After market surge, investors focus on out-of-favour stocks

With the US stock market on pace to end the year with a gain of almost 30 per cent, including dividend payouts, fund managers are finding themselves searching for stocks that have been largely ignored, as they head into 2014.

The only problem - they are finding slim pickings. The average stock now looks expensive by historical measures. The trailing price-to-earnings ratio of the Standard & Poor's 500 index - a measure of how much investors are willing to pay for profits - has crept up from below its long-term average of 15 at the beginning of the year to its current, pricier level of 18.5. "It's getting tough to find anything out there worth investing in when everything looks expensive," said William Mann, a co-manager of the $353 million Motley Fool Independence Fund.

The Federal Reserve said on Wednesday it will cut its monthly bond-buying stimulus in January by $10 billion to $75 billion, reducing the influx of easy money that has helped push stocks broadly higher.

While the announcement has actually only helped stocks thus far, strategists say that further reduction in the central bank's stimulus could push bond yields higher. That would make stocks comparatively less attractive for the income-focused portfolio managers who, Bank of America/Merill Lynch estimates, make up approximately 40 per cent of the fund universe.

As a result, some fund managers are moving into out-of-favour companies, ranging from US steel makers to Italian banks, on the theory that these unpopular stocks will offer more upside than the broader market in the new year. If they are right, then it could be a sign that the bull market that began in March 2009 is edging closer to its end.

Value funds, which tend to focus on out-of-favour stocks, typically outperform momentum-focused growth stocks in the second half of bull markets, according to Lipper, a Thomson Reuters company.

In 2006, for instance - the fourth year of a bull market that ended in 2007 - value funds (defined as those that look for bargain stocks that often pay dividends) returned an average of 17.3 per cent, while growth funds (those that look for stocks with momentum) gained an average of 8.5 per cent. This year, value funds are up by an average of 34.2 per cent, compared with a 36.1 per cent jump in growth funds. Both categories are beating the wider stock market.

Consensus estimates
The benchmark Standard & Poor's 500 index is only expected to gain 8 per cent in 2014, to 1925, according to a Reuters poll of 43 strategists. If that more sober outlook turns out true, it leaves plenty of room for mistakes on the downside.

Few see the stocks that have led the market this year continuing their run. Netflix Inc, for instance, will likely end the year as the top-performing stock in the S&P 500 index with a more than 300 per cent gain. Best Buy Co Inc, a company that flailed in 2012, jumped 254 per cent for the second-largest gain. Cyclical growth stocks like Boeing Co, Delta Air Lines Inc and TripAdvisor Inc each shot up by 80 per cent or more.

That is leading some strategists to say investors should focus more on less-loved stocks and sectors in the coming year, provided they have sustainable businesses.

With corporate cash stockpiles near record levels, David J Kostin, chief equity strategist at Goldman Sachs, expects that S&P 500 dividend payouts will increase faster than earnings. As a result, he recommends firms that he expects to raise their dividends in 2014 such as AT&T and Cisco Systems, which both underperformed the market this year.

Contrarian plays
Commodity-sensitive stocks and European industrials are among the stocks attracting contrarian investors lately.

"In this market we're finding more opportunities in specific companies whose industries are in decline," said James England, a portfolio manager of the $756 million Meridian Contrarian Legacy Fund.

England recently added materials maker GrafTech International Ltd to his portfolio, in large part because of the dim outlook for the steel market. The company's industrial materials segment, which includes products sold to the steel industry, accounts for approximately 82 per cent of its revenues, according to Thomson Reuters data.

Yet, England likes the company, whose shares have gained a market-trailing 18 per cent for the year, because the company has "consistently gained market share from competitors during market downturns," thanks to its strong management team, he said.

Eric Marshall, a co-manager of both the $836 million Hodges Small Cap Fund and the $13 million Hodges Pure Contrarian Fund, has also been adding commodity-sensitive stocks such as United States Steel Corp, Tyson Foods Inc and Chesapeake Energy Corp.

Commodities have fallen this year as a result of the US energy production boom and concerns about stagnant growth in China, the world's second-largest economy. Yet, strategists say that Chinese stocks look poised to rebound in 2014 thanks to a mixture of free market reforms and a shift out of expensive Indian shares by emerging market investors.

That shift could benefit American companies as well. US Steel, for instance, has seen its shares trail the market this year thanks to the slow rebound in commercial construction, which accounts for about 40 per cent of the steel industry in the United States, according to Moody's. "We think that this is a company that has been beaten up already and is in a good position to bounce back," Marshall said, but he declined to share his target price for the company. Internationally, European companies such as Dutch paints and chemicals company Akzo Nobel and Italian bank Intesa Sanpaolo are among the most attractive contrarian options, said Dale Winner, a co-manager of the $217 million Wells Fargo Advantage International Equity fund.

Winner recently added to his position in Akzo Nobel, whose shares are up 6 percent for the year, after the company finalized the sale of its struggling North American paints division and moved to cut costs in Europe. Analysts are split on the company - an equal number hold 'buy' and 'sell' recommendations - but Winner sees it as a bet on the moribund European economy to show more signs of recovery in 2014.

He's been buying into Intesa Sanpaolo for the same reason. The bank, whose shares trade at less than half of book value, has struggled as the Italian economy has shrunk for the last 8 consecutive quarters. Winner points to slight gain in industrial output in October as a sign that the country is slowly emerging from its recession.