By Lauren R. Rublin
Adam Parker, founder and CEO of Trivariate Research, has long been fascinated by the information that can be found in missing data. He studied the subject in graduate school, earning a doctorate in statistics, and then took his passion to Wall Street, where what isn't evident is often key.
Parker was a top-ranked semiconductor analyst at Sanford C. Bernstein, and later global director of research, before becoming chief U.S. equity strategist and director of global quantitative research at Morgan Stanley. He subsequently ran a hedge fund, and launched Trivariate in 2021 to provide U.S. equity research to institutional clients, focusing on macro, fundamental, and quantitative variables, or the triple play implied by the firm's name. Last year, he launched Trivector Research, aimed at financial advisors and individual investors.
Parker's often-contrarian investment calls have won a devoted following on Wall Street. He shared his latest views on a variety of subjects, including equity valuations, dividend investing, and the trouble with software stocks, in an April 16 interview with Barron's. An edited version of the conversation follows.
Barron's: You pivoted from research to money management and back to research, and from working at large financial firms to running your own firm. Is there a central theme to your Wall Street career?
Adam Parker: I have always been interested in empirically studying things. The common thread is analytical rigor. My firm is called Trivariate to reflect the three variables -- macro, quantitative, and fundamental -- that we use to analyze stocks. I have relied on each in my career, and starting my own business was a way to fuse them.
How does that fusion work in practice?
We are interested in explaining what causes stocks to go up or down. Sometimes volatility is caused by macro factors -- a war, a change in the interest-rate path, a consumer disruption. The macro backdrop can explain a lot of variability.
Quantitative analysis means being efficient in digesting information and studying the relevance of historical patterns. Every day we download and compute hundreds of pieces of information for the largest 3,000 U.S. stocks.
Fundamental factors can mean anything from new products to deals, litigation, and the complexity of the capital structure. We think you need a combination of macro, quantitative, and fundamental analysis to optimize your chance to outperform.
Why did you choose the stock market as the avenue to express your interests?
When I finished my Ph.D., a friend at Sanford C. Bernstein told me they were hiring analytical people and that the firm had my kind of DNA. I interviewed and loved it. I worked at Bernstein for 11 1/2 years as an equity research analyst, and became a semiconductor analyst. I liked the balance of research and communication.
Does Trivariate begin its analysis with a macroeconomic view?
No. The stock market leads the economy, not the other way around. The economy has continued to surprise on the upside, just as trailing six months' stock performance forecast. Twenty-five years ago, I might have said you need to add an economic skeleton to your views. I don't believe that anymore. Its usefulness in building a winning equity portfolio is pretty low.
You should have some view about what introduces volatility to a stock, but my experience has been that economists and strategists have often been wrong. I would rather be wrong because of my own inputs.
What is your starting point for picking stocks?
No. 1, we try to forecast earnings, and No. 2, we try to forecast the price/earnings ratio. If you multiply the two, you get an idea of the market's price, or an individual stock's price. Many scenarios determine P/E multiples, including changes to the perceptions about interest rates, and changes to the perceptions about growth. At the stock level, what matters most is gross margin expansion, and beating the consensus expectations for earnings.
What is the outlook for gross margin expansion?
The median company's gross margin is contracting today. That means the median company's multiple probably goes down. We predicted that in our year-ahead outlook. It is one reason why we don't expect the stock market to gain as much this year as in the past few years. We came into the year expecting returns to be more muted, with the market flat to up 10%. I think that still is right. We expect more than half of S&P 500 companies will struggle to achieve gross margin expansion this year. In the past few years, more than half saw significant margin expansion.
Another important factor is estimate achievability. The penalty for missing earnings estimates lately has been much bigger than the reward for beating them, and cheaper stocks that miss have been falling more than expensive stocks that do so.
Your research shows that price/earnings ratios aren't helpful in picking winning stocks. Why don't they work?
Buying cheap stocks and shorting expensive stocks is a strategy that hasn't made money for 15 years. More importantly, the probability is higher that the stocks that grew more expensive in the past quarter will beat earnings estimates, as opposed to those that got cheaper. And, the chance that they beat estimates a second time is much higher. Buying momentum isn't being late to the party. It is predicting estimate achievability.
Framing this more fundamentally, maybe the market is saying that more-expensive stocks have a higher probability of benefiting from AI or being impregnable to AI disruption, while cheaper stocks have a higher probability of being disrupted.
Also, it is important to think about how much money is now run in a valuation-insensitive way. Most quantitatively focused investment firms have a three-hour to five- or 10-day investment horizon. This is called midfrequency. They have hundreds of long and short positions, so they are market neutral, meaning they should make money whether the market goes up or down. More than half of daily trading volume is valuation neutral.
Is dividend investing, or dividend growth, a winning investment strategy? What does your work show?
Individual investors don't think about dividends as much as they should. The S&P 500's dividend yield is low today because the largest companies in the index have very low dividends. But roughly a third of all equity returns in the past 100 years have come from dividends. The level of dividends doesn't matter as much as the growth.
We look at a lot of dividend factors, including payout ratios relative to the median payout ratio, which is probably around 35% to 40% for S&P 500 companies. Investors generally don't like companies with extremely high payout ratios, because the risk is higher that the dividend will be cut or canceled if the business turns down.
Which sectors screen most positively in your research?
We are recommending tech and healthcare. We recommend an underweight in consumer staples and consumer discretionary stocks.
Healthcare has been a bad call. We are recommending it because we are pretty convinced that healthcare earnings estimates are more achievable than average in the long term. We have an aging population that requires services, tools, diagnostics, hospitalizations, drugs, and other things. Revenue per share among S&P 500 healthcare companies has been growing every year for 30 consecutive years. The sector will be a big beneficiary of artificial intelligence. We are living longer and are more productive as we age. Many healthcare stocks will eventually benefit.
Let's take managed-care stocks, which have been annihilated year to date. The company we use raises prices 9% a year, and there is zero chance they will provide 9% more service. They are going to earn more money in the coming years unless there is a major recession and many smaller businesses fail, which seems unlikely. Their long-term estimate achievability is well above average.
Also, healthcare is a top-three M&A [mergers and acquisitions] sector. And there will be a number of new technologies that can help grow their revenue. The weakness in my presentation is that I could have said this three months ago, and the stocks are down. It is a longer-term view.
Which parts of tech do you like best?
We favor semiconductors over software. My highest-conviction call is not to be sucked in by any rally in software. Stocks that get cheaper, like software stocks, have a high probability of missing earnings estimates in the next 12 to 18 months, as we saw recently with ServiceNow. There are material challenges to the group's long-term potential. The disruption potential is high.
Why? No. 1, the companies don't have the pricing power they once did. Ultimately, large customers are going to develop some of their own bells and whistles, or cut seats. And No. 2, software companies are desperate to attach AI tools to prevent their customers from doing so themselves. Those tools won't be free, which means capital spending will be higher and operating expenses will be higher. Yet, analysts' estimates continue to embed the same 80% gross margin in their estimates as in the past.
Are there particular healthcare stocks that look attractive?
I like McKesson, Cardinal Health, and Cencora, the former AmerisourceBergen. They are wholesale drug distributors. Demand for drugs is going to be steady. There is population certainty there. McKesson has about $360 billion in annual revenue and a 1% net profit margin. If margins can expand to 1.5% or 2%, that would imply 50% to 100% earnings growth. In that scenario, the stock could trade for 35 times earnings,
I like Quest Diagnostics and Labcorp Holdings for similar reasons. And I expect managed-care stocks to be much higher in three years. I don't see the political will to reduce healthcare spending.
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