When former Federal Reserve Chairman Ben Bernake started signaling the coming wind-down of Quantitative Easing (QE) in May 2013, bond markets quickly took notice. The ten-year Treasury yield leapt from 2% to 2.5% in the space of a few weeks. It continued to drift upward from there, reaching 3% by the end of the year. Less accommodative Federal Reserve policy should allow interest rates to drift back to more historically normal levels, although they might take a long time getting there.
Rising bond yields tend to put pressure on the stock market. In the July 2013 issue of Investor Advisory Service, we noted that high-yielding utilities and telecom stocks had come down especially hard since Bernake signaled the beginning of the end of QE, although the overall market remained solid.
Meanwhile, the economic data still reflected the low interest rates if the recent past. Housing and auto sales, two industries which rely on consumer financing, were both looking quite strong. Home refinancing was probably a driving force behind better consumer spending, which showed 4.3% year-over-year growth in May 2013, well ahead of the consistently tepid results of the last few years.
Stocks seemed reasonably valued, maybe a bit on the generous side by historical standards. The S&P 500’s forward P/E was 14.5, modestly higher than its historical average. If the economy was indeed accelerating, that P/E was probably a bargain. With rates rising, we wondered whether companies could continue to grow sales and profits fast enough to justify those valuations. Looking back, with the stock market up about 20% over the past twelve months, investors who remained bullish were certainly rewarded. Economic performance has remained uneven, but it seems to be good enough for stocks to continue to win a beauty contest over bonds.
Each month we feature three companies that we think are especially interesting and potentially timely. Let’s take a look back at one of our three July 2013 features, Franklin Resources, Inc. (NYSE: BEN) to see how the stock has fared in the twelve months since we first presented it to our subscribers.
Franklin Resources is an investment management company, the parent of the Franklin, Templeton, and Mutual Series fund families. Institutional investors, 401(k) plans, and retail investors around the world use the company’s products to gain exposure to its expert managers and global reach. One wrinkle compared with other publicly-traded investment managers is that Franklin’s assets under management are about equally balanced between stocks and bonds. Many of its competitors are skewed heavily toward the stock market. If interest rates continued to rise, we thought Franklin could outperform its stock-market focused competitors.
We showed Franklin to our readers at a split-adjusted price of $49.04. Returns have been okay but have lagged the overall market a little since then. At a recent price of $55.22, adding back a small dividend, shares have gained 14% in the last twelve months, noticeably behind the S&P 500’s 20% return.
Franklin shares got off to a rough start, falling 10% before the calendar even flipped over to July. When a stock pick starts out badly, it usually takes a long time to catch up. Financial results were fine. The company followed up a strong first quarter with 17% revenue growth and 21% EPS growth in Q2. Investors seemed to react very badly to negative fund flow data which suggested that Franklin was struggling to compete for new business, especially ETFs and other passive investment options. The long run threat is certainly real, but flows can also be highly volatile on a quarter-to-quarter basis.
Q3 results showed slower growth, but with excellent margin expansion. Revenue increased 9%, with operating income up 18%. EPS rose just 4% due to losses in currency translation and seed capital investments. Investors seemed happy enough with the quarter. BEN shares bounced back, reaching all-time highs in January.
Shares came back down sharply from those highs, however. The rising interest rate trend reversed in early 2014, bringing 10-year Treasury yields down from 3% to about 2.6%. The stock market remained strong, but Franklin’s competitors benefited more. Retail investors simply lost interest in bond funds. With yields so low, who could blame them? As long as all the action is in the stock market, it’s going to remain hard for Franklin to keep up. Although not publicly traded, reports seem to indicate that west coast bond giant PIMCO has suffered a more extreme version of the same fate recently. Clients are simply wandering away from the big bond houses. While Franklin’s mid-teens return over the past twelve months is respectable, it fails to keep up with the overall market. When interest rates start to rise again someday, retail investors will probably come back to fixed income, possibly in droves. For the foreseeable future, Franklin may just give investors a dampened version of stock market returns. It will probably always lag a little in strong markets like we’ve seen over the past twelve months. One silver lining, the stock should hold up a little better than its competitors during periods of market weakness.