US states will struggle to cover costs this year, says ClearBridge

Scott Glasser is New York-based senior portfolio manager of the Legg Mason ClearBridge US Appreciation Fund and screens stocks for quality. He has 18 years of investment industry experience. ClearBridge Advisors is Legg Mason's largest equity manager, with $53.7 billion in assets under management as of December 31.

In 1993, Glasser joined the research department of ClearBridge's predecessor firm Shearson Lehman Brothers as a consumer analyst and became a portfolio manager a year later. Before that, he was a credit analyst at Bear Stearns.

AsianInvestor: What is your outlook for the US over the next year?
SG: In the US, we will have similar types of problems to Europe's sovereign-debt issues except that they will be in either states or municipalities, where they will struggle to cover their costs and they have debt issues. Economically, our working thesis is that the economy here is getting better, but at a slow pace, and the recovery will be sub-par. All the economic data supports that.

Loan growth here continues to be negative and you will not get vigorous growth until you get real loan growth by the banks. We therefore want to make sure that from a stock-selection standpoint we are not picking equities that are dependent on a vigorous rebound in economic growth.

GDP will continue to be okay and things will continue to move along, but don't be fooled: it is still government spending that is driving demand. There is some business spending, but it is clearly not coming from the consumer, which is two-thirds of the US economy.

Finally, our view is that the market will provide modestly positive returns this year. Recent earnings were good, but the market sold off on those earnings because expectations were very high. We need to continue to see an improvement in earnings and, more specifically, an improvement in top-line growth, because that is an indicator of true demand. You saw some small increases in the past quarter, but you need sustained increases in top-line growth to really generate some momentum.

In an environment where that is hard to come by, you want companies with consistent, predictable earnings. Indeed, we have always preferred high quality, high return, earnings-driven companies -- and these will be in favour this year. So we think that, tactically, we are in a pretty good spot.

What big themes do you see emerging over the next 12 to 18 months?
The biggest opportunity we see in this market is higher-quality companies with consistent earnings growth, high returns and lower leverage. In this market, you are starting to see -- and will continue to see over the course of the next year -- a return to higher-quality stocks.

The second theme I would highlight is companies that have an advantage from a capital-management standpoint. What I mean by that is there are a number of companies that are blessed with tremendous cash flow, having got through the recent market dislocation okay, but do not have opportunities externally to deploy that cash flow, and some of them are using it very aggressively to buy back their shares. An example of this is Travelers, the leading property/casualty company in the US and our largest position.

Property/casualty is a cyclical business, which is currently at trough levels. Pricing is either flattish or increasing, but Travelers has a lot of capital that it's looking to deploy. It's likely the company will buy back as much as 14% of its outstanding shares over the course of the next year, which is incredibly significant, because it means that when things do turn positive, you're going to get tremendous leverage on that lower share count.

Another example of this theme is [New Jersey-based] NRG Energy, which is the only utility we own. The company just bought back 5% of its shares in the last year and will probably buy another 5% in the next year. So there are a lot of companies that have pretty strong cash flows and large cash positions.

So we are looking for companies that could significantly reduce their share base -- and when I say significantly, I mean a reduction of more than 5% -- if there are no opportunities externally to grow the business. So that is a second theme: capital management.

The third theme I would highlight is the industrial sector, where we are overweight, but demand is low. There is growing demand in some sub-sectors -- in aerospace, for example, and also in some of the infrastructure sectors -- but you are not really seeing a lot of demand overall.

There is an inventory rebound, but you are finding that corporate America is likely to continue hanging on to its cash, which is now up to 11% of assets according to a recent report by JP Morgan, because the environment is uncertain and still risky. In the industrial sector, companies have been under-spending, so you have some pent-up demand in terms of capex spend as we go forward, and industrials are going to be a big beneficiary of this.

The final theme is our belief that the US consumer will continue to be weak on a discretionary basis. Recent surveys have shown that spending patterns are unchanged and that consumers continue to be very price-sensitive. We are not seeing any big-ticket purchases in terms of their buying habits and unemployment, as we know, although it has improved a little bit, remains very high is likely to stay high for a long period of time

Are we going to see more M&A activity over the next year?
You are, and we're starting to see it. This is a reflection of the low cost of finance, high cash levels and the fact that demand is hard to find, therefore, if you're not generating growth organically, you're going to want to generate it by going out and buying companies. So the trend in M&A will continue to grow, and it is going to be across industries. In fact, you have already seen it happening in energy, pharmaceuticals and some technology companies.

What about your sector positioning?
Healthcare was a major underweight for a period of four or five years [and that was still the case in September], as healthcare stocks dramatically underperformed. However, we have started to reduce that underweight by adding to our existing holdings in pharmaceutical companies Merck and AmerisourceBergen. Most recently, we also added a European pharmaceutical company to the portfolio.

All this is a reflection that, in our minds, the industry has reached an inflection point, where growth and multiples are no longer slowing because pharmaceutical companies have taken steps to address what is a big generic risk in the next few years -- patents running out.

They have also made changes to their management structures, appointing CEOs with non-pharmaceuticals backgrounds, which gives them a fresh perspective. They have also reorganised their sales organisations, which were significantly bloated, and we've seen some M&A activity here in the US, all of which will help to address the patents issues they face over the next couple of years.

Finally, we reduced our exposure to energy over the past quarter. Energy had been a very good sector for us and we had a bias towards natural gas companies, which have strong production profiles and display vigorous growth. However, a lot of these stocks rallied quite significantly in the fourth quarter, and after this good performance we reduced the number of stocks, and our exposure to the energy sector is slightly underweight now.

Finally, what other changes do there need to be to improve the market?
Time has to pass. There are a lot of wounds that are still either open or sore. From a retail perspective, you have lost probably at least half a generation of investors, and they won't come back in for some time. And the unfortunate thing is that when they do start to return, the market will already be significantly higher.

To repeat, time is a big factor here. As we get through this year, as we provide some stability, as we get some spending, as confidence starts to return and as US unemployment starts to subside, all this will provide confidence for the markets. But it won't happen over the course of a quarter. It will happen over the course of the next couple of years.