‘There are times when you want to bet against consensus, and now is one of those times.’
If August’s stock-market weakness has you concerned, brace yourself because it’s going to get a lot worse.
That’s the outlook of Eli Salzmann, who manages the Neuberger Berman Large Cap Value Fund NPRTX. While most investors have migrated to the “soft landing” and “no landing” camps, Salzmann holds steadfast to his belief that a recession is on the way.
Why should you care what he thinks? Because where most mutual fund managers have a tough time beating the U.S. market, Salzmann’s $12.6 billion fund outperforms nicely over the past three- and 10 years, according to Morningstar Direct.
Much of that long-term outperformance comes from out-of-consensus forecasts about macro trends — like the one behind his current cautionary stance.
“The economy is heading south in the next six to nine months,” he told me in a recent interview. “Make sure your portfolio is very defensive and protects on the downside, because the downside isn’t going to be pretty.”
If you are looking for defensive names to consider, here’s how Salzmann is positioned for what he expects will play out.
Top holdings include “steady Eddie” consumer staples names including Procter & Gamble PG, +0.66%, PepsiCo PEP, +1.26%, Philip Morris International PM, +1.05% and beverage and snack giant Mondelez International MDLZ, +0.92%. The fund also has substantial positions in utilities including Duke Energy DUK, +0.66%, Sempra SRE, +1.10% and Exelon EXC, +0.55%, and mature healthcare giants Johnson & Johnson JNJ, +1.43%, Merck MRK, +0.69% and Pfizer PFE, +0.61%. Salzmann recently had 18.8% of the fund’s portfolio in consumer defensive names, compared to 8.6% for large-cap value funds overall, according to Morningstar Direct.
Likewise, the fund manager is underweighting cyclical sectors like banks, technology, and consumer discretionary companies in the portfolio. For example, he has 2.6% of his fund in tech vs. 12.5% for large cap value overall, Morningstar reports.
This defensive posture has decidedly hurt the fund so far this year — when the crowd moved into cyclical sectors as worries about recession eased. Salzmann’s fund trails both the Morningstar large-cap value category and Morningstar U.S. large-cap value index. But he’s not throwing in the towel.
“Do we think it is time to cave in and go with everyone else? No. We are staying where we are,” Eli Salzmann says. “There are times when you want to bet against consensus, and now is one of those times. We think being defensive is absolutely the right move.”
Salzmann’s cautious economic outlook and defensive posture are based on three core concepts that reformed bears largely abandoned this year.
1. Monetary policy takes around 18 months to impact the economy — and it’s about to hit: Since the Federal Reserve raised rates aggressively in the first part of 2022, that means the U.S. central bank’s policy change is only now going to start hitting the economy. “At some point past September, leading indicators will have tough time,” Salzmann says. Likewise, tighter monetary policy takes about 24 months to hurt company earnings. He adds: “At some point later this year or next year you will see companies miss earnings in a big way.”
The important wrinkle here is that investors consistently forget about this time lag, and shrug off a dramatic monetary policy change. “When the economy did not slow in a substantial way towards the end of last year everybody said it’s time to go back in the water. Guess what. The sharks are still there.”
‘What happened with the banking sector was simply the appetizer.’
For example, Salzmann expects more trouble in the U.S. banking sector, in part because of exposure to commercial real estate loans. But he expects problems beyond that, as the aggressive Fed rate policy inevitably “breaks” something.
“What happened with the banking sector was simply the appetizer. Other issues will come up,” Salzmann says. He doesn’t offer predictions about what the Fed will “break” next. Fair enough, because past Fed policy moves show the breakage happens in unexpected places — like Orange County, Calif. in the mid-1990s, or Lehman Brothers during the Great Financial Crisis.
2. The inverted yield curve continues to predict a recession: A lot of investors have written this forecast off, because the yield curve has been so wrong for so long. It has been inverted for 11 months. “People on Wall Street are saying the saying yield curve does not matter. I have heard this rhetoric before, but it has a 100% success rate,” he says. “100% of the time when the yield curve has been inverted for this length of time there is a recession.”
3. Inflation will be higher for longer: “We are not going back to 2% or below on a sustained basis. We think inflation will be in the 3% to 4% range,” Salzmann says. He cites the decline in globalization, which removes the downward pressure on U.S. prices exerted by lower production costs in China and India. If he’s right, both the U.S. economy and cyclical stocks will face challenges because the Fed will have to maintain its anti-inflation campaign.
The bottom line: Despite rosy metrics out there like the Atlanta Fed GDPNow expected 5% third quarter growth, Salzmann thinks we are moving into the late stage of the cycle where the economy moves towards a recession — and when defensive names outperform.
Salzmann has benefited from contrarian calls in the past, albeit in the opposite direction — or towards cyclical names and away from defensives. In both 2016 and the first half 2020 he went long cyclicals at a time when other investors moved to defensive names because of worries about global recession.
Making the right contrarian macro calls is only part of the challenge for portfolio managers. They also have to be in the right stocks to benefit from their calls. Salzmann shares two tactics he says contribute to his fund’s success.
1. Favor sectors where capacity is scarce because they have been deprived of capital: The capacity shortage means surviving companies in the space can enjoy higher profit margins because they have fewer competitors.
Here, Salzmann cites basic materials, where he owns an array of mining companies including Newmont NEM, -1.92%, Rio Tinto RTNTF, +4.02%, Wheaton Precious Metals WPM, -0.47%, Franco-Nevada FNV, -0.84%, Freeport-McMoRan FCX, -0.18% ), Mosaic MOS, +1.17% and Barrick Gold GOLD, -0.38%. Around 9% of the fund’s portfolio recently was in such basic-materials stocks, compared to 3.6% for large cap value funds overall, Morningstar says.
Energy is the other sector where capacity is scarce because of underinvestment. Global oil investment was 40% lower last year than in 2014, says Goldman Sachs analyst Bruce Callum — part of an underinvestment trend that has gone on for years. In energy, Salzmann’s fund has taken big positions in Exxon Mobil XOM, +1.79% and Chevron CVX, +0.75%.
2. Favor companies that look cheap against normalized earnings: Many stock investors take the easy way out and value stocks against Wall Street consensus earnings forecasts. It’s better to do the legwork and recognize when earnings are temporarily suppressed — and about to bound back to normal. This helps you find the really cheap stocks with better potential. “We look for companies with below-normal returns that have catalysts over the next 12 to 18 months,” Salzmann says.
Consider Procter & Gamble as a mini-case study. Financial databases typical show the stock has a forward price-earnings multiple of about 24. That does not look cheap. But those consensus earnings estimates are too low, Salzmann says. The company has been investing in new product development and automation. “So, earnings are below normal,” he adds.
Investors will see a boost in earnings due to market-share gains and profit margin improvement linked to productivity gains because of these investments, Salzmann says. Incorporating these anticipated earnings gains, Procter & Gamble trades at 19 times Salzmann’s expected normalized earnings, which are considerably higher than consensus earnings expectations. “On the surface, Procter & Gamble does not look that cheap,” he says. “But it is cheaper than it looks because earnings are well below normal.”
Michael Brush is a columnist for MarketWatch. At the time of publication, he owned FCX and XOM. Brush has suggested PM, JNJ, PFE, FCX, MOS, XOM and CVX and in his stock newsletter, Brush Up on Stocks. Follow him on X (formerly Twitter) @mbrushstocks