While U.S. equity markets have been in a bearish mood for a few months, Steve MacMillan, a U.S. equity specialist at Toronto-based Fidelity Investments ULC, has been cautious for some time. He’s patiently looking for buying opportunities to position the $2.5 billion gold-rated Fidelity Small Cap America Series F for the next re-bound.
“The fund is generally positioned more cautiously and always looking for corrections in the market,” says MacMillan, a portfolio manager who assumed the fund in April 2011. “Rather than having a view that I should make a market call, this is more a strategy to focus on capital preservation. Over the past six months or so I have been rotating out of stocks that had become too expensive, or had valuation risk, or were more economically sensitive. On the margins, I have added some utilities and real estate investment trusts [REITs]. But if you look at the turnover of the fund, it’s usually about 20% a year”, he says.
“It’s not like I wake up one day, and say, ‘I need to totally change what I’m doing,’” says MacMillan, an 18-year industry veteran who graduated in 2000 from Wilfrid Laurier University with a bachelor of business administration and who joined Fidelity as a banking analyst in 2008. “This low turnover [ratio] really forces me to think like a long-term investor. And that allows me to ignore the benchmark.”
The 5-star fund is benchmarked against the Russell 2000 Index (C$), but its concentrated portfolio of about 50 stocks bears no resemblance to the index. Over most periods, the fund has outperformed the benchmark, including the last 12 months (as of Dec. 10) when it returned 8.87%. For the same period, the index has been flat.
Currently, MacMillan is holding about 16.5% in cash, although he is not any hurry to invest it. He concedes that the market is not overly expensive, as it is trading at about 16 times earnings, or in line with the long-term average. “My greater concern is the “e”, or earnings. If you look at the S&P 500 Index, total earnings from 2012 through to 2016 bounced around US$110 a share. Next year’s expected earnings are almost US$180 a share. In a three-year period the expectation is 68% earnings growth. To me, that is not a sustainable earnings number. We are reaching the peak of the earnings cycle.”
The robust U.S. economy, which has record low levels of unemployment, has seen a series of interest rate hikes that are beginning to make their impact. “Consumer durables, like housing and automobiles, are starting to roll over. Sales numbers are starting to go the other way,” says MacMillan, adding that rising home prices have worsened affordability measures. “You had a very strong economy, and loose monetary policy. Then you had a fiscal stimulus through tax cuts in 2018 which resulted in a significant earnings boost to the S&P 500, combined with a lot of share buy-backs for a lot of multi-nationals.”
MacMillan believes that competition will intensify for sectors such as retailing and regional banking, which may begin to see a decline in returns and margins. “In the economy in general, you have slowing revenue growth and cost pressures and rising rates. A lot of companies spent a lot of money in 2018 on capital expenditures. But as we start to see a slowing economy a lot of those investments will be pulled back,” says MacMillan. “To me, it makes sense of be cautious on earnings. That is why I’m focused on areas such as utilities, REITs and consumer staples. The worst places in the market are cyclicals, such as industrials, materials and energy.”
Although MacMillan does have a top-down view that underpins his caution he is largely a bottom-up investor. “When I’m looking at a cyclical business, for example, I have to be cautious about where these companies are in the earnings cycle. That blends together with the top-down view.”
It’s difficult to determine how long this bearish period may last. “From an economic standpoint it could be a couple of years before we see the full extent of the slowdown and [later a] recession and acceleration,” says MacMillan. “From a market standpoint it could be priced in over the next six to 12 months. Then there will be some good opportunities to put cash to work and buy some great businesses in 2019.” As a manager who meets with about 500 companies a year he notes that as the market keeps gyrating the buying opportunities should increase.
From a strategic viewpoint, MacMillan looks for companies that have high sustainable cash flows and high returns on equity that are supported by strong competitive advantages, earnings visibility and stability and whose shares trade at low valuations.
One representative portfolio holding is Grand Canyon Education, Inc., (LOPE) a Phoenix, AZ-based organization that operates an online and in-class university for about 90,000 students. “They are offering an education that is roughly half the cost of other out-of-state universities. Students graduate with much less debt and are able to find jobs and get much better outcomes,” says MacMillan. “Essentially, they are a for-profit organization competing against not-for-profit institutions that are far less efficient. They are providing a better service at a better price.”
The stock is not inexpensive as it trades at 24 times earnings. “But its earnings are growing in the teens,” says MacMillan. “It will be a much bigger business in five years time.”
Another favorite is Hanesbrands, Inc., (HBI), a leading maker of apparel such as socks and T-shirts. A long-term holding, it has recently under-performed, but MacMillan believes the stock, which trades at about US$15 a share, is poised to recover.
“My thesis is around management’s ability to generate $2.25 per share in free cash flow in 2020. It’s a company that has great stability in earnings because of the recurring nature of their business,” says MacMillan, adding that the firm’s Champion brand has been growing at around 30% a year. “We should see a positive outcome for the business.”
Going forward, MacMillan acknowledges that returns are likely to be lower than in the past. “But what I am trying to achieve is preserving that capital and investing in a thoughtful risk-adjusted prudent manner. The goal is not to maximize returns over any period. It’s making sure that in a decade from now we have made money in a thoughtful risk-adjusted way.”
