare, which gained 14.5 percent, more than double the estimates. Consumer discretionary stocks grew 13.2 percent, 30 percent above what was estimated. Financials have reported growth of 5 percent, shy of the 5.8 percent estimates. Energy fell 56.6 percent and was largely responsible for the drop in S&P 500 earnings. Although the decline in energy was steep, it was still 8 percent better than forecast.

Estimates for the current quarter are declining, as they commonly do. Analysts tend to start optimistically, only to become overly cautious before the onset of  reporting season. The financial sector is currently expected to grow earnings 12 percent in the fourth quarter, while consumer discretionary and healthcare should improve by 7.5 percent and 6.0 percent, respectively. Energy is still predicted to pull earnings lower with a 65 percent  drop, followed by a 19.9 percent decline in materials and a 7 percent drop in technology. The S&P 500 Index is forecast to see earnings slide 3.7 percent.

While the U.S. remains sound, China’s slowdown continues to weigh heavily overseas. The outlook is worsening for materials, which are expected to see a double-digit drop in earnings in the fourth quarter. Copper is a key industrial commodity. Dubbed “Dr. Copper” for its ability to predict economic growth better than PhD economists, copper is trading at a new 5-year low. Other industrial commodities such as iron ore and steel are in even poorer shape. China accounts for at least a plurality of demand for all of these metals and, in some cases, the majority. Due to slowing growth in China as well as a rebalancing away from infrastructure development, demand for natural resources is falling. To make it even more challenging, the government has refused to close steel mills over the past several years. The result is an incredible supply glut, with Chinese exports surging onto the world market as the massive overproduction is no longer being used domestically.

Improving economic growth, a stronger currency and cheaper imports have historically been positive for investors in the United States. Global investors, including those in China, are looking to escape domestic currency risks by owning U.S. dollar assets. Solid, dividend-paying companies will remain attractive to foreign investors, while domestic sectors that benefit from trends in interest rates, such as financials, will begin to outperform.

Fund Spotlight: Invesco Diversified Dividend Investor Fund (LCEIX)

Dividend-paying stocks remain a very attractive option for core holdings, despite the likelihood of increasing interest rates. Dividend-paying companies tend to be financially stronger than their competitors and are typically under pro-shareholder management. Over the long term, a significant portion of returns is generated by dividends, especially in a flatter year, such as 2015. Unless stocks end the year with a strong rally, dividends could easily deliver 50 percent or more of the year’s returns.

Established in 2005, the Invesco Diversified Dividend Investor Fund (LCEIX) primarily seeks long-term capital growth with a secondary focus on current income. To accomplish these goals, the fund invests in dividend-paying stocks that the portfolio manager, Meggan Walsh, and analysts believe are undervalued based on numerous metrics. In addition to domestic issues, the five-star Morningstar-rated large value fund may invest up to 25 percent of assets in foreign securities. More than $1 million of the fund manager’s personal assets and a portion of the management team’s deferred compensation are invested in LCEIX, resulting in a strong alignment between the personal goals of the management and that of its investors.

Investment Strategy

The team focuses on firms with stable management, healthy balance sheets and free cash flow growth as well as strong earnings over the next 2-to-3-year period. When selecting dividend-paying stocks, managers and analysts focus on companies that pay steady or increasing dividends. The stocks should also be at least 35 percent undervalued based on several discounting models and valuation measures. Investment ideas are run through several downside market scenarios to measure overall risk versus reward, seeking stocks with at least a 3-to-1 upside potential. Holdings are considered for removal from the portfolio when fundamentals deteriorate or the stock price drops 15 percent below the cost basis for an extended period. This measure enables the fund to generate total returns by balancing capital appreciation and income with capital preservation. The portfolio typically holds 70 to 85 stocks that cover all sectors.

The fund uses a “winning by not losing” philosophy to keep its earnings and performance up in down markets. While the fund has underperformed in strong bull markets, the tenet has enabled the fund to beat the underlying index 83 percent of the time in bear markets. LCEIX focuses on high-quality stocks with a concentration in defensive sectors. It also holds a large cash position to protect against a broad decline in the market. While limiting its upside potential, the philosophy has enabled the fund to succeed over the long term. LCEIX has 3-year upside and downside capture ratios of 86.26 and 74.65, compared with the equivalent large-value category averages of 91.76 and 109.47, respectively.

Portfolio Composition and Holdings

As of October 30, 2015, the fund has $11.79 billion under management. The fund has a 78 percent exposure to U.S. stocks and a 12 percent investment in foreign shares held entirely in the United Kingdom and developed Europe. In addition to a 31 percent exposure to giant-cap shares, the fund holds 39 percent of assets in large-caps, along with 27 percent and 3 percent in mid- and small-cap shares, respectively. The portfolio has an average market cap weighting of $28.5 billion compared with the category average of $75.6 billion, plus a price-to-earnings ratio of 18.17 and a 1.99 price-to-book ratio.

The sector weightings reflect the fund’s defensive risk/reward attitude. The portfolio is overweight consumer staples and utilities and underweight energy, healthcare, technology and financial services. The fund holds 86 individual issues, which makes it more concentrated than the average of its category peers. The top 10 holdings make up slightly more than 23 percent of total assets. In descending order, they are General Mills (GIS), Campbell Soup Company (CPB), Coca-Cola (KO), Heineken (HEINY) and AT&T (T), Eli Lilly (LLY), Kraft Heinz (KHC), Walgreens Boots Alliance (WAG), PPL Corp. (PPL) and Target (TGT). The fund has a very low 6 percent annual turnover rate, well under the Morningstar large-value category.

Historical Performance and Risk

LCEIX has above-average returns and low risk ratings from Morningstar. As of the end of October, LCEIX has delivered total 1-, 3- and 5-year returns of 5.99 percent, 14.86 percent and 12.49 percent, respectively. These compare with the category returns over the same periods of 0.80 percent, 13.10 percent and 11.18 percent. While lagging the S&P 500 slightly over the past 3- and 5-year periods, LCEIX beat the major market index over the most recent 1-year period and is on par with the index year-to-date. Strong stock picking has helped drive these results. The fund’s consumer defensive stocks have been the primary contributors to the recent performance because the sector has outperformed year-to-date.

LCEIX has a 3-year beta and standard deviation ratings of 0.77 and 8.76, respectively. These compare with the large value category averages of 0.98 and 10.84.

Fees, Expenses and Distributions

LCEIX has a 0.76 percent expense ratio and a 12b-1 expense of 0.18 percent. The fund has a minimum initial investment of $1,000 and a subsequent investment minimum of $50. The most recent quarterly income distribution occurred on September 17, totaling $0.069 per share with a reinvestment price of $18.35. Capital gain distributions are paid annually in December. The 2014 distribution equaled $0.3642 per share. The current 12-month SEC yield is 1.69 percent.

Outlook

While the fund’s prudent approach generates returns that lag the Russell 1000 in stronger markets, the investment strategy has limited its downside during bear markets. It also comes with a relatively low expense ratio for an actively managed fund. Although distributions have been limited and the yield is a bit on the low side for a dividend fund, returns have been solid. The result is a strong long-term risk-versus-reward profile that has beaten the Russell 1000 Value Index on a risk-adjusted basis since the fund’s inception. This should continue in the future as the fund’s performance during the market’s recent volatility confirms that its portfolio and prudent investment strategy are well positioned to weather a sustained market correction.