Insights from our annual roundtable on the best stocks and the biggest risks.
Every party has to end sometime. That’s the troubling thought that’s been nagging at many investors this year, even as they’ve continued to profit from one of the longest-running bull markets for stocks in history. Positive economic trends and transformative changes in technology are helping many companies deliver standout returns—but is it time to get choosier about sorting winners from losers? To answer that question as we roll into 2018, Fortune convened our annual roundtable of investment experts.
This year’s panel included David Giroux, chief investment officer for equity and multi-asset at T. Rowe Price and manager of a $45 billion portfolio; Kera Van Valen, managing director and portfolio manager at Epoch Investment Partners, a firm with $49 billion under management; Byron Deeter, partner at Bessemer Venture Partners, a global VC firm with $4.5 billion under management; Dan Chung, CEO and chief investment officer of the $19 billion Fred Alger Management advisory firm; and Savita Subramanian, head of U.S. equity and quantitative strategy at Bank of America Merrill Lynch Global Research, whose wealth-management client balances total $2.7 trillion. Here, edited excerpts from their discussion.
FORTUNE: I’d like to ask about the very long bull run that we’ve had in stocks. The bull market is almost nine years old. Some Cassandras, myself included, have been worried that markets are overvalued, especially in the U.S. Is a slowdown or even a market correction looking more likely in 2018?
SAVITA SUBRAMANIAN: It does feel sort of unsettling. By next July if the market continues to go up, we’ll be in officially the longest bull market, by technical definitions, in history. And it doesn’t feel good to buy equities now.
But if you think about 1999, it was a year where valuations were getting high. One sector was driving most of the returns of the S&P 500. It didn’t feel great to buy equities, yet that was one of the best years of that bull market.
It also turns out that valuations are a really lousy market-timing model. If you’re concerned about what happens over the next 12 months, the amount of returns that are explained by the price/earnings ratio are basically close to zero.
Dan Chung, Fred Alger Management, CEO & CIO
Dan Chung, Fred Alger Management, CEO & CIO Photograph by Spencer Heyfron for Fortune
FORTUNE: You invoked 1999: One of the better performing areas of the market in the past year has been, once again, technology. But, Dan, you were saying that tech valuations, relative to history, are not that high.
DAN CHUNG: If you look at the 20-year median P/Es of each sector, even with the run that they’ve had, technology and health care are basically trading at their median P/Es. The sectors that are trading at premiums are actually materials, utilities, staples, and industrials, where they’re somewhere between 14% and 20% premiums to their medians. So by that measure, technology and health care actually remain reasonably valued.
BYRON DEETER: We passed some major milestones last year that I think speak to the fundamental performance of these tech businesses.
In July, the five largest market cap companies on the planet were all venture-backed tech companies, including Apple, Alphabet, Microsoft, Amazon, and Facebook. No. 6, by the way, is Alibaba, also venture-backed technology, in China. The fundamental business performance of these companies has allowed them to pass the old guard of Berkshire, JPMorgan, and Exxon for the world’s most valuable companies.
And as you think about the trends ahead—mobility, machine learning, cloud computing—a lot of these tailwind trends that are ripping through large portions of the economy are increasing and going to continue.
KERA VAN VALEN: We’ve also moved from a market that’s been fueled by quantitative easing to one where it’s actual fundamentals—earnings growth, cash flow growth—that have driven the markets. We think that can continue, so we’re not looking for a correction by any means.
“We think [growth] can continue, so we’re not looking for a correction by any means.”
– KERA VAN VALEN, EPOCH INVESTMENT PARTNERS
FORTUNE: David, do valuations in particular asset categories worry you?
DAVID GIROUX: Globally, wherever you look, valuations are high and credit spreads are kind of tight. Treasury interest rates are kind of low as well, so there’s no real good value.
Foreign stocks are nominally cheaper than U.S. stocks, but really when you look under the surface and take out the FANG stocks [Facebook, Amazon, Netflix, and Google], European stocks and U.S. stocks are somewhat similarly valued.
“Globally, wherever you look, valuations are high and credit spreads are tight.”
– DAVID GIROUX, T. ROWE PRICE
I would say the one sector that we like a lot is non-pharma health care. You’re getting companies basically running at a market multiple with 1.5 to 2 times the growth rate of the market. So you think about something like the life science tool companies, like a PerkinElmer (PKI, -0.05%), or Thermo Fisher Scientific (TMO, -0.28%). They have a lot of exposure into China. And you think about what’s driving China’s growth rate, it’s health care, food safety, water quality. These are things that all the life sciences companies sell into.
FORTUNE: That is in some ways a technology play too.
CHUNG: Right. I think in pharma and biotech, for example, you’ve got, oh, I don’t know how many years ago the human genome was sequenced and then the development of ever faster, ever cheaper sequencing techniques. That set the base for research that is now coming out with new drugs. For example, immuno-oncology: Cancer tumors are not all the same, basically, and genetic differences can determine what cancers respond to which drugs and which do not. And it’s not just cancer, of course. Cystic fibrosis [drugmaker] Vertex (VRTX, +0.15%) has shown pretty remarkable advances there in treating that terrible disease.
On the equipment side, we like Illumina (ILMN, -0.62%), which is one of the genetic sequencing companies that provide the heavy horsepower to analyze specific genetic codes and sequences for clinical and research purposes. There are also advances that are software and automation driven. So a great company like Intuitive Surgical is using more and more automation software to allow surgery to be done with more control, less damage to healthy tissue or nerves, and less invasiveness.
FORTUNE: Let’s talk about tax reform. We’ve been talking about American companies selling their products worldwide. And as we know, they’re parking a lot of their earnings overseas. If tax reform passes and a lot of that cash comes back to the States, does more of it flow to shareholders?
VAN VALEN: It’s unlikely that any one-time cash change, or any tax reform per se, is going to increase capital investments because access to funds has been quite easy in recent years. So a one-time event shouldn’t change that. We would expect it potentially to materialize more through share buybacks. If there’s a permanent level to the tax reform and tax reductions, then dividends could increase even without companies having to change their capital allocation policies because they would be more profitable.
DEETER: There are some real potential positives from tax policy. In terms of immigration policy, I’m a little more concerned. The data shows that 51% of companies in the tech sector with over a billion dollars in market cap were started by at least one immigrant founder. If you throttle that back, or if you start to limit immigration, there will be disastrous impact on the innovation economy.
Savita Subramanian, Bank of America Merrill Lynch, Head of U.S. equity and quantitative strategy.
Savita Subramanian, Bank of America Merrill Lynch, Head of U.S. equity and quantitative strategy. Photograph by Spencer Heyfron for Fortune
SUBRAMANIAN: That’s absolutely right. Tech is the most exposed to H-1B visas of any sector. So, yeah, that is a big risk for the tech story.
FORTUNE: If that risk comes to fruition, who gains if the U.S. loses?
SUBRAMANIAN: In stocks, you’d want to go domestic; you’d want to go for U.S. companies that hire primarily U.S. workers. I think that’s ultimately inflationary and potentially stagflationary, because we’re crimping off growth from overseas.
CHUNG: I think China would be in a very strong position for investors. Their Internet industry is just as strong as the U.S. They’re making huge investments in the Silk Road initiative for infrastructure. And if the U.S. is really withdrawing from globalization and immigration, they are a source of capital as well for all of these projects, as well as talent.
And I would point out companies like Tencent (TCEHY, -1.01%), where in mobile payments they’re well ahead of Western or even European standards.
GIROUX: I actually spent a lot of time in D.C. over the last year. I think you will see tax reform. I think it’s a positive for the U.S. market because the average company today is at about a 27% tax rate. If that can go down to 20%, that could boost earnings for the market, 7%, 8%, 9%. The domestic companies, financials, consumer discretionary companies would probably be the winners.
So if you look at a company like a Pfizer (PFE, +0.76%) that has a 34% tax rate, their earnings could potentially go up as much as a dollar a share if you had tax reform. You could look at a Dr Pepper Snapple (DPS, +0.00%) with a 34% tax rate, where their earnings—it was actually trading at a discount to what it historically traded, where the earnings could go up 15%. There are a lot of high-tax-rate companies that are just not being appropriately valued for [the impact of a tax cut].
FORTUNE: Historically it’s been argued that a big tax cut benefits smaller companies more.
SUBRAMANIAN: It’s true. Small-caps pay a higher effective tax rate. They would stand to gain a lot more from that tax cut. But within small-caps you need to be careful because the question is, How much of that tax benefit are companies going to actually retain? And what we’ve found is that when you have a windfall for a sector or for the market overall from a lower corporate tax rate, a lot of that benefit is actually competed away.
So for example, if you’re in a commoditized industry and you and all of your competitors get a windfall in terms of a lower tax rate, maybe you pass that on to your customers through lower prices, and that marginal benefit actually gets whittled away by natural competitive forces.
Byron Deeter, Bessemer Venture Partners, Partner.
Byron Deeter, Bessemer Venture Partners, Partner. Photograph by Spencer Heyfron for Fortune
FORTUNE: Could tax reform turn 2018 into a big IPO year?
DEETER: Quite possibly. We have this very bizarre market dynamic right now, which you can call the logjam of the unicorns, the unprecedented number of high-quality companies that have chosen to delay their IPOs. Eight years ago was the first time a venture-backed private tech company was valued at over a billion dollars. We have over 200 today worldwide, and well over half those are in the U.S.
“We have this very bizarre market dynamic right now, which you can call the logjam of the unicorns.”
– BYRON DEETER, BESSEMER VENTURE PARTNERS
And so you’ve got this glut of fabulous companies, high-quality companies that in prior years would have been public, and today are sitting on the doorstep with ranges from the Ubers and Airbnbs and Pinterests in the tens of billions to dozens of enterprise cloud companies that are worth well over $1 billion.
I know of several companies personally that are targeting early 2018 IPOs if the market holds up, but are waiting until late Q1 or early Q2 so that they can include their full 2017 audited financials. We just need predictability—low volatility and willing buy-side investors.
FORTUNE: What are some of the specific industries where you’ll see new technology moving the needle next year?
DEETER: Automotive a few years from now will be completely transformed by the three big trends: electrification, on demand, and soon, autonomy. I don’t believe kids born today in the U.S. will get their driver’s licenses, and it will seem like a hobby to drive a car, much like riding a horse is, because it’s irrational and unsafe.
FORTUNE: Do you think the legacy automakers can keep up?
CHUNG: They cannot keep up. They’re going to play because they can be late followers, but the leaders are clearly going to be companies like Tesla, Google [and its parent Alphabet], Uber, and we’ll see if Apple still is playing in the automotive field. And the important part, I mean, the car may say GM on it, but if they have to license the automated driving technology from somebody else, if they have to purchase better electronics from the outsource, then the value in the car might increasingly go to the technology leaders as opposed to GM.
DEETER: I would just add there’s over a dozen automotive companies spending over a billion dollars each toward the combination of this autonomy and electrification wave. And so I give GM, Ford, and Daimler some credit. They’ve been acquisitive but also have invested internally.
FORTUNE: Let’s talk about inflation. You’ve had the Federal Reserve signaling that it’s going to continue to tighten interest rates, and you’ve had some wage growth that might move the needle a little bit. How is that affecting your strategy?
VAN VALEN: We’ve been talking about when interest rates will rise for five years now, so it is a little bit of a relief to actually be in an environment where interest rates are rising.
That’s true even for sectors like utilities, which everyone assumes will be challenged. Utilities have performed in line or better than the S&P 500 since the first interest rate hike in 2015 here in the U.S. So as long as you’re focusing on the right utilities, not just high-yielding companies, but companies that actually have the cash flows and the growth to support their cash returns back to shareholders, we think that the rising interest rate environment is actually a good thing as long as it is a reflection of improvement in the economy.
And even the utilities sector is benefiting from technology, for example with smart meters. Smart meters mean not having to employ as many people to go out when there’s a storm. You don’t have to drive around the block to figure out where the tree fell that knocked down the power line because the smart meter can tell you this immediately. PPL (PPL, +0.14%) is an example of a company currently investing in a smart-meter replacement project that is modernizing the power grid to make it more resilient. This smart-meter project does contribute to the rate base, earnings and cash flow growth, which ultimately helps drive the growth in the dividend.
SUBRAMANIAN: The Fed has been printing a lot of money, and normally you see inflation alongside that. And we haven’t.
One interesting trend that we’re noticing in the U.S. is this growing scarcity of labor within more manual-labor-oriented jobs. So for example, our industrials analysts, our transports analysts have been writing about the fact that these companies can’t find manual labor types of workers. And the reasons are pretty unusual. There is a larger percentage of people addicted to opioids, and that’s shrunk the pool of available workers. There’s a higher incarceration rate. And we’ve also noticed that the average, you know, typically male members of society that sign up for these jobs are playing more video games.