MILWAUKEE, April 8, 2014With the bull market crossing the five year mark and the Federal Reserve unwinding quantitative easing, a panel of Baird equity and bond portfolio managers addressed Baird’s bi-annual PWM Symposium. The panel featured Michelle Stevens, Senior Portfolio Manager for Baird’s Small/Mid Cap Value team, Chuck Severson, Senior Portfolio Manager for Baird’s Mid Cap Growth team, and Warren Pierson, Senior Fixed Income Portfolio Manager.
The panel provided a range of views regarding market valuation, the current macro environment, and sector picks. They touched on the energy boom, opportunities in industrials, healthcare in light of the Affordable Care Act, the impact of Fed tapering, and municipal bankruptcies. To interview a Baird Portfolio manager, please contact Jody Lowe at email@example.com or (414)322-9311.Macro Environment Comments
Great environment to be investing in small cap and mid cap. Despite a long run of small cap stock outperformance, Small Cap Manager Michelle Stevens believes the prospects for growth to accelerate over the next year are still good. “Historically speaking, rising rates are good for small caps. We concentrate on domestic equities, partly due to our view that the US economy will improve and partly given that small caps tend to generate more of their revenue domestically. Our outlook is less sanguine on Europe.”
Chuck Severson also has a bias toward towards US-based companies in the mid cap space. “The United States is the best house on a lousy block for global growth; we see modest improvement with more stable and increased labor demand. We are incrementally more positive on Europe, which is getting better slowly and has clearly stopped getting worse. Asia is a bit of a concern given slowing growth, but we maintain some exposure in that region.”,/p>
Bond positioning in current rate environment. With the Federal Reserve keeping rates artificially low, few are buying bonds for return potential but are instead seeking stability, according to Warren Pierson. “Don’t be longer than you should be on this steep yield curve. We think the sweet spot is probably in the intermediate space.”
Despite dire predictions for bonds, Baird has seen net inflows into its fixed income products. “We are seeing strong two-way flows amidst investor concerns about rising rates, but inflows have been more pronounced. We’ve benefited from investors who added exposure to our core bond approach. We remain duration neutral and seek to add alpha through security selection versus some peers who make duration or currency bets to add value.”
Impact of Fed tapering on equities. Said Severson, “It can create tricky near-term situations, but we tend to take a positive view of tapering if the Fed eventually has to raise rates. Our perspective is that if it is due to improving economic activity and not just about liquidity, it will be good. In that environment, the industrial, technology and financial services sectors should perform well. We do have some credit exposure, primarily in banks and credit cards. We also like traditional asset managers and M&A as themes in an improving equity environment.”
Impact of tapering on liquidity. According to Pierson, the bond markets aren’t what they used to be given that dealers’ allocation of capital to their trading desk is less than it has been in the past. “Shocks tend to dry up liquidity and tapering may be one of those shocks – note that the initial tapering caused challenges in emerging markets given liquidity concerns. In this environment, bond investors need to maintain adequate liquidity to face uncertainty. Given our ‘core of the core’ approach, we seek to maintain layers of liquidity for adequate protection.”
Key Sector Thoughts
Small Cap overweight financials – After avoiding some traditional financials, the small cap value team has slowly gotten back in to financials. “In the last 12 to 18 months, we have lightened up on defensive financials such as mortgage REITs and alternative credit providers while adding banks and other lenders who will benefit in an improving credit environment.” Stevens likes companies issuing mortgages in an improving housing market such as Hilltop Holdings (HTH) a Texas lender which has an experienced CEO and right now is issuing more new purchase loans than refinancings. Another favorite is Bank of the Internet (BOFI), a bank with only one branch that keeps costs low and efficiency high in order to drive volume.
Mid Cap overweight industrials – With a US economy growing faster, Chuck Severson likes industrial stocks. “The competitiveness of higher-quality industrial companies is the best it has been. These companies are fundamentally better, and are enjoying better returns and margins. Additionally, many companies are bringing production back to the US – a positive for new construction and retooling of existing plans. Rockwell Automation (ROK) is a prime beneficiary of these trends. Finally, the significant investment in energy infrastructure – drilling, pipelines and even crude by rail are themes that play into the industrial renaissance.”
Small Cap also overweight energy – For Stevens, finding companies levered to the shale play domestically is an important theme. “We find the best ways to invest are the infrastructure plays, including trucking companies to haul water for fracking or businesses building out the pipelines to take it to the gulf coast. As a way to play the secular growth in liquefied petroleum gas (LPG) trade, we are invested in a shipping company, Navigator Holdings (NVGS) which operates specialized semi-refrigerated gas carriers and Targa Resources (TRGP) which stores, fractionates and transports natural gas liquids.”
Finding Consumer discretionary with underappreciated balance sheets. Despite the strong run, the value team is finding individual companies with strong balance sheets that are attractively priced in the consumer discretionary sector. “We like both Hanesbrands (HBI) and Jarden Corp (JAH) and have seen both take the cash they hoarded during the downturn and put it to work. Both made large ‘tack on’ acquisitions where they knew what they were getting and could augment their cash flow. Hanes bought Maidenform and Jarden bought Yankee Candle. Again we like the more domestically focused names.”
…However, some growth names are expensive. On the growth side, consumer discretionary has been the top performing sector since 2009. Said Severson, “In some cases, we had a bit of altitude sickness from very high multiples. We have pared back several positions recently, including Under Armour (UA). However, you typically get a pullback after year-end results are reported, and we have begun selectively adding again, most recently in Tractor Supply Company (TSCO).”
Healthcare has opportunities despite uncertainty. The Mid Cap team has a number of healthcare names, despite the added uncertainty of the Affordable Care Act. Said Severson, “Our approach is to focus on the less controversial aspects of the law, such as mental healthcare. We have a position in Acadia Healthcare Company (ACHC), which is a facilities based mental health company. We’ve known the management team a long time, which gives us comfort that the business is well run and that they know how to operate in this complex environment. Additionally, we have also maintained positions in companies that help reduce the overall cost of healthcare such as generic and private label pharmaceuticals, healthcare IT and pharmacy benefit management.”
While a few bankruptcies made headlines this year, bankruptcies will be the exceptions, according to Pierson. “The value from the experience is that it has raised sensitivity to credit risks. For many, municipals used to be a close second to Treasuries. But that has changed.”
Last year money flowed out of municipals when the taper started and bankruptcies increased investors’ sensitivity, but that has started to reverse. However, there are continued structural issues that municipalities need to address, according to Pierson. “Even though revenues are rising, expenses are still rising faster. Many municipalities will continue to be challenged to meet the promises that were made in some situations. In selecting municipal credits, our approach is wealth preservation by paying particular attention to issue selection. It is analogous to the used car market where you need to be very selective! Happily, there are lots of opportunities; it just takes work to find them. We’ve recently purchased a few local G.O. bonds in Illinois where the credit fundamentals are solid yet the bonds seem to be marked down due to the State’s budget challenges.
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This is not a complete analysis of every material fact regarding any company, industry or security. The opinions expressed here reflect our judgment at this date and are subject to change. For additional information on the securities mentioned contact us at 1-800-792-4011.
Baird makes a market in the securities of Rockwell Automation, Targa Resources, Under Armor, Tractor Supply Company and Acadia Healthcare Company. Robert W. Baird & Co. and/or itng related compensation from these companies within the next 3 months.
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Small and mid-cap stocks may be subject to a higher degree of risk than more established companies’ securities. Securities of small and mid-size companies may be more volatile, less liquid and face greater risks and price fluctuations than larger, more established companies. Fixed income securities’ value generally declines in a rising interest rate environment. Some of the potential risks associated with municipal bonds include call risk, reinvestment risk, default risk, and inflation risk.