3Q15: A Lot of Noise.… · 3Q15: A Lot of Noise ... to less substantial but noisier Greek crises...

3Q15: A Lot of Noise Macro headlines overlook improving fundamentals

GLOBAL SECTOR VIEWS FROM THE JANUS EQUITY TEAM

3Q 2015

GLOBAL SECTOR VIEW

2 | Global Sector View

For four decades, fundamental, bottom-up research has been at the core of the Janus investment process. Our deep team of analysts covers approximately 1,500 stocks around the globe. Each takes a do-it-yourself, unconstrained approach to research. We believe this differentiates us from our peers and drives results for our clients and the investors they serve.

Every quarter, our seven global sector teams share their bottom-up perspective on key themes in the equity markets and how those themes impact their sectors and areas of coverage.

The opinions are those of the authors as of July 2015 and are subject to change at any time due to changes in market or economic conditions. The comments should not be construed as a recommendation of individual holdings or market sectors, but as an illustration of broader themes.

TABLE OF CONTENTS

> Communications 4

> Consumer 6

> Energy + Utilities 8

> Financials 10

> Health Care 12

> Industrials + Materials 14

> Technology 16

Global Sector Views from the Janus Equity Team | 3

3Q: A Lot of NoiseOur belief that politicians ultimately find reasonable solutions in a timely manner blew up like a SpaceX rocket as the quarter ended. Greece, as Falcon 9’s brief flight did in June, made a lot of noise as negotiations on its bailout and new austerity measures went down to the wire. In the end, the noise did not amount to much of anything when the sides reached a tentative agreement in early July. Our long-held belief remains that, this Greek drama notwithstanding, equity market gains are not over. It’s hard to argue equity markets are cheap on average but investors should not seek to be average. In a market more about alpha than beta, the global equity market backdrop still lends itself to stock picking and active investing.

After Greek voters rejected an austerity plan, markets traded off but the reaction was generally mild, especially compared to less substantial but noisier Greek crises of the past. Most indices ended the quarter flat to down, then rebounded in early July when Greece and Europe finally reached an agreement on new bailout terms. It is a softer year so far but after six straight years of up markets, a calmer S&P 500 Index is welcome. (By comparison, the 1990s had nine up years – 1991 to 1999 – although that didn’t end too well.) We remain positive on U.S. equities, however, and do not feel that markets are stretched. P/E multiples are at the higher range of recent years but they are not extraordinary for a low-inflation environment, which implies lower longer-term rates. On cash flow, valuations are more reasonable.

Remember that the math of a 2.3% 10-year yield implies a P/E of more than 40, if you compare the price to the interest income. There’s no risk in the Treasury, but no growth either. Meanwhile, we are seeing growth in equities. Estimated earnings growth for 2016 vs. 2015 for the S&P 500 companies looks healthy if you take out the oil sector. Furthermore, we think there will be a broad range of growth rates for companies. It takes analysis, but it remains possible to find companies that are using acquisitions, breakthrough products or market share gains to drive earnings growth and to justify valuations.

For key sector trends, look at our sector reports on the subsequent pages. Stock picking requires understanding the sector outlooks.

Growth matters in Europe too, and we are seeing a firming of conditions there. Greece represents less than 2% of European GDP. So even if the country finds itself on the outside looking in (as of this writing, the Greek parliament still needed to approve the proposed austerity measures) – the Greek problem will not undermine Europe. It is different from the last time a Greek default threatened the stability of other banking systems in Europe.

What’s been overlooked in all of the noise about Greece is that quantitative easing (QE) is gaining traction in Europe. The weaker euro helps fuel export growth while stronger auto sales, positive loan growth and better bank balance sheets portend a local recovery. The scope for margin expansion remains.

Our European financial analyst sees green shoots and expects lower loan losses, rising returns and the all-important increasing of dividend payments, bullish signs for financials and perhaps for equities broadly.

In Japan, the Abe administration has engineered a favorable backdrop for Japanese equities in terms of supply-demand: corporates are buying their own shares back, the Bank of Japan is buying Japanese equities as part of its QE, the government’s main pension fund is buying Japanese equities and moving away from bonds, and the market is running out of sellers. The message once again, however, revolves around stock picking. New initiatives are also encouraging better corporate governance. Companies are raising dividends and appointing outside directors. More importantly, some companies are restructuring whole industries.

China and the rest of Asia are vexing. While China, too, has the ability to stimulate its economy, it is not a country without challenges. The industrial sector is slowing, part of a rationalization plan that ultimately leads to a more efficient economy. We expect over time that the consumer sector will offset some growth pressures in China; in the shorter term, however, we are seeing contrary signs such as slower car sales and a continued lull in luxury spending. The rise in the Shanghai stock market and recently, a government attempt to prop it up after a pullback, are worrisome.

A slowdown in China is touching economies elsewhere in Asia. India is an exception as political reform (in true Indian style) slowly grinds forward. Brazil, with political and economic troubles, looks like more of a market where you pick a few cheap stocks but understand it is a difficult slog ahead.

At the end of the day, remember that it’s not all Greek. Economic growth is here. It may not be robust but in many parts of the world conditions are improving. Rising rates, as long as they are data dependent, can support equities as alternatives to bonds and as a way to participate in a calmer, steadier economic environment. Rather than making you afraid to fly, the exploding Falcon 9 should make you more careful about how you choose to fly. It is time to make the same smart choices about equities too.

Adam Schor, CFADirector of Global Equity Strategies

Carmel WellsoDirector of Research


Trends & Opportunities > Consumers are watching more television content than ever, but viewing habits are

shifting. An increasing amount of content is viewed online or on demand.

> Advertising spending is quickly switching to digital platforms that can target consumers on mobile devices.

> Cable distributors and telecom companies are seeking large mergers. Partnerships offer the infrastructure, platforms and scale needed to deliver consumers “TV everywhere” services.

Risks & Headwinds> As viewing habits shift, future advertising revenues for content companies

are hard to predict. Changes in television viewing habits are occurring faster than distributors and content companies can develop advertising and measurement models to monetize that viewing.

> The growing popularity of Internet services such as Netflix and Hulu are a threat to pay-TV distributors, which could see more customers drop video packages.

> The traditional cable television bundle is being threatened by both Internet services and pay-TV distributors that are trying to offer more flexibility in pay-TV packages. A breakup of the bundle would mean less revenue for some content companies that are left out of new bundled offerings.

Investment Implications> We have increased our exposure to Internet service companies offering

advertising platforms that are winning advertising market share. Advertising on these platforms allows for better targeting and higher conversion rates.

> We are investing in a limited number of cable distributors that can offer video services bundled with robust broadband offerings. The revenue streams of these companies are more insulated from the risks of substitute video services that may offer unique packages of channels.

> We are also investing in mobile tower companies, which provide the infrastructure that allows for more video viewing on smartphones and tablets.

> We are selectively investing in content companies that are experiencing viewership gains in online and on demand settings. These companies should experience increased monetization from those channels once business models around those platforms develop.

> We have avoided many media companies that we believe are producing content that could be easily replicated online. These companies are at greatest risk of losing share if the traditional cable bundle changes significantly.

COMMUNICATIONS

Consumers are

watching more

video than ever,

but the way they

view it is changing

the sector.


Mobile Reach

A growing amount of advertising spending is going toward mobile platforms, where specific customers can be better targeted.

Mobile Internet Ad Spending Worldwide, 2013-2019

Source: eMarketer. As of March 2015.*Estimated.

2013

$19.2B

2014

$42.6B

2015*

$68.7B

2016*

$101.4B

2017*

$133.7B

2018*

$166.6B

2019*

$195.6B

3.7% 7.8% 11.9% 16.5% 20.5%

24.1% 26.8%

% of Total Media Ad Spending


Trends & Opportunities > Spending power is improving for consumers with lower incomes. Wage increases

and lower gas prices are benefiting blue-collar workers. Lower-income households have also had time to digest headwinds such as the expiring payroll tax cut, the expiration of extended unemployment benefits and a shrinking food stamp program.

> As the U.S. economy stabilizes, restaurant sales are improving. Growth has been higher for the “fast-casual” segment.

> The decline in mall foot traffic means weaker same-store sales comparisons for many retailers. However, some retailers have been able to parlay the brand recognition from their physical stores into impressive online growth.

Risks & Headwinds> A strong dollar and weak emerging market growth are a headwind to

multinational consumer staples companies.

> New free shipping policies by Amazon signal the company is continuing to make investments to take market share in online sales, a risk for retailers with vulnerable excess returns that Amazon may target.

> Changing food preferences pose a structural risk for larger name-brand food companies. Consumers are shifting toward natural and organic foods and millennials are gravitating toward specialized food products.

> Retail and apparel companies are in the early days of investing to improve the multichannel shopping experience. The impact these investments will have on margins is still largely unknown.

Investment Implications> We are investing in several companies that primarily serve lower-income consumers.

> We have avoided the big-box retailers that face the largest threat from Amazon. We see select opportunities with niche retailers that evolved quickly to create a better online and mobile shopping experience.

> Many of our other retail holdings include companies with protection from insurgent e-commerce competition. Products for these companies require a consultative sale, are harder to ship or are goods that the consumer needs immediately.

> Within the consumer staples sector, we prefer companies that derive a greater portion of their revenues in the U.S., where consumer spending is stronger.

> We are avoiding large-cap U.S. packaged food companies and own a few select grocers that benefit from the migration toward organic and natural foods.

CONSUMER

Wage increases

and lower gas

prices are giving

consumers with

lower incomes

greater spending

power.


Maximizing the Minimum Companies and Cities Considering or Enacting Wage Increases.

Spending is improving for consumers with lower incomes as cities and companies are increasing baseline pay across the U.S.

Source: The New York Times / Janus. As of 2015.

Seattle

Portland, Maine

New York

Washington, D.C.

Louisville

Chicago

Kansas City

Sante Fe

Albuquerque

San Diego

Los Angeles

San Francisco

Oakland

$15

$15

$13

$10.84

$8.75$11.50

$15

$15$12.25

$9

$15

$15

$10.68

City Minimum Wage

Passed

Proposed



Risks remain

that could lead

to lower oil

prices in the

coming months.

Trends & Opportunities > Growth opportunities in the energy sector are harder to find after a sharp drop in

oil prices and risks of further declines.

> While there are risks the oil market could remain oversupplied, the quick drop in rig count by U.S. energy and production companies could help set a floor on oil prices.

> Energy service companies are cutting prices 20% to 30% , which has allowed many U.S. exploration and production companies to maintain neutral cash flow in a low-price environment.

> Natural gas prices could rise in the coming months. The reduction of associated gas (a byproduct of shale oil production), increasing demand from utility companies that are turning away from coal, and eventually, improved infrastructure to haul gas from the Marcellus and Utica shale areas are all supportive of prices.

Risks & Headwinds> Oil from Iran or Libya could flood the market if sanctions against Iran are lifted

or oil from Libya comes back on line. Saudi Arabia could also increase production to backfill any declining supply from the U.S.

> Oil demand could soften in the fall as refineries head into their seasonal maintenance and summer demand abates.

> There is no margin of safety in the valuations of most U.S. exploration and production companies. Current valuations imply higher oil prices than we expect.

Investment Implications> We still find opportunity in a number of midstream companies whose contracts

are not tied to the price of the underlying commodity. Many of these stocks were unfairly punished when energy stocks sold off broadly, but their earnings streams should hold up.

> We have invested in several integrated oil companies that can create value through a cycle by diverting cash from exploration and production businesses to higher value, nonproduction businesses, such as a refining or specialty chemical operations.

> We are generally avoiding exploration and production companies, as well as capital equipment and service companies.

> We still see potential in pure natural gas producers drilling in the Marcellus and Utica shale areas.

ENERGY + UTILITIES


OversuppliedTotal Crude Oil in Storage (Excluding Strategic Petroleum Reserve)

Source: U.S. Energy Information Administration. As of 6/11/2015.

600,000

Weekly U.S. Ending Stocks (excluding SPR of Crude Oil)

500,000

400,000

300,000

200,000

100,000

01/14 03/14 5/14 07/14 09/14 11/14 01/15 03/15 05/15

0

Barr

els

While a drop in rig count helped alleviate some of the excess oil supply, storage levels remain high. We see risks that the market could continue to be oversupplied.



Trends & Opportunities > Loan growth is recovering in the eurozone, notably in France, Belgium, the

Netherlands and the Nordic countries. In such a bank-dependent region for financing, loan growth to the small and medium enterprise client segment is particularly important to the European macro.

> Strengthening capital positions among some of the largest European banks positions them to accelerate dividend growth.

> Rising household wealth in the U.S. and parts of Asia is creating demand for investment advice and insurance products that preserve newfound wealth.

> A switch from cash to plastic and electronic payments remains one of the better long-term secular growth opportunities in the sector.

Risks & Headwinds> We are in the latter innings of federal litigation against U.S. and European banks, but

civil litigation costs are a large question mark for the industry.

> While capital positions at European banks have improved, uncertainty about future regulations that could require additional capital requirements tempers enthusiasm for banks’ dividend distribution and future return on equity.

> Disruptions from an unstable Greece remain an important risk for the European financial sector.

> Within the U.S., loan spreads are falling as competition increases.

Investment Implications> With quantitative easing set to run for an extended period, we still see upside for

many European bank stocks leveraged to a cyclical recovery. We have built in a significant buffer to our projections for European bank earnings to account for any additional capital requirements.

> Our European bank holdings are focused on quality franchises with stronger balance sheets and cash flow generation. In the early phases of an economic recovery, such banks can start distributing more of their earnings sooner, while still able to meet any increasing capital requirements.

> Payments companies remain a large investment opportunity.

> We are investing in companies that can take market share in the growing wealth management industry by offering innovative products and services.

> We are also investing in global insurance companies with a large presence in Asia. Brand recognition should help these companies take market share from smaller, local competitors as demand for insurance grows.

FINANCIALS

The outlook for

European banks

is improving.


Preserving WealthInsurance Premiums, Asia Pacific ex. Japan

Life Insurance Premiums Property & Casualty Insurance Premiums

Source: McKinsey & Company. As of July 2014. *Estimated.

U.S.

$ B

illio

ns

U.S.

$ B

illio

ns

1,000

800

400

200

600

600

500

400

300

200

100

02002 2012 2020* 2002 2012 2020*

0

172

495

873

75

236

480

11%Change 12%

Change

9%Change

7%Change

As rising household wealth grows in Asia, demand for insurance is also increasing.



Trends & Opportunities > Improved genetic analysis is leading to the discovery of revolutionary, not

evolutionary, new drugs. We believe this has led the Food and Drug Administration (FDA) to approve innovative therapies at a faster rate than at any point in its history.

> Drug pipelines already look exciting. In 2015, new treatments should launch that directly address cystic fibrosis, several prevalent forms of cancer, psoriasis, and heart disease, the leading cause of death worldwide. Novel therapies for Alzheimer’s, Crohn’s disease, severe asthma and hemophilia are also advancing in development.

> Techniques for treating disease are evolving. Where we once took a chemical pill once or twice daily, we now have therapies that can directly target our genetic code or unlock the potential of our immune system to fight cancer.

> High-impact research translates into significant pricing potential. Drug pipelines now address significant unmet needs, but often smaller populations. This provides the opportunity and desire to price at a significant premium to prior standards of care.

> The M&A market remains strong. The opportunity to achieve efficiencies of scale, coupled with the low cost of capital, has led several elements of the health care delivery system to consolidate.

Risks & Headwinds> There is excessive risk taking in the sector. Private companies with drugs in the

pre-clinical trial phase are able to go public with rich valuations. Valuations for selected companies with early stage clinical pipelines are also high.

> Profit taking remains a risk. We remain encouraged by the underlying fundamentals of the sector, but would not be surprised if any potential short-term negative headlines surrounding health care sparked volatility.

> Biosimilars could threaten sales of some biotech treatments. This risk is stock specific and well anticipated by the market.

> The adoption of risk-sharing arrangements between insurance companies and providers creates long-term uncertainty. The Affordable Care Act has done little to blunt the demand equation for health care. As players adopt new methods for care coordination and new financial models, we fear some industry participants will be disrupted.

Investment Implications> We own a number of companies developing promising therapies, but given higher

valuations and enthusiasm, we believe selectivity is important. We are closely evaluating the science behind each therapy under development to determine its likelihood of clinical success.

> We conduct our own analysis to determine the potential market size of new drugs, which we believe the market frequently gets wrong.

> We own several specialty pharmaceutical companies with a long track record of making strategic acquisitions to develop their drug pipelines. We also own innovative specialty pharmaceutical companies we believe could be future takeout targets.

> We are underweight health care services companies, which could be exposed to fluctuations in demand for health care products and services.

HEALTH CARE

Innovation in the

sector remains

high, with new

treatments poised

to launch for

many high, unmet

medical needs.


6677

108

0

20

40

60

80

100

120

2012-20142009-20112006-2008

Num

ber

of D

rugs

App

rove

d

Passing MusterNumber of Drugs Receiving FDA Approval

Source: Washington Analysis, FDA 2014.

The substantial improvement new innovative drugs represent over existing options has led to a more favorable regulatory approval environment.



Trends & Opportunities > Management teams have an improved outlook for Europe, but are yet to see a

surge in order growth.

> Merger and acquisition activity and share buybacks within the sector remain high, due in part to an increase in shareholder activism.

> The auto industry is a pocket of strength within the sector. Improved consumer balance sheets, low interest rates, and decisions by many consumers to delay auto purchases coming out of the financial crisis are encouraging auto demand in the U.S. and Europe.

Risks & Headwinds> A strong dollar is leading to lower revenues for many U.S. exporting companies.

> Weakness in the energy sector is a headwind for many U.S. industrial companies, which derive roughly 5% to 20% of their revenues from energy companies.

> Low oil prices could also defer demand for fuel efficient planes, causing weakness in the aerospace supply chain.

> The agriculture cycle remains weak, due in part to lower corn prices and excess supply of used machinery.

Investment Implications> We are looking beyond currency headwinds, and taking a long-term view with

the U.S. exporting companies we hold.

> Our biggest concern regarding currencies is whether European or Japanese industrial companies will use a weaker currency to lower prices and take market share. So far, competitive behavior has been rational. Most non-U.S. companies are using the weaker euro or yen as an opportunity to improve margins.

> We are not chasing M&A activity by making isolated calls on a particular future takeout target. Instead, we are investing with companies whose management teams have shown a history at previous companies of making strategic acquisitions that consolidate a fragmented industry.

> The industrial companies we own that are tied to the energy sector serve midstream and downstream end markets, which are hurt less by low oil prices than large exploration and production companies.

> We are investing more heavily in auto suppliers than automakers. Many auto suppliers have higher margins, less competition and more product differentiation than automakers. Auto suppliers benefit not only from strong auto demand, but content growth within the automobile.

INDUSTRIALS & MATERIALS

Share buybacks

and M&A activity

remain high in

the sector.


Driving GrowthSeasonally Adjusted Annual Auto Sales in the U.S. and Europe

Source: Janus. 2015.

Western Europe

U.S.

006/90 04/92 02/94 12/95 10/97

Mill

ions

of p

asse

nger

car

s an

d tru

cks

sold

08/99 06/01 04/03 02/05 12/06 10/08 08/10 06/12 04/14

5

10

15

20

25

Auto sales remain strong in the U.S., while European sales are rebounding.



Trends & Opportunities > Businesses are quickly shifting IT architecture to the cloud, from hardware,

servers and on-premises data centers.

> The semiconductor industry is consolidating. As the industry matures and growth rates slow, companies are looking to build scale and trim research and development departments.

> Smartphone and tablet user growth is slowing. Now that smartphones and tablets have been widely adopted, their usage is increasing.

> We see more commercial and consumer applications tied to the Internet of Things. The proliferation of devices that connect to the Internet and interact with each other is a multiyear trend still in its infancy.

Risks & Headwinds> The market for desktop computers is rapidly declining.

> Enterprise hardware companies are slow to react as businesses move to a software-designed data center operating in a cloud. With enterprise hardware becoming commoditized, management teams have been reluctant to consolidate and trim costs.

> The market is overlooking the risks to legacy tech companies. Many legacy tech companies tied to desktop computing or enterprise hardware trade at high valuations, due to the perceived safety of large cash reserves or growing dividend payments.

Investment Implications> We are investing in companies that built their businesses with a “mobile-

first” strategy, and derive the majority of earnings from mobile applications. These companies benefit in the environment where smartphones have been widely adopted and are used more frequently.

> We have large positions in some of the semiconductor companies that are consolidating the industry. We also have smaller positions in companies that operate in industries where semiconductor demand is growing. Such companies are likely future acquisition targets.

> We have largely avoided legacy tech companies tied to dying areas of technology. We selectively own a few tech hardware companies that are in position to consolidate their industries by acquiring smaller hardware companies.

> We hold several companies we believe will benefit from the Internet of Things, including microcontroller and connector manufacturers and companies offering infrastructure platforms that allow devices to communicate.

TECHNOLOGY

The decline of

the desktop and

rapid adoption

of the cloud

represent sea

changes for the

technology sector.


Slowing Pace

While smartphone penetration continues to grow, the pace has been leveling in recent years.

Connectivity Via Mobile Smartphones in the U.S.

Source: Kleiner Perkins Caufield Byers. As of May 2015.

70%

60%

50%

40%

30%

20%

10%

0%2009 2010 2011 2013 20142012

Smar

tpho

ne S

ubsc

riptio

n Pe

netra

tion

18%

31%

36%

52%

59%

64%


> Invest with our clients’ interests first.

> Develop a deep understanding of the companies we research.

> Employ a strong valuation discipline focused on quality growth.

> Develop independent and differentiated views on our companies, supported by in-depth primary research.

> Spend as much time thinking about what could go wrong as about what could go right.

> Take a long-term view.

> Seek to anticipate change, don’t just analyze it.

> Attract the best and brightest analysts in the business, and foster an environment in which they can succeed on behalf of our investors.

GUIDING PRINCIPLES OF JANUS RESEARCH



JANUS GLOBAL EQUITY SECTOR TEAM LEADERS

T E C H N O L O G Y

Garth Yettick, CFA

F I N A N C I A L S

John JordanH E A LT H C A R E

Andy Acker, CFAH E A LT H C A R E

Ethan Lovell

E N E R G Y + U T I L I T I E S

Kris Kelley, CFAC O M M U N I C AT I O N S

Jean Barnard, CFAC O N S U M E R

Jeremiah Buckley, CFA

I N D U S T R I A L S + M AT E R I A L S

David Chung, CFAT E C H N O L O G Y

Brinton Johns

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There is no assurance that the investment process will consistently lead to successful investing.

When valuations fall and market and economic conditions change it is possible for both actively and passively managed investments to lose value.

In preparing this document, Janus has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources.

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3Q15: A Lot of Noise.… · 3Q15: A Lot of Noise ... to less substantial but noisier Greek crises...

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Transcript of 3Q15: A Lot of Noise.… · 3Q15: A Lot of Noise ... to less substantial but noisier Greek crises...