Investing in a Slow-Growth World: Opportunities in U.S. Equities

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1 Investing in a Slow-Growth World: Opportunities in U.S. Equities Market Commentary December 2015 SINCE THE END OF THE GREAT RECESSION, the United States has experienced a longterm trend of slow-but-positive economic growth. Based on the lingering hangover from the credit crisis, we anticipate this will continue for some time. Periods of slow economic growth are usually challenging for investors, and the current environment is no exception. Yet, equity investing strategies do exist for investors to consider. In the following pages, we review the current economic backdrop, discuss corporate earnings and offer three investment themes we think may make sense for this slow-growth environment. A Slower for Longer World: What Does That Mean for Earnings? The financial crisis, recession and sharp bear market of 2007 to 2009 left many lasting scars. Investors remain uneasy, many companies are hoarding cash and consumers are saving more and reducing debt. These attitudes and behaviors are understandable, but they have led to relatively slow economic growth. In the 22 quarters since the end of the Great Recession, U.S. real economic growth has averaged just over 2.2%, while nominal growth has averaged 3.8%. While we ve experienced a few quarters of solid growth, an equal number of quarters have disappointed. At the same time, inflation has remained contained, averaging only 1.6% during this period. While we think it is reasonable to expect modest improvements in growth from here as the labor market continues to heal and as spending levels have been picking up, we are not expecting to see a return to boom-like conditions in the foreseeable future. Robert C. Doll, CFA Senior Portfolio Manager, Chief Equity Strategist Exhibit 1: Growth has Remained Slow Since the Recession 5 Annual Real GDP Annual Nominal GDP Annualized Growth % Scott M. Tonneson, CFA Senior Research Analyst, Portfolio Manager 1 0 6/30/2010 6/30/2011 6/30/2012 6/30/2013 6/30/2014 6/30/2015 Source: Nuveen Asset Management, Bloomberg and the Department of Commerce. NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE

2 This slow-growth and low-inflation backdrop means many companies have worked hard to increase their earnings, but have generally done so through better efficiency and cost controls rather than increasing revenues. Exhibit 2 compares current earnings to the last sustained equity bull market. During both bull markets, companies effectively increased overall earnings, represented by operating earnings per share (EPS). During the posttech-bubble bull market, however, companies grew earnings by increasing revenues (represented by sales per share). During the current bull market, in contrast, revenue growth has been extremely anemic. On an annualized basis, revenues have grown only 1.5%, compared to 9.2% during the prior cycle. IN AN ENVIRONMENT OF SLOW ECONOMIC GROWTH, many companies have struggled to improve their earnings, which suggests differentiation is key. Exhibit 2: Revenue Growth Is Lacking During This Cycle Revenues vs. Earnings: Current Bull Market 12/31/2008 6/30/2015 % Change Annualized % Change S&P 500 Operating EPS % 12.8% S&P 500 Sales Per Share 1, , % 1.5% S&P 500 Operating Margin 4.7% 9.5% 99.0% 11.2% Revenues vs. Earnings: Previous Bull Market 3/31/2003 6/30/2007 % Change Annualized % Change S&P 500 Operating EPS % 16.6% S&P 500 Sales Per Share % 9.2% S&P 500 Operating Margin 7.0% 9.3% 32.0% 6.8% 20.0% Current Cycle Previous Cycle 15.0% 10.0% 5.0% 0.0% 12.8% 16.6% Annualized Earnings Growth Anemic Revenue Growth 1.5% Annualized Revenue Growth Annualized Margin Expansion Source: Strategas Research. Past performance is no guarantee of future results. Current Bull Market Cycle is defined by Strategas Research as starting at the end of the credit crisis through the latest available data. Previous Bull Market Cycle is defined as between the end of the tech bubble bursting and before the beginning of the credit crisis. All time periods selected reflect the closest quarter-end point. 9.2% 11.2% 6.8% As a result of management teams driving cost efficiencies, operating margins have improved dramatically during the current bull market. After speaking with corporate management teams, we sense there is little room for further improving cost controls and margins. Going forward, earnings growth will likely depend more on revenue improvements, which is generally a much more difficult proposition. From an investment perspective, this shift makes it more important than ever to identify companies with the ability to improve revenues and earnings in a slower growth world. Three investment themes can help accomplish this objective: focusing on free cash WE BELIEVE IDENTIFYING COMPANIES WITH THE ABILITY TO GENERATE REVENUES in a slow-growth world will become increasingly important in the months and years ahead. 2

3 flow, seeking unit growth over pricing power and emphasizing U.S. versus non-u.s. earnings sources. Theme One: Free Cash Flow One of the first, and most important, themes we suggest is free cash flow (FCF). Simply put, free cash flow is the money a company generates after it pays normal operating expenses (such as salaries and overhead). Excess cash allows a company tremendous flexibility. It can reinvest in its business by purchasing new equipment or ramping up hiring. Or the company could return cash to investors by increasing dividends, buying back stock or reducing debt. CORPORATIONS THAT HAVE DEMONSTRATED THE ABILITY TO GENERATE FREE CASH FLOW have historically outperformed. Not surprisingly, these companies tend to outperform. Exhibit 3 compares the top and bottom one-fifth of Russell 1000 Index companies by free cash flow. Over time, companies with greater amounts of free cash flow dramatically outperformed those with low levels. Interestingly, this dynamic has intensified since the Great Recession. Weak economic growth makes generating free cash flow more difficult. Companies generating greater amounts of free cash flow have differentiated themselves from their competitors, and we expect this trend to continue. Exhibit 3: Free Cash Flow Has Been Associated with Outperformance Top FCF Quintile Bottom FCF Quintile /2005 9/2006 9/2007 9/2008 9/2009 9/2010 9/2011 9/2012 9/2013 9/2014 9/2015 Source: Strategas Research. Quintiles refer to the Russell 1000 Index. Past performance is no guarantee of future returns. Different indices, economic periods, methodologies and market conditions will produce different results. It is not possible to invest directly in an index. Theme Two: Unit Growth over Pricing Power Our second slow growth investment theme has to do with focusing on companies that do not necessarily depend on faster economic growth levels to outperform. Specifically, we would suggest avoiding companies that require pricing power in favor of companies that can achieve unit growth regardless of the strength of the economy. Companies that require pricing power do not have the ability to adjust their prices to reflect changing demand dynamics. Alternatively, a company may make a product that sees less demand as prices increase. WE PREFER TO EMPHASIZE COMPANIES THAT DEMONSTRATE UNIT GROWTH, rather than those that require pricing power. 3

4 Consider an orange grower. If orange growers experience a hard winter freeze, supply will decrease and prices will rise. Consumers are not forced to buy oranges, and many would simply purchase different fruits. As a result, the orange growers would suffer even though the price of their product increased. Similarly, we can look to oil-producing companies. Oil producers can be referred to as price takers, since they must take the prevailing price of oil even if it is falling. Over the past year, oil supplies have increased and demand has fallen. Many oil producers have suffered as a result. In contrast, we think focusing on unit growth makes more sense during times of slower growth. Consider pharmaceutical companies. Exhibit 4 shows the number of people taking prescription medications to treat Hepatitis C has increased dramatically. Demand for these medications does not depend on the strength of the economy, and patients will purchase the medication even if prices rise. A handful of companies manufacture these drugs, and this is a good example of unit growth. FOCUSING ON DOMESTICALLY ORIENTED U.S. COMPANIES can allow investors to capitalize on stronger relative economic growth. Exhibit 4: Companies Capitalizing on Unit Growth May Be Well Positioned Hepatitis C Drugs Weekly Prescriptions (000 s) /2013 6/ /2014 6/2015 Source: RBC Capital Markets From an investment perspective, a number of companies, industries and sectors demonstrate good unit growth prospects, despite slower economic growth. This is one reason we prefer certain health care and technology companies, among others. At the same time, this is an argument for avoiding companies that lack pricing power, such as some energy and materials companies. Theme Three: U.S. Versus Non-U.S. Earnings Our final theme is based on a broader view of the global economy. We have been discussing how growth has been slow by historical standards in the United States, but it is important to place this in the context of the entire global economy. In many ways, the U.S. economy is the best house in a bad neighborhood. Growth in China is slowing and many emerging economies are suffering due to lower commodity prices. Japan is in a recession. Growth in Europe is recovering, but the region faces ongoing debt problems and long-term structural issues. U.S. growth is hardly stellar, but it is decent compared to the rest of the world. 4

5 This is important when thinking about investment opportunities. Many so-called U.S. companies are actually much more global. Chemical companies or companies that produce household products may do as much (if not more) business overseas as in the United States. In contrast, health care services companies and many retail companies tend to focus on the domestic market. In general, we think it makes sense to focus on companies that derive more revenues from U.S. sources. Exhibit 5 shows that over the past couple of years, such companies have tended to outperform those that are more internationally oriented. At some point, it is likely that this theme will end and reverse itself, but for now, we anticipate it will persist. WE THINK THE CURRENT BULL MARKET HAS LEGS, but gains will be tougher to come by and selectivity will remain critical. Exhibit 5: U.S.-Oriented Companies Have Outperformed Recently 130.0% Foreign Exposure Domestic Exposure 120.0% 110.0% 100.0% 90.0% 12/31/2013 3/31/2014 6/30/2014 9/30/ /31/2014 3/31/2015 6/30/2015 9/30/2015 Source: Bank of America Merrill Lynch. Foreign exposure depicts the equal-weighted performance of the 50 stocks within the S&P 500 Index that have the highest foreign revenue percentage. Domestic exposure depicts the equal-weighted performance of those stocks in the S&P 500 Index that derive all of their revenues from domestic sources. Past performance is no guarantee of future returns. Different indices, economic periods, methodologies and market conditions will produce different results. It is not possible to invest directly in an index. Selectivity Remains Critical in a Slow-Growth World Investing in a slow-growth world may present some challenges, but we see opportunities. Additionally, equities are capable of thriving when economic growth is slow. As a case in point, from its low in 2009, the S&P 500 Index has more than tripled as we approach the end of In part, this is because inflation is virtually nonexistent and monetary policy is highly accommodative both byproducts of a slow-growth world. We don t expect an imminent end to the bull market, but we think the easy money has already been made. Investment gains will be more difficult to come by, and selectivity in investment choices will be increasingly critical. That s why we think investors should consider focusing on investment themes that have the potential to outperform as economic and earnings growth remain slow. 5

6 Robert C. Doll, CFA Senior Portfolio Manager, Chief Equity Strategist Bob Doll is a senior portfolio manager and chief equity strategist at Nuveen Asset Management. Bob manages the Large Cap Equity Series, which includes traditional large cap equities, specialty categories and alternative strategies. He is a highly-respected authority on the equities markets among investors, advisors and the media. As the author of widely-followed weekly commentaries and annual market predictions, Bob provides ongoing, timely market perspectives. Prior to joining Nuveen Asset Management, Bob held similar roles at other large asset management firms, including serving as chief equity strategist at Blackrock, president and chief investment officer of Merrill Lynch Investment Managers and chief investment officer of Oppenheimer Funds, Inc. He has 34 years of portfolio management experience, received a B.S. in accounting and a B.A. in economics from Lehigh University and an M.B.A. from the Wharton School of the University of Pennsylvania. He is a Certified Public Accountant and holds the Chartered Financial Analyst designation from the CFA Institute. Bob appears regularly on CNBC, Bloomberg TV and Fox Business News discussing the economy and markets. He has also been quoted in major business publications such as The Wall Street Journal, Barron s and Financial Times. INDEX DEFINITIONS The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy. The Russell 1000 Index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000 Index and includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1,000 represents approximately 92% of the U.S. market. Scott M. Tonneson, CFA Senior Research Analyst, Portfolio Manager Scott is the lead fundamental research analyst for the Nuveen Large Cap Equity Series, which launched in June The Series delivers traditional, specialty, and alternative strategies across the domestic large cap equity universe. He has also been a member of the management team for the firm s Equity Long/Short Strategy since Scott began working in the financial services industry in 1994 and joined the firm in Prior to his current role, Scott served as a senior quantitative research analyst responsible for building models to deliver relevant quantitative data to the equity portfolio teams. Previously, he worked at Ameriprise Financial as a quantitative equity analyst, business analyst, and account analyst. Scott received a B.A. in accounting from the University of St. Thomas and an M.B.A. from the University of Minnesota s Carlson School of Management. He also holds the Chartered Financial Analyst designation and is a member of the CFA Institute and the Chicago Quantitative Alliance. CFA and Chartered Financial Analyst are registered trademarks owned by CFA Institute. For more information, please consult with your financial advisor and visit nuveen.com. on Twitter Subscribe to the Weekly Commentary RISKS AND OTHER IMPORTANT CONSIDERATIONS The views and opinions expressed are for informational and educational purposes only as of the date of writing and may change at any time based on market or other conditions and may not come to pass. This material is not intended to be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice. The information provided does not take into account the specific objectives, financial situation, or particular needs of any specific person. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Investing internationally presents certain risks not associated with investing solely in the U.S., such as currency fluctuation, political and economic change, social unrest, changes in government relations, differences in accounting and the lesser degree of accurate public information available, foreign company risk, market risk and correlation risk. In addition, investing in securities of developing countries involves greater risk than, or in addition to, investing in developed foreign countries. Past performance is no guarantee of future results. is a registered investment adviser and an affiliate of Nuveen Investments, Inc Nuveen Investments, Inc. All rights reserved. GPE-EQOPPS-1215P INV-AN-11/16 Nuveen Investments 333 West Wacker Drive Chicago, IL nuveen.com