Solid earnings growth — and thus stock price gains — expected in key sectors

Broad U.S. equity-market gauges ended 2013 near record levels powered by record-high corporate profits, increased dividend payouts, continued share repurchases and improved investor confidence. The Federal Reserve’s decision to begin tapering its stimulus efforts also appeared to be positive for investor sentiment and could provide a favorable environment for earnings growth potential, in our view.
While tapering may create some short-term uncertainty, better economic growth would be positive for investor sentiment and would provide a favorable environment for earnings growth potential, in our view. After the market rise in 2013, valuations at year-end were generally closer to fair value, in our opinion. We would expect to see market performance driven less by multiple expansion and more by earnings growth in 2014.

There are a number of specific trends that led to particularly strong earnings growth for some companies in 2013 that we think could continue into 2014.

For example, in the U.S., consumer spending growth has boosted sales and profits for auto and auto parts manufacturers. Manufacturers that have developed advanced fuel efficiency technologies have benefited from this trend, as well as the trend for more fuel efficient cars. Fuel efficiency also has been a growth driver in aerospace, benefiting companies that have developed new high-strength, lightweight carbon fiber materials used in modern aircraft. This composite material is stronger than aluminum while being significantly lighter, and it is more reliable than other traditional metallic materials, all of which can lead to lower aircraft maintenance and fuel costs. Longer term, additional applications of these materials may include cars and other industrial products for which innovations that can reduce weight are highly valued.

Among other industrial companies, new technologies and methods for the production of oil and gas in the U.S. have driven profit growth for the developers of those technologies, as well as oil producers, and they have moved the country further down the road to energy independence. Our positive outlook for these firms is underpinned by the fact that combined oil and natural gas shale resources in the U.S. have put it on pace to potentially top Russia as the world’s largest producer of both fuels, with the possibility of also surpassing Saudi Arabia as the world’s largest oil producer by 2020, a somewhat startling shift that has been reshaping global energy markets.

Elsewhere, new developments in electronic technology have enabled brand new content and Internet-focused industries to spring up, generating extraordinary revenue growth. Just one such strategic shift involves treating software as a service: Companies that provide as-needed delivery of software through cloud computing can give corporate purchasers access to state-of-the-art programs whose affordability might otherwise be out of their reach.

Additionally, we have significant optimism about what we view as a new renaissance period for drug research, development and production. In 2013 alone, new developments in genetic mapping and analysis led to spectacular breakthroughs in the treatment of cancer, cystic fibrosis, multiple sclerosis and Hepatitis C, creating billions of dollars of new market value for the discoverers of these treatments. Overall, we believe the biotech industry has reached a tipping point in terms of targeted therapies often termed “personalized medicine” because they target a specific molecule, which can both improve effectiveness and reduce the instance of off-target side effects.

These are just some of the examples of how the dynamic private economy in the U.S. and rapid technology changes for many industries have met our society’s needs and driven the U.S. stock market higher in recent years. Looking forward, we believe this dynamism will continue to raise living standards and could potentially deliver profit growth for many companies.

Edward B. Jamieson is president of Franklin Advisers Inc. and chief investment officer of Franklin Equity Group.