2023-07-17 18:50:50 ET
Summary
- 2022 was a confusing year for the market, with high dividend-paying stocks remaining resilient despite the Fed raising rates to levels above their collective yields.
- The strongest U.S. companies such as Apple and Microsoft are back on track in 2023, and we're excited about Apple's 'Vision Pro' and Microsoft's AI opportunities, respectively.
- We think large cap growth will remain the best investment strategy in the coming decade thanks to the area's strong cash-based sources of intrinsic value.
- Banking and energy equities remain unattractive, in our view, and we expect the pressure on value-oriented equities to continue given their net-debt heavy balance sheets and dividend liabilities.
- Overall, we're very bullish on the markets for this decade, and we believe big cap tech and large cap growth remain the places to be.
By Brian Nelson, CFA
Last year, 2022, was one of the most messed up market environments I have seen in a long time. The Fed was raising rates and yet dividend growth and high dividend-paying stocks were resilient, despite certificates of deposit at the local bank and Treasury bills yielding more than these equities. On the other hand, the strongest companies as measured by cash-based sources of intrinsic value--net cash on the balance sheet and future expected free cash flow--had one of their worst years, despite having characteristics of being safe havens.
This is worth repeating: Big cap tech and large cap growth were and are defensive (secular) growth positions and are the home to many very attractive businesses, unlike the net-debt-heavy, slow growing old industrial-economy names that are held down by dividend liabilities, which eat up most of their capital appreciation potential. Even Big Oil somehow found a way to rally so much during 2022 that if one didn't overweight energy in their portfolio, it was really hard to beat the market-cap weighted market return last year. Suffice it say, 2022 made absolutely no sense to us at all, and it left many confused.
Granted, the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio outperformed the market-cap weighted market last year, but things are finally making sense again. With the risk-free-rate yielding more than most U.S. equities, dividend growth and most income strategies are now under pressure. This makes perfect sense to us. The strongest U.S. companies are now back on track with Apple ( AAPL ), Microsoft ( MSFT ), and the areas of big cap tech and large cap growth leading the way so far in 2023. This makes perfect sense to us.
After all, these types of companies have strong net-cash-rich balance sheets and tremendous upside potential as the market builds in ever-increasing expectations of future free cash flow thanks in part to the catalyst of artificial intelligence [AI] spend. At Valuentum, we think the discounted cash-flow model is one of the most important tools to understand market movements and market returns. There is a reason why, for example, entities such as Apple and Microsoft, with their large net cash positions and strong free cash flow generation capacity, dominated last decade, while master limited partnerships ( AMLP ), with their huge net debt positions and meager retained cash flow, suffered.
Nominal gross domestic product for U.S. (St. Louis Fed)
Thank goodness that the broader markets are now also doing well, too. Heading into 2022, we had posited that inflation would eventually be a positive dynamic to equities, but we looked kind of silly through most of last year as our thesis largely fell on deaf ears (and many long-term investors panicked). However, investors are now starting to come around to focus on just how far U.S. nominal gross domestic product has increased since the depths of the COVID-19 crisis (see image above). The U.S. economy is simply booming, and the U.S. equity markets are back. Almost everything from my perspective is making sense again, and I'm feeling pretty good about it. A rational market like the one so far in 2023 is a comforting market.
Last year's market was not comforting as it made very little sense. It's somewhat unfortunate for many that 2023 has been such a strong year, too. Many likely sold out of equities during the back half of 2022, buying into Treasury bills while others opted for more equal-weight equity market exposure, or doubled-down on old industrial economy names that held up last year, but have done pretty much nothing so far in 2023 as big cap tech and large cap growth have soared. Not only this, but the stylistic area of small cap value has suffered as a result of its financials exposure in light of a looming transformation in the regional banking sector as a result of the crisis earlier this year.
We don't think material banking sector exposure outside traditional diversification considerations makes much sense given the heightened regulatory environment that would almost certainly pressure return on equity [ROE] in the coming decade. The regulatory pressure against fossil fuel production means taking a long-term position in energy equities just doesn't make a lot of sense either. That leaves most of the stylistic area of "value" as unattractive, in our view, with the balance of "value" heavily exposed to companies with large net debt positions and dividend liabilities that weigh on long-term capital appreciation potential. The trade for the coming decade seems, almost by default, to be one of the "growth" variety.
But where should investors go among growth options -- small growth, mid growth, or large growth? In our view, small caps just don't have the balance sheets to really build the foundational support for resilient intrinsic values. Many are also exposed to potential dilution in the event that new capital would need to be raised. Mid cap growth sounds like a good place, but for us, it's clear that large cap growth is probably the best consideration for long-term investors. In this area, one is getting some of the best companies in the world, and they simply aren't going away. Here is the top 10 for the Schwab U.S. Large-Cap Growth ETF ( SCHG ), for example:
The Schwab U.S. Large-Cap Growth ETF's (SCHG) top holdings. (Schwab)
The top 10 companies of the SCHG are amazing, and while they may jockey for position in the coming years, we like the collective weighting of these names. Apple is simply on fire, and we think the 'Vision Pro' will knock the ball out of the park when it comes to fiscal 2024 numbers. Microsoft's ownership stake in ChatGPT and the integration of AI across its suite of products offers a huge catalyst over the next 5-7 years that the market is just now starting to factor in.
We're less enthused about Amazon ( AMZN ) as we describe in this note , but it's an "okay" company, and while Nvidia ( NVDA ) and Tesla ( TSLA ) have had monumental runs so far in 2023, we expect both of them to eventually grow into their valuations. Alphabet ( GOOG ) ( GOOGL ) remains one of our favorite companies, too, thanks to its tremendous net-cash-rich balance sheet and future expectations of free cash flow.
Alphabet has upside in AI, and the global search market is large and growing fast enough that we don't expect competition to eat Alphabet's lunch. But even if Alphabet does eventually lose share in search, it would likely be Microsoft's Bing that would take it, and that's actually a good thing for large cap growth (given Microsoft's weighting in this area, too). Even if Alphabet falters, large cap growth may not.
As with Amazon, we're not that excited about Meta Platforms ( META ), but mostly because the company is doing well as a result of cost-cutting as opposed to material revenue growth. Meta's balance sheet isn't as strong as it once was either due to its misstep with the metaverse, and for a company that showed the kind of weakness in free cash flow that Meta did over the past 12-18 months, we're just not willing to trust the name again. It used to be an awesome company, but now Meta is just a good one, in our view, with its vulnerabilities having been exposed last year.
UnitedHealth ( UNH ) offers a good balance of modest healthcare exposure--it, too, has a solid balance sheet and tremendous free cash flow generation--while Visa ( V ) is probably one of the best companies in the world given its massive operating margins. Visa benefits from the network effect, doesn't take on credit risk like Discover ( DFS ) or American Express ( AXP ), and is an excellent play on the continued move to a "cashless" society. We view Visa as a consumer discretionary idea, not a financials entity in the traditional sense given its lack of banking-related dynamics. A run on Visa cannot occur, unlike that which happened to SVB Financial ( SIVBQ ).
Large cap growth (SCHG) has trounced the market, the stylistic area of 'small cap value' and the area of 'dividend growth' for some time now. (TradingView)
What are some of the risks?
First, we probably saw the biggest one during 2022: The market could just get things flat-out wrong for a while. Sure, inflation was raging last year and this may have impacted valuations via discount rates on the future expected free cash flows of longer-duration equities (i.e. those with free cash flows not expected to occur until long into the future), but big cap tech and large cap growth were and are already generating substantial free cash flows. Longer-duration equities are more like those found in the ARK Innovation ETF ( ARKK ), not in the areas of big cap tech and large cap growth, which are already throwing off tons of cash. A technical rotation away from big cap tech and large cap growth is a key risk like that of last year, but again last year's rotation made little sense, especially since the higher yields from the Fed's aggressive rate hiking cycle should have made dividend growth equities and income payers-- which counterintuitively held up extremely well last year--much less attractive not more.
Another risk may be if Apple's new iteration of its iPhone or the 'Vision Pro' fail to deliver the kind of numbers that the market is looking for during fiscal 2024. With Apple being a market leader, this could have an adverse impact across a great many of indices. The same may be true with Microsoft, but perhaps less so, as AI is more a 5-7 year story than something that must come to fruition next year or the year after that. Nvidia and Tesla are big wild cards, as these names are among the most speculative of the bunch, but we like the long-term secular trends associated with both. Even, for example, if numbers aren't revised upward for Nvidia and Tesla as the market may want, there will be other quarters in the future where these equities can deliver. In any case, however, if the market loses confidence in either Nvidia's AI chips or Tesla's long-term dominance in electric vehicle technology, it could hinder big cap tech and large cap growth's underlying strength.
Perhaps surprisingly, we don't view a global economic recession as a huge long-term risk to the areas of big cap tech and large cap growth. For one, these areas are overflowing with cash-based sources of intrinsic value, meaning that their collective balance sheets are flush with cash. That means bankruptcy risk in the event that the broader global economy heads south where credit availability dries up is practically nil for these groups. The companies that we'd grow concerned about in a global economic recession are the overleveraged entities with lofty payout ratios and high dividend yields as their operations could face some major financial hiccups. That means many REITs ( VNQ ), MLPs, and mortgage REITs ( REM ) would fare the worst in a recession. On the other hand, we would expect big cap tech and large cap growth to hold up relatively well in a recessionary environment, while leading the market higher on the other side during expansions, much like we're witnessing so far in 2023.
With banking equities and energy equities largely unattractive, value-oriented equities under pressure due to their debt-heavy balance sheets and relatively meager dividend yields (in comparison to short-term Treasury rates), and small caps still unproven in a world where tech giants can drive them out of business by merely investing what might amount to a rounding error in their cash flow to compete with them, we think big cap tech and large cap growth will remain the place to be in the coming decade, as it has been for at least 15 years now. There are some risks of which to be aware, of course, including an irrational market rotation like that of 2022 and firm-specific considerations as outlined in this article, but we simply can't see it any other way: We're extremely bullish on the long-term potential of the U.S. equity markets, and our favorite areas remain big cap tech and large cap growth. The markets are finally making sense again, at least to us.
This article and any links within are for informational and educational purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice. AI in part wrote the summary for this article.
For further details see:
Finally, The U.S. Markets Are Making Sense Again!