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Equities have been in a bull market since March 2009, and performance so far in 2013 has been surprisingly strong. Since the market bottom in 2009, stocks have outperformed most asset classes, including fixed income. Can they continue to outperform bonds again in 2013? In the current “muddle-through” economy, larger mid cap companies with proven management teams, especially those with secular growth stories, appear to hold some promise, according to Deepak Khanna, Lord Abbett Partner & Portfolio Manager of the Fundamental Equity Fund.
Q: The U.S. stock market has performed well this year, and many believe that stocks are fairly valued. How are you managing the Fund in this environment?
A. In 2011 and part of 2012, stocks were highly correlated with each other. That is, whether they were good stocks or not, they were all going up or down together, depending on the macroeconomic environment. But in the fourth quarter of 2012, we started to see a change. The market again began rewarding company fundamentals, such as sales and earnings growth.
This is important because our process is largely focused on these fundamentals. We believe that if we understand a company’s fundamentals correctly, we improve the odds of potential reward. We also pay close attention to the source of a company’s growth in earnings per share [EPS]. The market rewards EPS growth more if it comes from sales or productivity improvements than if it comes from share buybacks or dividend payouts.
We also consider relative valuation. That is, we pay close attention not only to a stock’s valuation versus its peers but also versus its own history. This helps us minimize the risk of buying a stock that is overpriced.
Q: Corporate earnings tend to be cyclical and are currently at all-time highs. Can they go higher?
A. We believe they can go higher. So far in this earnings cycle, revenue growth has contributed little to the rise in earnings. Improvements have come largely from better margins.
If global economic growth were to rise from around 2% currently to 3%, that would do wonders for revenues, especially for cyclical companies.
For the global economy to improve, however, monetary policy needs to start working and consumer confidence needs to improve. Therefore, we remain focused on those companies that are capable of driving earnings regardless of the global macro environment.
Q: Where are you finding the best opportunities?
A. We like the upper end of the mid cap range, that is, companies with market capitalizations between $5 billion and $15 billion. That’s where we are investing in established companies with seasoned management teams that have proven themselves by emerging from the small cap category. Many of these companies also have enough cash flow to reinvest in the business to take it to the next level.
While we invest in companies that we believe have attractive valuations, we look for strong growth as well. As for sectors, we’re focused on those with secular growth prospects. Unlike cyclical companies, secular company growth is driven by other factors. For example, one sector we like is health care, which not only is generally undervalued today but which is positioned for long-term growth in the U.S. market, given that some 32 million more people will be entering the insurance pools on January 1, 2014.
Other secular growth segments that we like are media companies, specifically, content providers. Today, consumers want content on all their devices 24/7. Content providers have the content and the pricing power.
In the energy sector, we like certain smaller exploration and production companies. We also favor certain “big box” retailers, given that U.S. consumers are gaining confidence as the housing market recovers, and with it, household wealth.
When we see the global economy begin to turn up, we will be quick to consider industrials and other cyclical sectors.
Q: What are the most prominent risks facing the market?
A. One of the biggest risks is that Europe might not turn around for another three to five years. A second risk is emerging markets. China’s growth has slowed somewhat, and there is a new premier, so it’s not clear how the new government will manage the economy. The third risk is geopolitical. There are some hot spots around the world, and they are simmering. We address these risks by examining which companies have the most exposure to these areas.
Risks to Consider: Although the Lord Abbett Fundamental Equity Fund invests a significant portion in large cap company stocks, it also invests in mid cap and small cap company stocks, which tend to be more volatile and less liquid than large cap company stocks. Mid cap and small cap companies typically experience higher risk of failure than large cap companies. Investments in multinational companies generally pose greater risks than those of domestic companies, including market, liquidity, currency, and political risks. These factors can affect Fund performance.
Other Risks to Consider: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. Investments in small and mid-sized companies involve greater risks not associated with investing in more established companies, such as business risk, significant stock price fluctuations and illiquidity. Investing in international securities generally poses greater risk than investing in domestic securities, including greater price fluctuations and higher transaction costs. Special risks are inherent to international investing, including those related to currency fluctuations and foreign, political, and economic events. These risks can be greater in the case of emerging country securities. No investing strategy can overcome all market volatility or guarantee future results.
The opinions in this publication are subject to change, may not reflect the views of the firm as a whole, and should not be relied upon by the reader as legal, tax, or investment advice. Information discussed is for educational purpose only and should not be considered a recommendation to purchase or sell securities. Readers should not assume that the securities depicted were or will be profitable. Consult a financial advisor on the strategy best for you based on your individual goals, investing time horizon, and risk tolerance.