Buy large cap value stocks.
That is one of the sharpest statements Bank of America’s Savita Subramanian uttered during her bullish keynote address to kick off Morningstar’s annual investment conference in Chicago Wednesday.
“That’s where I see tremendous opportunities over the next five to 10 years,” said Subramanian, head of equity strategy and head of US equity and quantitative strategy at Bank of America Global Research.
The market strategist conceded that she’s zigging when most of the market is zagging. Indeed, value stocks have badly trailed growth over the past year. The Russell 1000 Growth Index has returned 37.87% over the past year, compared with the 12.95% gain of the Russell 1000 Value index.
“Everybody hates large cap[value,” Subramanian admitted. But “large cap value to me is one of the most attractive areas of the market. It's got a low payout ratio; it's got decent growth expectations. We're seeing a lot of cash return. Cash is more valuable today than it was during zero interest rate environments.”
Subramanian might seem to be on an island in her love for value but she’s not totally alone. While some market strategists expect the rally in growth to continue, they told Financial Advisor Magazine in May that investors should add some value stocks to their portfolios for diversification and gains.
Subramanian joined the growing ranks of ardent bulls in March when she raised her firm’s price target for the benchmark Standard & Poor’s 500 Index to 5,400, one of the highest on Wall Street at that time. Yet, Subramanian told an audience of mainly wealth managers and advisors in a hangar-sized conference hall that they shouldn’t regard such estimated market targets as exact predictions. They are instead guideposts to the possible direction of the market. Though the strategist admits she has less conviction in her target, Subramanian firmly argued the market might be heading even higher.
The S&P closed at 5,382 Thursday and topped 5,400 on Friday. “We are a hundred percent gonna be wrong on that number on December 31st,” Subramanian said of her price target. “Today, I have less conviction in the absolute level of equities. If I were pressed to answer directionally whether the market moves higher or lower through year end, I would say higher.”
In other key takeaways, Subramanian also said Wall Street sentiment is now “neutral” and we’re in a goldilocks economy, where there’s neither high growth nor a slowdown. She also allows that S&P stocks are indeed “very expensive” by most metrics. But the strategist suggests that investors shouldn’t sweat that equities could get even more expensive still.
In her remarks, Subramanian painted an ideal environment for stocks. She noted that real rates between 1% or 2% is the “best environment for equities.” Historically, she explained, inflation of 2% to 4% is also good for equities and positive real wage growth is “a blessing for consumption.”
“We're in Goldilocks, but nobody believes it,” Subramanian said. “What I wanna talk about is how things aren't that bad. It feels bad because we're adjusting to a new level of rates and inflation that haven't been around for quite a while, but we're actually in a pretty awesome environment. Everything is awesome to quote my son's favorite song.”
The top strategist also argued that the market is beginning to broaden from the so-called Magnificent Seven, or mega tech stocks such as Nvidia, Meta Platforms and Alphabet, that have been driving the markets to record highs as they’ve supplied almost all the earnings power. But the other 493 companies are begging to catch up, according to Subramanian.
The Magnificent Seven “are basically starting to decelerate in their earnings growth and the rest of the market is catching up,” Subramanian noted. “And we're hearing this from companies during earnings season. We're hearing that companies outside of tech are actually ratcheting up their earnings expectations.”
Those companies upping their earnings outlook can be found in retail, financial services, industrial, materials, energy and healthcare. Subramanian also said her firm isn’t detecting any “demand degradation” during company’s earnings calls or press releases.
“Is there any reason to worry about the economy, about consumption, et cetera?” she asked. “I don't think there is.”
Among other positive economic signs, the strategist cited normalizing labor market, tight labor market with positive wage growth and manufacturing recovering from a recession.
There’s also little reason to worry about the pricey market, Subramanian suggested. “The market is statistically expensive. Does that matter?” she asked. “I think there's an argument to be made that the market should be a little bit more expensive today.”
Mainly, Subramanian argued that today’s S&P 500 is quite different from what it was many years ago and it’s composition might indeed warrant a higher multiple. “Twenty or 30 years ago, 70% of the market was manufacturing,” she noted. “It’s a totally different mix today. Leverage is lower; the amount of debt that the average corporation is sitting on has dropped to amongst the lowest levels in decades.”
Furthermore, corporate debt is of longer duration, giving corporations more runway to refinance it. The average maturity on corporate balance sheet of an S&P company has widened to more than 12 years now from seven years in 2007, according to Subramanian. And 70% of that debt is long-term and fixed at very low rates.
Finally, she said management is more on its toes today, held to a high standard and that’s a good thing. “The US large-cap publicly traded companies are the most scrutinized platforms in the world,” Subramanian said. Corporations are also producing higher quality earnings, relying less on stock buybacks, for example.
“If the leadership teams at these companies screw up, they get fired,” the strategist said. “Maybe that's not great for (our) culture and happiness, but it actually creates a much more efficient stock market with more earning stability.”
Historically, the market has rewarded efficient companies. “The bottom line is there has really never been a period of time where efficiency wasn't awarded by higher returns,” Subramanian continued. “So here we are today; we're done with all the low-quality arbitrary sources of earnings growth. We are about to see companies become more efficient. We haven't had a productivity cycle for a good 20 years, and I think we're about to see one.”
The Bank of America strategist also said investors looking for dividend yield will be able to find ample options in equities. According to Subramanian, most companies in the S&P outside the tech sector pay a dividend have a yield above 2%. Those that don’t are indicating they’re aiming to up their dividend yield, she said, noting that Meta and Alphabet have already initiated dividends.
“Nobody has cared about dividends for the last 20 or 30 years because you made all your money on price returns. You made all your money on growth stocks, enjoying massive multiple expansion,” she said. “I think over the next 10 years where we get our returns are more from income rather than price appreciation, which means value wins, growth loses.”
Those investors migrating from fixed income will probably go into equity income, basically large cap value, she said, adding that with Meta and Alphabet initiating dividend, big tech stocks are morphing into growth at reasonable price or GARP and into value stocks.
The strategist said unloved sectors such as energy and financials are trading at low multiples and “I think we’re gonna see something pretty, pretty awesome happen in that area of the market.”
In arguing for energy, Subramanian suggested investors might not be appreciating that the changed compensation structure for energy chief executive officers have firmed up company fundamentals. “I know this sounds crazy but hear me out,” she said. “Something really important happened for energy companies in the last 10 years.”
Energy CEOs are now being paid on decarbonization and cash return rather than on production targets, which created boom-bust cycles for energy commodities. This supply discipline has resulted in less earnings and price volatility, according to the strategist.
“Why would you want to own those companies?” she asked. “Here’s the thing, energy has become the new high-quality sector.”