March 5, 2012
|Larry Puglia, Manager of the Blue Chip Growth Fund.|
Large-cap U.S. stocks, as represented by the S&P 500 Index, have roughly doubled since their low point in March 2009 after the collapse of Lehman Brothers, but the index posted just a modest 2.1% return in 2011. Larry Puglia, portfolio manager of the T. Rowe Price Blue Chip Growth Fund, believes investors became focused on several key challenges, including lackluster economic growth, another year of home price declines, and the lack of job creation in the U.S. and several major developed countries. Although corporate earnings continued to expand, in part due to cost-containment initiatives, revenues at some of the largest companies slowed due to European sovereign debt concerns and slowing growth in China. The challenges continue, but a number of factors—including attractive valuations and strong company balance sheets—could benefit blue chip stocks in 2012. The following reflects Puglia's views as of February 15, 2012.
We regard the current environment as having more complexity and risk than is typical. Among the complicating factors:
- The U.S. and other developed economies face significant deficits that could imperil prospects for growth or even stability, particularly if interest rates rise significantly.
- Unrest in the Middle East and the effect it has on oil prices and general stability must be carefully monitored. Of particular concern are the elevated geopolitical risks, such as the turmoil that could ensue if Iran is attacked.
- Major spending cuts and other policy actions could dampen rather than enhance growth in the short run.
- Confidence among business managers and investors has improved (as has job growth) but may build slowly. Employment statistics underestimate the number of unemployed because many discouraged job seekers have given up looking for work.
- Dollar instability and potentially sharp increases in inflation and interest rates remain significant threats.
On balance, we remain positive on the prospects for stocks. While the challenges will certainly require time to resolve and test the patience of policymakers and investors, corporate earnings at selected companies could continue to impress, interest rates and inflation should remain at acceptable levels, and the valuations of many high-quality companies are quite reasonable.
Despite the uncertainty surrounding how effective fiscal and monetary actions will be in healing the economy, there are several things working in our favor:
- Stocks historically have performed quite well following a lackluster 10-year period of performance. Essentially, we have experienced two major bear markets in the past 10 years.
- The valuations of stocks are attractive, especially in relation to the very low level of interest rates. The spread between the earnings yield on stocks and the 10-year Treasury rate is very attractive in any historical context. The free cash flow yield of many companies exceeds 10% and also implies attractive valuation, especially in the context of 10-year Treasury note yields of approximately 2%.
- We believe that the high-quality, consistent-growth companies we seek to purchase are especially attractive and could conceivably perform well even if the economy only experiences a modest recovery. Stringent expense management could also support rapid earnings growth if revenues begin to accelerate.
- Many large-cap growth companies have solid balance sheets with record amounts of cash and strong capitalization. This should allow them to manage through challenges and opportunistically invest in new products or businesses as change creates dislocation.
- Many of our holdings generate significant free cash flow. Shareholder-oriented management can use this cash to pay dividends, repurchase shares, or make value-added acquisitions.
Stocks set new 52-week highs in February 2012, due in part to an optimistic view that Greece was making progress on its debt crisis and that the Federal Reserve would keep interest rates low and may engage in additional quantitative easing. We believe investors are also reacting positively to improving job growth in the U.S. We continue to strive to enhance returns in a difficult environment by investing in high-quality companies with durable, sustainable earnings and cash flow growth. The three key issues for stocks going forward are:
- Will the European Union be able to craft a credible framework for resolving the sovereign debt crisis and reinvigorate eurozone economic growth?
- Will China have a soft landing or are more significant problems lurking for the Chinese economy?
- How will the U.S. presidential elections and actions by policymakers affect America's ability to address its structural fiscal issues?
Despite recent solid gains in selected stocks, investor concerns about these questions are already somewhat reflected in the stock market's current valuations. However, further progress in Europe and the U.S. economy, positive economic surprises, or an improvement in investor sentiment could result in additional gains for stocks.
Because growth stocks have higher valuations and lower dividend yields than slower-growth or cyclical companies, the share price volatility may be higher. As such, fund prices could decline further in market downturns than non-growth-oriented funds.