Franklin Equity Group®
Edward B. Jamieson, President, Chief Investment Officer and Portfolio Manager
Broad US equity-market gauges ended 2013 at record levels powered by record-high corporate profits, increased dividend payouts, continued share repurchases and improved investor confidence. The Fed’s decision to begin tapering its stimulus efforts also appeared to be positive for investor sentiment and could signal a favorable environment for earnings growth potential, in our view. After the market rise in 2013, valuations at year-end were generally closer to fair value, in our opinion. We would expect to see market performance driven less by multiple expansion and more by earnings growth in 2014.
There are a number of specific trends that led to particularly strong earnings growth for some companies in 2013 that we think could continue into 2014. For example, in the United States, consumer spending growth has boosted sales and profits for auto and auto parts manufacturers. Manufacturers that have developed advanced fuel-efficiency technologies have benefited from this trend, as well as the trend for more fuel-efficient cars. Fuel efficiency also has been a growth driver in aerospace, benefiting companies that have developed new high-strength, lightweight carbon fiber materials used in modern aircraft. This composite material is stronger than aluminum while being significantly lighter, and it is more reliable than other traditional metallic materials, all of which can lead to lower aircraft maintenance and fuel costs. Longer term, additional applications of these materials may include cars and other industrial products for which innovations that can reduce weight are highly valued.
Among other industrial companies, new technologies and methods for the production of oil and gas in the United States have driven profit growth for the developers of those technologies, as well as oil producers, and they have moved the country further down the road to energy independence. Our positive outlook for these firms is underpinned by the fact that combined oil and natural gas shale resources in the United States have put it on pace to potentially top Russia as the world’s largest producer of both fuels, with the possibility of also surpassing Saudi Arabia as the world’s largest oil producer by 2020, a somewhat startling shift that has been reshaping global energy markets.
Elsewhere, new developments in electronic technology have enabled brand-new content and Internet-focused industries to spring up, generating extraordinary revenue growth. Just one such strategic shift involves treating software as a service: Companies that provide as-needed delivery of software through cloud computing can give corporate purchasers access to state-of-the-art programs whose affordability might otherwise be out of their reach.
Additionally, we have significant optimism about what we view as a new renaissance period for drug research, development and production. In 2013 alone, new developments in genetic mapping and analysis led to spectacular breakthroughs in the treatment of cancer, cystic fibrosis, multiple sclerosis and hepatitis C, creating billions of dollars of new market value for the discoverers of these treatments. Overall, we believe the biotech industry has reached a tipping point in terms of targeted therapies often termed “personalized medicine” because they target a specific molecule, which can both improve effectiveness and reduce the instance of off-target side effects.
These are just some of the examples of how the dynamic private economy in the United States and rapid technology changes for many industries have met our society’s needs and driven the US stock market higher in recent years. Looking forward, we believe this dynamism will continue to raise living standards and could potentially deliver profit growth for many companies.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. Generally, those offering the potential for higher returns are accompanied by a higher degree of risk. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with their relatively small size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. The financial instability of some countries in the EU, together with the risk of that impacting other more stable countries, may increase the volatility and risk of investing in companies in Europe. Value securities may not increase in price as anticipated or may decline further in value. Smaller-company stocks have historically had more price volatility than large-company stocks, particularly over the short term. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. Lower-rated bonds and distressed debt entail higher credit risk. Mergers, reorganizations, liquidations and other special events involve special risks as pending deals may not be completed on time or on favorable terms. Short sales of securities involve the risk that losses may exceed the original amount invested. Investing in the natural resources sector involves special risks, including increased susceptibility to adverse economic and regulatory developments affecting the sector—the prices of such securities can be volatile, particularly over the short term. Real estate securities involve special risks, such as declines in the value of real estate and increased susceptibility to adverse economic or regulatory developments affecting the sector. Investments in REITs involve additional risks; since REITs typically are invested in a limited number of projects or in a particular market segment, they are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. Diversification does not guarantee a profit or protect against a loss. These and other risks pertaining to specific funds or strategies, such as those involving investments in specialized industry sectors or use of complex securities, are discussed in the relevant fund’s prospectus.