Editor's note: In today's second installment of our U.S. equity roundtable, the managers discuss their value disciplines, and how they apply under current market conditions to stock selection in financial services and information technology.
Our panelists: Peter Moeschter, executive vice-president, Franklin Templeton Investments, in Toronto; Gavin Ivory, vice-president, global equities and head of the global equity team at Toronto-based Beutel, Goodman & Co. Ltd.; and Janet Navon, managing director, director of research and a member of the U.S. investment team at New-York-based Epoch Investment Partners, Inc. They met with Morningstar columnist Sonita Horvitch, whose three-part series began on Monday and concludes on Friday.
Q: Corporate U.S. is in good shape. There continues to be a huge amount of cash on U.S. companies' balance sheets.
Navon: Yes, we own one of the biggest U.S. cash-flow generators, Apple Inc. AAPL.
Ivory: The cash position of companies in the Russell 3000 Index is US$1.5 trillion. This is huge and up 60% in three years.
Moeschter: Companies have restructured and streamlined their businesses over the past three years, while governments have not.
Q: Can you briefly discuss your value discipline?
Ivory: Our over-arching principle is preservation of capital. The value of the business is determined by the present value of sustainable free cash flow. We invest for at least three years. We don't make macro forecasts and have concentrated portfolios.
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| Gavin Ivory | |
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Moeschter: We look out over an economic cycle, which is usually about five years, and assess the normalized earnings power of the company. We buy the stock cheaply. This builds in a margin of safety. There is low turnover.
Navon: We focus on cash flow and free cash flow and how management is redeploying that cash flow. In that sense we are kindred spirits. We differ from Gavin and Peter in that we do look ahead in terms of the macro picture to identify the range of possibilities, rather than make a macro call. This enables us to assess the upside to the businesses, as well as the downside.
Q: Time to look at your holdings in key major U.S. sectors. We will focus on financials, technology, consumer-related stocks and health care, which collectively represent about a two-thirds weighting in the S&P 500 Index. Let's start with financial services at 14% of the index. Janet, you have 22% in this sector.
Navon: We have been avoiding the banks for some time now. They are unlikely to make the kind of returns going forward that they have in the past. This is being compounded by what the U.S. Federal Reserve Board is currently doing. It is buying longer-term government bonds so as to lower long-term interest rates and flatten the yield curve. Banks benefit from a steeper yield curve.
Most of our holdings are non-bank financial companies. We own insurers: MetLife Inc. MET and Prudential Financial Inc. PRU. We also own money manager Franklin Resources Inc. BEN [Franklin Templeton]. Another holding is TD Ameritrade Holding Corp. AMTD.
Moeschter: In our global portfolios, we have been a little more active lately in some of the larger U.S. banks. We also own some investment bankers, such as Morgan Stanley MS. A lot of the big U.S. banks are trading at half their book value and at a discount to tangible book value. There could be more write-downs to come and more shares to be issued, but the valuations are below average.
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| Peter Moeschter | |
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Ivory: We have 13% in financials in Beutel Goodman American Equity Class. This is a higher weighting than in the last few years. We have been adding to our existing three names, in particular to MetLife, which Janet holds as well. Other significant holdings are Wells Fargo & Co. WFC and Northern Trust Corp. NTRS.
Q: Gavin, MetLife was in your top 10 holdings at 5.4% at the end of June.
Navon: It's in our top 10 as well at 2.6% at the end of June.
Ivory: MetLife has problems in terms of the value of the investments it holds. It is also dealing with the low interest-rate structure and the lack of appetite for many financial products that used to earn high margins. The market valuation implies that MetLife and many other insurance companies will never earn their cost of equity. We disagree. MetLife currently trades at six times earnings, which is roughly half that of the market as a whole, and 0.6 times book value per share. It should trade at a significantly higher valuation.
Navon: MetLife has excess capital. If you impute some kind of earnings on this, then it looks even more attractive.
Ivory: It has said that it will deploy its excess capital in a way that is beneficial to shareholders.
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| Janet Navon | |
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Q: Technology constitutes 18.6% of the S&P 500 Index. All three of you own Microsoft Corp. MSFT.
Moeschter: It's a big, cheap company that generates a lot of cash. The risk is that Microsoft puts its cash to work in ways that are value destructive. The stock trades at a big discount to the sum of the company's underlying businesses and at barely 10 times earnings per share.
Navon: The dividend yield is 2.4%. There are misconceptions about Microsoft. That it's going to be undone by cloud computing. Yet, it's one of the biggest companies in cloud computing. The fact that it has been unsuccessful in consumer electronics is almost irrelevant, because it is primarily a business-enterprise company. It has been doing phenomenally well in this. Finally, we are in an upgrade cycle. Everybody is moving to Windows 7 and Office 2010. Microsoft has a lot of wind at its back.
Ivory: It's one of the most widely owned and also the most reviled companies in the United States. As Janet mentioned, the feeling is that Microsoft has lost its way in Internet land. But, there are very few companies in the world, and particularly in technology, whose return on capital is higher today than it was 10 years ago. Microsoft is still generating a 30% return on capital. As Peter mentioned, it generates a huge amount of free cash flow, currently US$25 billion per annum.
Q: Janet, Apple?
Navon: We've had it since 2002, when it was a turnaround.
Ivory: It has been one of the best stock investments in the United States.
Navon: At that point in time, about half of its market value was in cash. We paid about US$24 a share initially. Currently, Apple has US$30 in cash per share on its balance sheet and no debt. It will earn about US$27 to US$28 per share this year and US$32 next year. At a stock price of US$380, the stock is not expensive. The company will produce cash flow around US$20 billion this year. One headwind is the competiting tablets coming out. Another is the cash on the balance sheet that is not earning anything.
Q: Peter?
Moeschter: The largest U.S. technology stocks are actually quite cheap. In addition to Microsoft, Cisco Systems, Inc. CSCO is a large holding at this point. This is a stock that we could not invest in, in the past, because of its valuation. Now it's trading in line with Microsoft's price-earnings multiple of 10 times. Cisco has become more realistic about its potential growth rate, which is still a positive, healthy rate. It is cutting costs. There should be some margin improvement. It has a healthy balance sheet. Investors have not been giving the company credit for all of this.
Ivory: Cisco is a significant position in Beutel Goodman American Equity. We added to it substantially in the last couple of months, after its second-quarter results. It is now almost 5% of the portfolio. Cisco's products are hotwired into the front end of any kind of recovery. There is a tremendous amount of deferred spending among U.S. companies, which have all this cash on their balance sheets.
Navon: We own Oracle Corp. ORCL, which is the poster child for maturing technology businesses. Oracle has grown productively through acquisitions. It is now at the juncture where it understands that it doesn't have as accretive uses for its cash through growth as it did in the past and is positioned to start returning this to shareholders.
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