Since 2010, it's become apparent that global growth has been trending steadily downward. Indeed, William Booth, managing director and senior research analyst at New York-based Epoch Investment Partners Inc., argues that a new pattern has emerged. "Two percent GDP growth is the new 4% for mature economies."
In the past, GDP growth estimates were too optimistic, observes Booth, and have been consistently revised downward. "But now we're in a period of stabilization," says Booth, lead manager of the $1.5-billion Epoch International Equity. Much of the low-growth pattern is attributable to a confluence of factors such as aging populations in industrialized countries, and slowing growth in China as it transitions to an economy focused on domestic consumption. "We're not going back to the good old days," says Booth. "The key is that we are in for a prolonged period of slow growth."
As a bottom-up investor, Booth is not discouraged by the fact that low growth is the "new normal" and many equity markets are at record highs. Indeed, he maintains there are lots of investment opportunities. "We can find many companies that are benefitting from structural growth and can grow in any economic environment -- whether it's 4% GDP growth or no growth."
Booth focuses not on conventional measures such as price-earnings multiples, but on a company's ability to generate free cash flow. "Understanding the ability to grow free cash flow over time, and management's allocation of capital, is at the heart of our process," says Booth, adding that a top-down view of macroeconomic trends is useful in shaping investment portfolios.
Besides leading the international equity fund, Booth also works alongside William Priest, Epoch's CEO and co-chief investment officer and lead manager of the $3.5-billion Epoch Global Equity. Founded in April 2004, Epoch has about US$42.5 billion in assets under management. It has been a wholly owned subsidiary of Toronto-based TD Bank Group since March 2013.
"The ability of management to allocate cash flow properly determines whether the value of the business rises or falls," says Booth. Management can do five things with free cash flow, he adds. They can pay a cash dividend, buy back stock, pay down debt, make an acquisition or invest internally, in research and development for instance. "If a company can invest that cash flow, either internally or externally, and generate a marginal return on invested capital that exceeds the marginal cost of capital, then making that investment will increase the value of the business."
Booth notes that stocks are driven by a combination of three factors: earnings growth, dividends and changes in valuation. It is the latter that lately has been the main driver in global markets, Booth says. Price-earnings expansion accounted for 64.3% of total returns in the S&P 500 Index in the period from 2012 through to June 2016. As for the MSCI World Index, multiple expansion accounted for 81.9% of returns in the same period.
"But over the very long term, things are different. When you look at the S&P 500 Index, valuation expansion plays a smaller part," says Booth, a former chemical engineer who entered the investment industry 15 years ago after graduating with an MBA from New York University's Stern School of Business. "That's what we believe will happen going forward. Earnings growth and dividends will play a much larger role. Valuations will face headwinds, rather than tailwinds, as they have in the recent period."
Buying a stock at a discount to what it may really be worth is a key part of the methodology. So is finding companies that earn high returns on equity. "If we can find a stock that has 10-15% upside, that's attractive," says Booth, adding that the firm tends to focus on companies that are mispriced because of adverse market perception. "But it's also difficult to time a stock purchase precisely because sometimes it takes a while for the market to recognize the value of the company."
Booth cites two examples of stocks that have either been punished by controversy or not recognized for their growth potential. In the former case, there is 
CVS Health Corp. (CVS), a leading pharmacy retailer and pharmacy benefit manager in the U.S., which is held in Epoch Global Equity. Like many other health-care stocks, the company has been under a cloud lately because of concerns about potential government action to rein in health-care costs which may, or may not, entail changes to the Affordable Care Act.
"CVS is benefitting from strong internal cost controls, a growing use of generic drugs and consumers who are moving to walk-in clinics due to a shortage of primary-care physicians," says Booth, noting that the firm has grown through the US$2-billion acquisition of 1,600 pharmacies within the Target Corp. (TGT) discount chain. From a valuation perspective, the stock generates a 7.5% free-cash-flow yield and trades at about US$90 a share.
But Booth believes there is about 30% upside. "Once we get past the presidential election, and there is more certainty about the legislation, the market will focus on the fundamentals and realize that the stock is undervalued."
Another favourite name is Airbus Group SE (EADSY), a leading global aerospace firm that is a top holding in the international equity fund. "Airlines are flush with cash and are renewing their fleets with more fuel-efficient planes. Meanwhile, in the emerging markets, there is growing demand for airplanes as incomes are rising and more people want to travel by air," says Booth, adding that among its projects Airbus is developing the A350 wide-body carrier, which will seat 280 to 360 passengers and succeed the A340.
Airbus is generating a 5% free-cash-flow yield. "But we expect this to double as it completes the investment and reaps the harvest of rising cash flows from the new planes," Booth says.
Epoch assumed management of Epoch International Equity, formerly TD International Equity, in September 2013. Over the three years ended Sept. 29, it returned an annualized 6.99%, or slightly below the International Equity category average of 7.77%. Epoch Global Equity, which the firm assumed in April 2013 when it was called TD Global Growth, returned an annualized 9.13%, versus 10.48% for the Global Equity category average.
"It's been a challenging backdrop," admits Booth, adding that stocks such as CVS Health have detracted from performance. "But we still have confidence in our names. And that in the future free-cash-flow returns will matter -- instead of valuations."
