Jim Young, vice-president investments at Invesco Canada Ltd. He is responsible for Trimark U.S. Companies and Trimark U.S. Companies Class. His style is growth at a reasonable price.
Janet Navon, managing director, director of research and member of the U.S. investment team at New-York-based Epoch Investment Partners Inc. Epoch manages assets for Toronto-based TD Asset Management Inc. and CI Investments Inc. Epoch’s funds managed include TD U.S. Large-Cap Value, TD U.S. Large-Cap Value Class, CI American Value and CI American Value Corporate Class.
Q: Time to talk about your disciplines.
Young: We invest in companies that can produce sustainable growth and look to innovation to drive that. New products can increase market share and command decent margins. Add the advantage of scale and it provides enough money for companies to reinvest in innovation-driven growth.
On valuation, we assess the characteristics that determine the business’s free cash flow and look at its growth in sales, earnings and cash flow. These two elements provide an estimate of what a company is worth. We own 40 companies. We stay with the investments for some time. For instance, I have held Wells Fargo & Co. (NYSE:WFC) since 1999. We will sell if the thesis changes or the stock becomes overvalued.
Fortin: We have also owned Wells Fargo since 1999 or early 2000. Our equity portfolios tend to be concentrated. Currently, the U.S. portfolio has 28 names. We follow a value approach and emphasize sustainable free cash flow. This sustainability reflects the company’s competitive advantage in its industry. When we initiate positions, we look for a 50% return over three years. If the holding reaches our target price, we automatically sell one third and review our investment thesis.
Navon: The big picture is important to us in assessing the macro backdrop. But in evaluating companies, we too focus primarily on cash flow. The discipline is to find those businesses that have such strong returns on capital that they can grow while still returning cash to shareholders. We focus as much on the downside risk as we do on upside when we use our valuation metrics. The objective is to preserve capital. The investment timeframe is three years. Our U.S. large-cap strategy has 40 to 60 names.
Q: Time to talk sectors and stocks. Let’s start with information technology, which has underperformed the market so far this year. At recent count this sector represented 17.8% of the S&P 500 Index, and as such is the biggest sector.
Navon: Microsoft Corp. (Nasdaq:MSFT) Oracle Corp. (NYSE:ORCL) and Apple Inc. (Nasdaq:AAPL) are in the top-10 holdings in our model U.S. large-cap portfolio. Apple’s stock was great until recently and Microsoft’s stock was disappointing until recently. Microsoft’s stock had a run this year. Its valuation had become so depressed that it could experience this kind of run and still remain attractively valued. Microsoft has been good at giving cash back to shareholders, both through dividends and share buy-backs. Microsoft is really an enterprise company. It’s a great cash-flow generator with a recurring revenue stream, because it has a subscription-based model. It has had little success in the consumer-electronics field. Microsoft is trying to convert its consumer business to a subscription model.
Fortin: Microsoft is one of our largest positions. We like its cash flow and the fact that it is increasing its dividends and is starting to buy back shares. Good capital allocation is important to us.
Young: I own Google Inc., Class A (Nasdaq:GOOG) , Apple and KLA-Tencor Corp (Nasdaq:KLAC).
Q: Google is trading at a much higher price-earnings multiple than Apple.
Young: Google has a higher multiple because it’s mostly a software company. It owns the search business and still has an 80% share of this market. This business grows revenue at 25% to 30% a year and throws off huge amounts of cash flow. It’s a great franchise, in a great area with an unassailable position. I would argue that its multiple is fairly low for the kind of growth it’s producing and its financial characteristics.
Apple is perceived as a hardware company and more product-cycle-driven. Its multiple is a little more challenged. But it is at least half software and the company has created a sticky environment for its products among its customers. The whole ecosystem works together. I don’t think that the innovation engine has slowed there at all. The iPhone 5s and the iPad Air are phenomenal developments.
|Apple Inc.||Google Inc. Class A||Microsoft Corp.|
|Dec. 2 close||$551.23||$1,054.48||$38.45|
|Market cap||$496.0 billion||$352.3 billion||$321.0 billion|
|Total % return 1Y*||-3.8||51.0||48.1|
|Total % return 3Y*||21.3||22.6||15.0|
|Total % return 5Y*||43.8||30.8||17.0|
|*As of Dec. 2, 2013. All figures in U.S. dollars|
Fortin: We have a large position in Oracle. We initiated this earlier this year. We like the wide-moat aspect of its enterprise-software platform. The company has historically been built on acquisitions. Our view is that it’s now in a position to grow with the platform it has. It’s hugely profitable. It’s a sticky business, as its customers tend to stay with the company.
Navon: That’s exactly what we look for. In recent years, Oracle has started to distribute more of its cash to shareholders. We’ve held this stock for some time.
Young: Technology is a key sector. The United States is the engine of innovation, not just in electronic technology but now in life-science technology as well.
Q: This leads us to health care. The sector was a robust performer this year, with most notably biotechnology stocks shooting out the lights. Health care has a 13.1% weighting in the S&P 500 Index. Important for some companies in the sector is the roll-out of President Obama’s health-care reform.
Navon: We’re becoming more cautious on the sector, because U.S. government reimbursement is becoming that much more challenging. We still have a couple of managed-care companies. We’re concerned that cuts in reimbursements may not be compensated by greater participation in health-care services.
Fortin: We focus on companies that invest in technology, new products such as drug companies and medical-device companies for that reason. Covidien PLC (NYSE:COV) is our largest holding in this sector. We’ve held the stock for six years. The company is in the medical-devices and medical-supplies business. Covidien is committed to returning at least 50% of its free cash flow to shareholders in the form of dividends and share buy-backs. In the last few years, it has returned almost 80% of that free cash flow to shareholders. There is still a lot of opportunity in this stock.
Q: Glenn, both you and Jim own Johnson & Johnson (NYSE:JNJ).
Fortin: It has an incredible long-term track record of strong profitability and returning cash to shareholders. It has three businesses: consumer health, medical devices and pharmaceuticals. The most attractive feature is its pharmaceutical business, which is the fastest growing division and generates the highest margins.
Young: We bought JNJ about 18 months ago, because it was the first of its peers to get through the patent cliff and it had a new and prolific pipeline of drugs. The company has solved a lot of the problems in its other two divisions. The stock has had a good run this year. But the company increases its dividend every year and the stock has a 3% dividend yield.
My biggest health-care holding is Celgene Corp. (Nasdaq:CELG), which is a biotechnology company. It specializes in cancer. For example, it has a product that addresses multiple myeloma, a cancer that starts in the plasma cells. Celgene’s is the biggest product in that area. It has introduced three new products this year, two cancer products and one for arthritis. The company will grow revenue at 25% a year for the next five years. That is the power of new products. Its valuation is getting up there, but it’s still less than its growth rate. It has 85% gross margins and these are rising. It’s a cash machine. It also owns pieces of many small biotech companies, including three or four that went public this year. These companies have very promising technologies. Health science is advancing strongly.