Mon, 21 Apr 2014
The T. Rowe Price Capital Appreciation manager says bargains are hard to come by today but does see some value in the highest-quality high-yield bonds.
Jason Stipp: I'm Jason Stipp for Morningstar. It's Beat the Market Week on Morningstar.com, and today we're checking with David Giroux of T. Rowe Price Capital Appreciation to get his take on the stock and the fixed-income markets and how he's positioning the portfolio today.
David, thanks for joining us.
David Giroux: It's my pleasure.
Stipp: David, there seem to be dual concerns that are vexing investors today. The fixed-income market seems a bit troubled as rates are certain to, at some point, go up. We saw some of that last year, and we've seen some investors leaving fixed income.
At the same time, the stock market feels at least fully valued, and some would say a little bit more than that. So, a lot of investors don't feel like there are a lot of good choices in the market today.
You are a manager who invests in both stocks and bonds. As you're looking at both of those asset classes and the opportunities and risks, how are you drawing a balance between them right now?
Giroux: Jason, I think that first of all, it's a great question. And what I would say is, it is a challenging environment for a multi-asset class manager, especially a multi-asset class manager who really cares about protecting clients' downside.
Because you're right, the equity market is somewhat expensive. The median company and the S&P 500 is trading around 17 times earnings now. That's basically the highest valuation level that we've seen in the last seven years. That's a level that is not consistent with being able to find a lot of great value in the marketplace today. So the equity market is not great.
Now, typically, when you see the equity market somewhat expensive, it means maybe bonds are attractive. The challenge, as you highlight, is that interest rates are still low. They have come up significantly off the bottom, but still relative to history, relative to where they should be, they're probably still a little bit low.
I would say the one area of both fixed income and equities where we see a little bit of value is what I would call the highest-quality high-yield bonds--companies that we think are sort of money-good, if you will, even in a difficult economic environment where you're earning 4% to 5% for really high-quality BB bonds.
When we think about high-yield in general, we think high-yield is a little bit of a bubble, but most of that bubble is really on the CCC credits and the B credits, where spreads are well inside of history. We think the highest-quality BBs look attractive relative to equities and relative to the fixed-income market in general.
Stipp: You mentioned that your fund operates in certain bands as far as your exposure to equities. What might we be able to infer about how you're viewing the equity versus the bond market by looking at how your portfolio is positioned between fixed income and equities today?
Giroux: On a long-term basis, we think about our equity exposure on a beta-adjusted basis being between 55 and the low-70s over time. And right now, we're in the high-50s, which would indicate that our view of the equity market is not positive.
Now, we still own about high-20s fixed income, which is in the middle of our long-term range, but our duration on our fixed income is quite low, because we are concerned about interest rates rising.
Now, again, I will say that we have increased the duration or interest rate sensitivity of the portfolio as rates have risen. We had very, very low duration last year when rates were very low, but as rates got closer to 3% at the end of last year, we did for the first time in a long time actually buy Treasury bonds.
Now, about 5% or 6% of the portfolio today is invested in Treasury bonds, again, back when yields were more like 3%, because we thought that was a better risk-adjusted return than cash with some downside optionality if the equity market went down.
Stipp: You mention that you would start to come back in and have started to buy some Treasuries. How would you imagine that your fixed-income strategy might change across the different parts of the bond market as we actually get back to what is a more normal interest rate environment?
Giroux: If you got back to a more normalized interest-rate environment--and I think about normalized interest rates on the 10-year Treasury being between 3.5% and 4%--if you did get to that environment, I think we would own a lot more fixed income, especially if the equity market continued to be at a high valuation. We would probably buy more investment-grade bonds; we'd probably own more Treasuries in that kind of environment than we do today. We'd probably own more high-quality BBs than we own today. So, rising rates, we actually would see as an opportunity to put more cash to work and maybe even reduce our equity exposure on the margin.
Stipp: David, on the stock side, Morningstar analysts see the market in a lot of places as fully valued; in some areas, they see that it's overvalued, but they also do see some pockets of opportunity here and there.
As you're looking across the equity markets, what are you seeing? Are you seeing that it's not necessarily overvalued across the board? There are some areas that are ripe for going in and making some good selections?
Giroux: I would say, generally speaking, I tend to agree with your Morningstar analysts that the equity market is somewhat expensive, and I would actually say there's not one sector or two that sticks out as being really attractive today. What I would say is, there are a handful of ideas out there, a handful of ideas that we own in our portfolio, where we say we still have very good risk-adjusted returns. We don't have to own the whole market. We only have to own a certain number of stocks where we think we have good risk-adjusted returns, not only on an absolute basis, but relative to the market.
When we think about companies like a Danaher or an AutoZone, we think these are companies that are very attractively priced for their return profile, their risk profile, where we see significant upside and modest downside. But there are very, very few of those kind of names, many fewer names like that than there were in 2011 or 2009, which is part of the issue we all face.
Stipp: We've seen some volatility in the market this year, geopolitical concerns have caused the market to be upset. We've certainly seen over the last year that the Fed's activities have caused some disruptions in the market. What do you think, though, is one of the more underappreciated risks that investors should at least have on their radar and be prepared for or expect could cause some trouble in the market?
Giroux: Jason, I think it's a very good question. What I'd say is, the risk that you should really be worried about is what I call the unknowable risk. The market thinks it can know what the future is going to be, but the market is actually very, very poor at judging the history. The future is far more uncertain than the market gives it credit for being. So, it's the event that no one's expecting that causes consternation, that causes equities to go down.
Last year, no one thought we'd end the year at 3% 10-year Treasuries. In 2007, people thought the housing issues in this country were going to be confined to the subprime market. No one thought you'd see housing prices fall 40% in the market. No one thought that would cause a 50% decline in the equity market. No one saw any of that.
So, you can talk about Russia being an issue. You can talk about emerging markets slowing down being an issue. You can talk about China being an issue, but I think what's really concerning is the unknowable risk.
And when valuations are high, the skew of the market is negatively skewed, because if that negative risk comes out, whatever it is, that unknowable risk, there's not a lot of upside and a lot of downside. Whether that be a recession, whether that be inflation. No one really knows, and so as I said, the unknowable risk is what worries me the most.
Stipp: I always like to end on a positive note, David. So, what do you think is a potential point of optimism that maybe investors aren't fully appreciating?
Giroux: Well, I think the one thing is, companies are returning more capital to shareholders. Companies are raising dividends. Some of that is in response to activism; some of that is in response to just better corporate governance. So, you are seeing that increasing on the margin, which is positive for earnings growth, positive for returns on invested capital. Companies, on the margin, are returning more capital to shareholders, which we tend to be in favor of.
Stipp: David Giroux of T. Rowe Price Capital Appreciation, it's great to get your insights on the bond and the stock market. Thanks for joining me today.
Giroux: It's my pleasure.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.