Active investors in North America face a number of persistent myths: The first, and most common, is that it is impossible to beat the US market. Many continue to believe that there is little mispricing in US markets, and – by extension – no scope for active managers to add value. The second is that the market is expensive: valuations are at all-time highs and there are no opportunities. The final problem for investors is the political situation, a disorganised government threatens the stability of stock markets.
Certainly, the US market is efficient and hard to beat. This is partly true over the past 12 months when market leadership has been dominated by four or five large technology companies. For those investors who have not held those stocks, it has been a headwind to beating the market return.
However, this is not the same as saying it is impossible to beat the market over the longer term. It is certainly difficult where a manager is holding a large, over-diversified portfolio, where they might hold 90-100 positions of just 1-2% of the portfolio, each held without significant conviction. However, holding a more concentrated portfolio, with fewer holdings and more conviction can be a means to deliver stronger returns.
Of course, building conviction isn’t easy. It takes manpower; getting out to companies, meeting management face to face, asking them uncomfortable questions, and building an understanding of how their business runs. Only by doing this is it possible to make a real call on whether the valuations are appropriate, potentially taking advantage of market over or under-reaction.
Having a smaller portfolio also keeps tighter control on the holdings: a stock needs to be sold to buy another stock. Investors are always on the look-out as to whether there is better value elsewhere. In our portfolio, we have recently sold five of our favoured holdings – Republic Services, Digital Reality Trust, MT Bank, Rockwell Automotive and Tiffany – all on valuation grounds.
We do not trade significantly, but in each case, we couldn’t see how the multiples were justified and wanted to rotate into companies that offered greater upside potential.
With The North American Income Trust, we are unlikely to own the FANG (Facebook, Amazon, Netflix and Google/Alphabet) stocks, as most don’t pay dividends. While this has been a headwind to relative performance, it also highlights a growing problem with the market. The FANGs now make up 12% of the market and can dictate market performance and multiples. Index investors are increasingly narrowly focused on a small number of highly valued companies.
On valuation, it has become commonplace to suggest that US markets are very expensive. Certainly some parts of the market are at peak multiples and peak margins and look ripe for a revaluation. However, the aggregate data is influenced by the high valuations of just a few companies: in particular, a few of the technology companies mentioned above.
This is not true for much of the wider market. Within the banking sector, for example, valuations look relatively modest. Capital adequacy has improved, there is no interest rate tailwind – interest rates are rising and regulation is falling. The banks in the index are all the big, global brands, such as Bank of America, JP Morgan or Goldman Sachs. These are exposed to capital markets and aren’t likely to benefit in the same way from rate rises. As such, we’re focused on regional mid-sized banks, looking for a diverse geographic footprint across the US. They are far more loan-and-deposit institutions, rather than making markets or doing initial public offerings (when a company offers its shares on the market for the first time). As such, they are more durable and have less volatility.
The other big issue facing US investors is the political situation. There is undoubtedly an impasse at the heart of government, which is making it difficult to pass legislation. However, we believe that this may be an advantage for investors. It means only sensible, fair legislation is being passed, rather than legislation that is narrowly partisan or self-interested.
At the moment, the US has an uncompetitive tax policy and any reduction in corporation tax makes sense. Equally, we have a situation where companies will borrow to pay dividends, rather than bring money back from offshore because of the higher taxation rates. It is an archaic system. It would have an impact for US markets if it changed, but it is not a necessity to support valuations.
As active stock pickers, we are still find plenty of opportunities at reasonable valuations in the US market. We are looking for companies that pay a strong organic dividend, that can grow the dividend over time. Importantly, as an income fund, we find plenty of companies that are willing to distribute excess cash to shareholders.
The US market is well-supported. Flows into equity markets are strong and there has been a pick-up in merger and acquisition activity. At the same time, earnings revisions are moving higher. It remains a buoyant environment for equity investors looking for capital growth and income from the US market.
The North American Income Trust plc, managed by Aberdeen Asset Managers, aims to provide investors with an above average dividend income and long term capital growth through active management of a portfolio consisting predominately of S&P 500 US equities.
The value of investments and the income from them can go down as well as up and investors may get back less than the amount invested.
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