The big news this morning is changing the investing landscape and adding to the positive market response to the election results. At 90% efficacy in the first release of a late-stage, large study trial, Pfizer’s vaccine candidate is giving investors renewed hope of controlling COVID and getting life back to normal. Not only are travel and leisure stocks surging, but we are also seeing outlooks improve for a broader economic recovery, and that is boosting banks, energy, industrials, and other consumer stocks. Although this vaccine still has to see its success carry through to the end of the trial, and supplies need to ramp to treat the entire population, such a strong effectiveness level is encouraging. After delivering initial doses before the end of the year to front-line workers, Pfizer expects to be able to deliver over a billion doses in 2021. Investors are forward looking and recognize that this points to a return to normalcy: going back to movie theaters, concerts, sporting events, restaurants, and shopping malls. Today’s strong stock increases in many of these areas should not discourage investors: even after today’s surge, COVID-central stocks still remain down upwards of 30% from pre-pandemic levels.
Note also that even with the market’s rise this year, and today’s surge, not all stocks have recovered since the COVID-induced selloff back in March. Now, more than ever, investors must approach investing with great care. Some stocks have surged as their companies benefitted from the shift in consumer behavior in response to the pandemic. Others have languished as full economic recovery remains in the future. In this environment, investors can control risk and potential return by choosing among stocks from four different buckets: secular growth opportunities, economic recovery plays, defensive positions, and COVID-central names.
We are still seeing multi-year appreciation opportunities in the secular growth bucket from a number of drivers, and even some new trends. While many of the larger companies, such as Amazon and Facebook, garnered lots of attention as beneficiaries of the change in consumer behavior caused by the pandemic, those stocks have risen so much that much of the opportunity is behind them. And the arrival of a promising vaccine is prompting a rotation out of some of these names. But looking beyond those, we see, for example, that the 5G cellular upgrade cycle is just beginning, and that offers expanded profits for the service providers, the smartphone sellers, and the providers of the equipment to build out that infrastructure. We also see rising needs for larger, faster data centers to handle all the extra internet traffic, and filling those needs will require several years of further investments. Outside of technology and communications, we can find secular growth drivers, for instance, among industrial companies serving rising HVAC needs and infrastructure buildouts. Companies catering to these and several other market opportunities will enjoy secular tailwinds for several years.
The second bucket includes companies more leveraged to economic recovery. These include banks and energy companies and many companies in industrials and consumer discretionary markets. Many of these stocks have failed to recover much from their March lows, but may very well offer much better appreciation potential from here than historically. As economic activity picks up, banks benefit from rising deposits and loans. They would also see higher net income margins as the Fed pursues its revised inflation rule (inflation averaging) and the yield curve steepens as a recovery gathers strength. And valuations are particularly attractive. Energy company stocks are also suffering from high inventories and continued low demand—from the slow recovery and from weak travel activity. Some of these stocks offer well-covered dividends and are still down by 35% or more. As demand strengthens with economic recovery, we expect select stocks in these areas to be among the biggest gainers. In the meantime, investors are paid to wait with dividend yields well above the market average.
Over the winter, COVID will remain problematic, so there are risks in the near term to the pace of economic activity. Today’s news emphasizes that even as near-term risks are much greater than long-term risks (that vaccine again), investors can be forward looking. The surge in cases between now and the vaccine’s widespread arrival may force targeted shutdowns by region or city, and certain type of business could be closed, at least temporarily. Even without shutdowns, we could also see consumers become more cautious and decide not to frequent restaurants, theaters, or bars, and to refrain from travel. This would constrain the pace of recovery of the service economy, and although that’s a significant portion of the U.S. economy, these would be short-lived. So, we should be prepared for a bumpy ride, and stocks from the defensive bucket build in some protection from this risk. If consumers stay home, they buy more groceries, for example. Other stocks would be impervious to these risks and would provide stability (e.g., defense industry). But any rally in these types of COVID-defensive names is likely to be temporary, so we wouldn’t be inclined to add to such names given the likelihood of a vaccine.
Finally, the COVID-central names include those most adversely affected by the pandemic. While cases are rising globally, Pfizer’s news strongly suggests that the end is in sight. And we are also likely to see positive results from other vaccines. Even after today’s surge, many of these companies remain down over 30% relative to the beginning of the year. The potential for appreciation is unusually high. But we still need to tread carefully—will cruise lines see as much demand as pre-pandemic, or will there be ongoing unease about being trapped among a large group of strangers for a week or more? Yet, with the ability to get vaccinated, more people will surely get comfortable with these kind of vacations, enabling such firms to bring ships back on line. They may have lower profits than before COVID, at least for a number of quarters, but a strong recovery in business seems likely. They still offer substantial upside from current levels. We are continuing to see opportunities to add to our exposure in this bucket.