Editor’s note: In the second installment of this week’s coverage of Morningstar Canada’s U.S. Equity roundtable, the portfolio managers discuss the strategies that companies are employing to enhance shareholder value. Coverage began on Tuesday and concludes on Friday.
Jim Young, vice-president investments at Invesco Canada Ltd. He is responsible for Trimark U.S. Companies and Trimark U.S. Companies Class.
David Pearl, executive vice-president, co-chief investment officer and head of U.S. equities at New York-based Epoch Investment Partners, Inc., which manages assets for Toronto-based TD Asset Management Inc. and CI Investments Inc. Funds managed include Epoch U.S. Large-Cap Value under the TD Asset Management banner and CI American Value.
Glenn Fortin, portfolio manager at Beutel, Goodman & Co Ltd. Fortin is a U.S. specialist and member of the firm’s global equity team. This team’s mandates include Beutel Goodman American Equity.
Q: Your comments on U.S. corporate dividends and share buybacks?
Young: Individuals and a lot of institutional investors want dividend growth. A 2% yield on the S&P 500 Index, and a 32% dividend-payout ratio overall, means that companies can easily grow dividends.
Pearl: Since the second quarter of 2009, almost all of the purchasing of equities in the United States was by corporations doing share buybacks. Corporations are cash-rich. In a world of slow corporate organic growth, a good use of cash can be to make strategic acquisitions. Corporations can also opt for the opposite and split companies to create shareholder value. Another trend is share buybacks. Companies believe that they will be more valuable in the future. They prefer buybacks to dividends. The issue with dividends is that they have to be consistent.
Fortin: In the case of share buybacks, valuation comes into play in terms of the prices that companies pay for their shares. In general, U.S. corporations and management are much more aligned with shareholders these days than they were in the past. We’ve been seeing the results in terms of increased dividends, buybacks and spinoffs. It all creates value.
Pearl: Take a company like Microsoft Corp. (Nasdaq:MSFT). It understands that it should only reinvest in its business if its return on capital is higher than its cost of capital. Microsoft recognizes that it is no longer a high-growth company.
Young: Yes. Mature companies in general understand the need for a balanced capital-allocation program.
Fortin: A lot of larger-cap technology companies are mature. They’re at a point in their life cycle where their balance sheets are strong, cash flow is strong, and they are highly profitable. They can therefore return money to shareholders as well as reinvest in their business.
Q: One third of the revenue of companies in the S&P 500 Index comes from foreign sources. The high U.S. dollar and slow global growth must be affecting them.
Young: It is an issue. Some companies are better than others in protecting themselves against the high U.S. dollar. Currencies tend to be a transitory matter and adjustments are made over time. Companies can adjust their prices.
Fortin: The high U.S. dollar hurts the companies in the near term. Our time horizon is longer term, and we’re not so concerned with what happens with currency over the next 12 months.
Q: President Barack Obama is looking to tax foreign profits of U.S. multinationals.
Pearl: U.S. corporate taxes are high, which is what led to U.S. corporations keeping money overseas. There could be a compromise between Democrats and Republicans on this issue. They could introduce a tax holiday for this, so as to encourage companies to bring money back to the United States.
Fortin: Beutel Goodman is a research-driven, bottom-up value manager. We focus on companies where there is disconnect between the public market’s value and our estimate of value based on discounted free cash flow. We look for a 50% return over a three-year period. When the stock reaches our target price, we sell one third of the holding. We run a concentrated portfolio of between 25 and 35 names and have a low turnover. Right now, we have 28 names in Beutel Goodman American Equity.
Young: We look for sustainable growth. Companies sustain their growth by being innovative and adaptive. If the company has a culture of innovation, it can continually generate new products. This secures its market share, a scale advantage and a margin advantage. It results in sufficient money to reinvest in the business and sustain it. They establish a virtuous growth cycle. Trimark U.S. Companies is a relatively concentrated portfolio with 40 companies. Our style can be considered to be a GARP style, growth at a reasonable price.
Q: Briefly discuss your investment styles.
Pearl: At Epoch, we run a variety of U.S. strategies, including our large-cap value mandates. We look for companies that generate cash and can grow cash flow profitably. We look for a high return on investment that exceeds the company’s cost of capital. There needs to be some sustainable advantage to ensure that the company can continue to grow its free cash flow. Quality of management is important and its capital allocation matters. We define value as a low stock price relative to discounted future free cash flow. We hold stocks for an average period of three to four years. There are 55 to 60 names in the U.S. Large-Cap Value portfolio.
Q: Time to discuss your holdings. Let’s start with technology, which represented 19.7% of the index at the end of December and produced a total return of 20.1% in 2014. Jim, Trimark U.S. Companies had 32.5% in technology at the end of December.
Young: We like the sector because there’s a lot of innovation by the companies. It’s a good growth sector. A big weight in the portfolio is Apple Inc. (Nasdaq:AAPL). I also have a sizeable weight in Skyworks Solutions Inc. (Nasdaq:SWKS), which is tied into the Internet. A big slice of its business is making products for Apple’s iPhones. Skyworks has been around for a long time and it has developed significant skills.
Apple is a highly innovative company. It was really a 30-year start-up. When the company finally brought all its skills together and redefined itself as a consumer electronics company, it could show those skills to the world and continue to innovate around them. It generates huge amounts of cash flow. The stock is not expensive.
Pearl: We have an overweight position in technology. Apple provides elegant and simple solutions for consumers. It started with the iPod. It combined hardware with software and made it easy for users to download songs using iTunes. It has done the same with its iPhone and its App store. Apple has built a brand that is now a luxury brand, particularly in the emerging markets. Its growth in China for the next couple of years far exceeds its growth in North America. Apple pays a dividend and it buys back stock. It has large cash holdings of US$200 billion. The stock is inexpensive. Apple is a major holding in Epoch U.S. Large Cap Value and CI American Value.
Fortin: Beutel Goodman American Equity had an overweight position in technology at 21.7% at the end of 2014. We prefer to invest in companies that focus on the enterprise market and that have strong recurring revenue streams. This leads us to software companies. We have a significant holding in Oracle Corp. (NYSE:ORCL). Its products are so entrenched in its customers’ businesses that it is expensive for its customers to switch.
Pearl: I also have a significant holding in Oracle.
Fortin: Oracle is probably one of the most profitable companies in the S&P 500 Index. It generates significant amounts of cash and over the past three years, it has begun to return more of that cash to shareholders. It pays a dividend, albeit a modest one, and more importantly it is buying back its shares. We view the shares as attractively valued and are comfortable with that.
Pearl: Enterprise is one of the most dynamic markets in technology. Corporations are highly profitable and want to keep improving their productivity, so they’re willing to spend on technology. Oracle facilitates that. It’s also done a good job of capital allocation, particularly in the hardest area: acquisitions. It has acquired dozens of companies over the past five years and done so profitably. It can offer a plethora of solutions to businesses, as a single vendor.
Q: Finally, we should discuss Microsoft.
Fortin: It’s not a big position in our portfolio.
Pearl: It’s a big position for us. Management is transforming Microsoft into an enterprise supplier. Enterprise is where the growth is, rather than the consumer business. Apple is the exception. Microsoft has become the second biggest cloud-services company. It’s working with Oracle on this. Two-thirds of Microsoft’s earnings are from enterprise. The company generates US$25 billion a year of cash. The stock has a dividend yield of around 3% and Microsoft is buying back stock. The company is growing modestly and reinvesting correctly. The stock trades at a low valuation.