Peter Anderson

RCM

Corporate profits are poised for a comeback and the strength of their resurgence is likely to exceed Wall Street’s expectations, according to RCM’s top investment minds.

Peter Anderson, co-CIO of RCM U.S., believes that U.S. companies’ aggressive cost-cutting measures have injected a tremendous amount of operating leverage into the corporate system. He expects the recent spate of headcount reductions, inventory drawdowns and capital spending cuts to have a positive impact on the bottom line for U.S. companies as early as the fourth quarter of 2009. “Corporate earnings are going to be stronger than anticipated,” Anderson says.

A series of aggressive government policy actions and improving economic indicators have laid a foundation for an earnings revival, he says. “Monetary policy and fiscal policy have been extremely stimulatory. We will see inventory rebuilding later this year. Consumer confidence has stabilized and retail sales have improved.”

He also notes that there is plenty of liquidity in the market right now with so many investors sitting in cash, which he believes creates a favorable scenario for stock investing. Indeed, money market funds held nearly $3.8 trillion at the end of May, according to the Investment Company Institute.

Anderson says that many institutional investors have significant cash positions because they are waiting for a correction to the recent run-up – the S&P 500 rallied 39% in the three-month period from March 9 to June 9. And while he concedes that there will be pauses and pullbacks in the market in the coming months, he believes they will be both brief and shallow. “When everybody’s waiting for a market correction, you usually don’t get it. I don’t think we’re going to faintly re-test the lows. It will be a more grinding market with some short-term corrections but they will not last too long.”

He sees a slower march higher in the major averages as the broad-based rally gives way to stock-specific gains, which plays to RCM’s strength as a bottom-up investment manager. “Equities will continue to rise but it’s going to be much more of a stock-picking environment,” he says.

The brief market pauses RCM anticipates on the road to recovery will provide opportunities to build their positions. Scott Migliori, co-CIO of RCM U.S., says RCM will look to capitalize on these hiccups en route to a turnaround. “Anything short of a recovery in the third quarter could cause some short-term dislocations, which we would view as a buying opportunity given our bias toward a recovery in 2010.”

In terms of its macroeconomic outlook, RCM is still forecasting a U-shaped recovery with GDP rising 1.5% in the fourth quarter of 2009 accelerating slowly in subsequent quarters throughout 2010. “We’re seeing a lot of green shoots,” Anderson says. “We believe inflationary pressures in the short-term will be modest.”

However, there are risks to that recovery scenario. The dreaded L-shaped recovery, where the U.S. would experience zero economic growth akin to what Japan experienced in the 1990’s, could sink corporate profits. “That would be distinctly negative because then your earnings assumptions are gone,” Anderson says. In addition, a mounting budget deficit that could potentially exceed $1.5 trillion in fiscal 2010 could wreak havoc on the recovery if left unchecked, ultimately sending taxes and inflation higher and higher as excess labor gets siphoned back into the economy and capacity utilization tightens.

Nevertheless, RCM has been positioning its portfolio for the U-shaped recovery scenario by gradually adding industrials, transportation, technology, energy and cyclical stocks to its portfolios. Within that universe, Anderson favors small-cap equities versus large-cap equities. “Generally speaking, smaller-capitalization stocks have greater volatility. If you think the market is going up, you want volatility. At this point, we want volatility.”

RCM says it is avoiding the healthcare sector, however. “Healthcare has two problems,” Anderson says. “Problem No. 1: Relative earnings momentum is going to look poor compared with most cyclical companies – that is if you believe we are heading into an economic recovery. Problem No. 2: The stocks are moving into an enormous headwind in healthcare reform. We don’t know how it’s going to pan out. What finally comes out of Congress is extremely uncertain at this point. And uncertainty is not a friend of stocks so it’s going to potentially cap the movement of healthcare stocks.”

In financial services – the epicenter of the recession – RCM is focused on high-quality companies whose prospects for long-term growth are strong such as Charles Schwab, Northern Trust and J.P. Morgan. But with respect to banks whose balance sheets have been compromised in the wake of the credit crisis, the RCM research team is not comfortable owning a bulk of those names even if they’ve had a nice run-up the past few months.

“Eventually, the higher quality companies, which typically lag early in the recovery cycle, begin to reassert themselves,” Anderson says. “I think we’ll be in that scenario soon.”