Domestic Equity—Growth | January 2014

Durable goods companies appear poised for sustainable earnings growth

By Thomas J. Pence, CFA; Michael T. Smith, CFA—Portfolio Managers, Wells Fargo Advantage Omega Growth Fund

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We expect consumers to increase their spending on durable goods (products expected to last longer than three years) in the upcoming quarters, which could elevate their current below-average spending levels toward historical average levels. In our view, such increases could provide select durable goods companies with a long-term path for superior earnings growth. Wealth effects from rising home values often strengthen consumer confidence and lead to increased spending on bigger-ticket, durable items. We see signs that the increasing wealth effects may increase consumer spending on durables despite the modest rates of job creation and low wage inflation. In our view, the current valuations for some durable goods companies do not appropriately reflect the strength and sustainability of their potential earnings growth.

Pent-up demand for durable goods indicates an attractive opportunity for investors

Quarterly personal spending on durable goods as a percent of gross domestic product (GDP) is currently far below its historical average. In fact, even though the figure improved to 7.5% of GDP at the end of June 2013, it still lingered below the bottoming that we’ve seen in past economic cycles (see Chart 1). Consequently, we believe there is significant catch-up spending on durables that is likely to develop over the next few years.

Solid gains in home prices should bode well for consumer spending on durables

The National Association of Realtors indicated that the median sales price of an existing home in the U.S. rose nearly 13% over the 12-month period that ended October 31, 2013. This sharp rise in home values contributed to significant gains in overall household net worth and provided a catalyst for higher spending on durables by consumers over the past couple of quarters. In the U.S. GDP reports for the second and third quarters of 2013, real personal spending on durable goods rose 6.2% and 7.9%, respectively, based on annualized quarter-over-quarter increases. These growth rates in spending on durables were much higher than the growth rates in overall consumer spending. Further, the rapid growth for durables occurred against a backdrop of only modest gains in payrolls and wages, indicating that the trend could be sustained even without strength from those drivers. Looking forward, we expect steady payroll gains, moderate wage increases, and attractive home affordability to support a long-term recovery in housing values, which we believe can drive long-term growth in spending on durables beyond a mere short-term rebound.

Chart 1: Personal spending on durables has room to grow back toward its historical average
Personal spending on durables has room to grow back toward its historical average
Source: U.S. Department of Commerce—Bureau of Economic Analysis
Past performance is no guarantee of future results. This chart is for illustration only and does not predict or guarantee the performance of any Wells Fargo Advantage Fund.

Sustainable growth should provide a lift to valuations for select durable goods firms

Sustainable increases in spending on durable goods would likely stimulate earnings growth in companies across a variety of consumer categories, including (but not limited to) appliances, autos, and furniture. In our view, investors could benefit from expanding price/earnings1 (P/E) ratios for these companies if confidence in the sustainability of their earnings growth increases over the next few quarters. The table below provides examples of durable goods companies that we expect to produce superior earnings growth and that currently have discounted valuations based on their PEG2 ratios (the ratio of the P/E multiple divided by the rate of earnings growth).

Table 1: Stock valuations* of select durable goods companies may be underappreciating their strong and sustainable growth prospects
Equities Ticker Calendar 2014
EPS3 growth
estimate
P/E on calendar
2014 EPS
PEG ratio on
calendar 2014
EPS
Appliances &
other durables

Best Buy BBY 15.4% 13.9 0.90

Furniture

Restoration
Hardware
RH 28.1% 31.6 1.12

Auto parts

Delphi
Automotive
DLPH 13.9% 11.9 0.86

LKQ Corp. LKQ 25.9% 24.1 0.93

S&P 500 Index4   10.0% 15.1 1.51

*Stock valuations as of 12-20-13; S&P 500 Index estimate based on information from FactSet’s Earnings Insight report on December 20, 2013.
Source: FactSet
Past performance is no guarantee of future results. This table is for illustrative purposes and does not predict or guarantee the performance of any Wells Fargo Advantage Fund.

Concluding observations

In our view, consumers held back spending on durable goods in recent years, likely to improve their personal balance sheets, while awaiting better indications of sustainability in the economic recovery. Going forward, we expect the wealth effects from rising home values to stimulate additional catch-up spending on durables. As a result, we believe select durable goods companies are likely to produce superior earnings growth; yet, these companies still have attractive valuations. Investors may benefit from expansion in the P/E ratios for durable goods companies if these companies consistently produce superior earnings growth over the next several quarters.

The portfolio managers also manage the Wells Fargo Advantage Discovery Fund.

Stock values fluctuate in response to the activities of individual companies and general market and economic conditions. Smaller-company stocks tend to be more volatile and less liquid than those of larger companies. Certain investment strategies tend to increase the total risk of an investment (relative to the broader market). This fund is exposed to foreign investment risk. Consult the fund’s prospectus for additional information on these and other risks.

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