Along with being the world's biggest economy, the United States is also the biggest equity market. Investing in the U.S. makes sense for Canadians because its economy is more diversified. The S&P 500 provides investors with much broader exposure to technology and health-care stocks, both of which are underrepresented in the S&P/TSX Composite Index.
Thanks to the high-flying health-care and technology sectors, U.S. stocks have outperformed the Canadian market over the past five- and 10-year periods. Canadian stocks have lagged as a group because of poor returns in the heavily weighted energy and materials sectors.
Although the U.S. stock market has done well, Morningstar analysts aren't thrilled by the choices available to Canadian investors in the U.S. Equity category. While no Gold or Silver medallist ratings have been awarded, the research team at Morningstar has three funds under analyst coverage that have received Bronze ratings:
Beutel Goodman American Equity
Management expense ratio: 1.50%
Morningstar medallist rating: Bronze
Equity managers at Beutel, Goodman & Co. Ltd. follow a bottom-up value discipline. They look for undervalued companies with strong competitive advantages, healthy balance sheets and growing free cash flow.
Before entering or adding to a position, fund managers Glenn Fortin and Rui Cardoso require a 30% discount to their assessment of the intrinsic value of a stock, and a total projected return of 50% or more over a three-year period. Once a stock's target price is reached, the managers automatically sell one-third of their position. The position is then reassessed and if the estimate of intrinsic value hasn't increased, the entire position is sold. This disciplined approach prevents the fund from holding pricier stocks and provides some downside protection.
The fund holds between 25 and 35 stocks at a time. Its maximum position in any stock is limited to 10% of the portfolio. The sector weights are restricted to a maximum of the S&P 500's sector weight plus 10 percentage points, and there's no sector minimum weight. Since the valuations of non-cyclical stocks have increased recently, the managers have moved into cyclical areas of the market, such as selected industrials. The portfolio is also overweight in financial services but doesn't have any holdings in the consumer cyclical or basic materials sectors.
The managers have allocated nearly one-third of the fund's holdings to mid-sized companies, up from 10% six years ago. That doesn't mean they're changing their approach to stock picking. Instead, they're finding value in companies that are dominant in their industries regardless of their market capitalization. The rest of the portfolio is invested in large-cap stocks.
Morningstar analyst Jeffrey Bunce notes that by adhering to the firm's disciplined approach to buying and selling stocks, the fund is one of only a few active strategies in the category to outperform the S&P 500 over the 10 years ended in June.
Mawer U.S. Equity
Management expense ratio: 1.18%
Morningstar medallist rating: Bronze
Before a stock is purchased in this or any fund run by Mawer Investment Management Ltd., there are multiple layers of vetting. Portfolio managers and analysts are encouraged to question each other's picks. Potential picks must go through a stress test before they can become an investable idea.
Portfolio managers Grayson Witcher and Colin Wong look for companies with sustainable competitive advantages that are trading at discounts to their intrinsic value. They like stocks with attractive price/earnings multiples and high returns on equity.
Witcher and Wong invest in companies of all sizes. Of the total portfolio, 26% was invested in mid-cap stocks as of July 31 -- twice as much as the benchmark index, the S&P 500. Small-cap and micro-cap stocks make up nearly 4% of the fund, compared to just 0.14% for the index.
The fund holds about 54 stocks but the biggest holdings tend to have wide or narrow economic moats, as opposed to having no moat at all. This suggests that Mawer's holdings will be able to maintain their competitive advantages. The fund's sector weightings are quite similar to the benchmark. However, the holdings vary significantly and the active share (the percentage of the holdings that are different than the index) is close to 80%.
Although the fund has performed well, Morningstar's Shehryar Khan said in an analyst report that the one area where this fund has suffered is in idea generation, due to a lack of resources. He notes that "it appears to be a challenge for a two-man team to both maintain the portfolio and scour the highly covered American stock market for potential hidden gems."
RBC O'Shaughnessy U.S. Value
Management expense ratio: 1.55%
Morningstar medallist rating: Bronze
This fund is managed externally by Jim O'Shaughnessy, CEO of O'Shaughnessy Asset Management, LLC, based in Stamford, Conn. His buy and sell decisions are based on quantitative analysis, not industry- or stock-specific research. Stock selection is based on characteristics associated with above-average returns over a long period: a strong balance sheet, earnings growth, earnings quality and value.
The fund can hold as few as 25 stocks but there are usually about 50 holdings. Every month, the fund is rebalanced and the 25 highest-ranking stocks are increased in weight. The stocks that rank lower are decreased in weight over a gradual period of time. Stocks that the quantitative model favours will end up becoming the largest positions. This can make the fund more concentrated. The 10 largest holdings will often account for more than 35% of the portfolio.
The model favours stocks with attractive valuations and is heavily exposed to the resource, consumer-cyclical and industrial stocks, while being underweight in the consumer-defensive and health-care names.
The relatively concentrated portfolio could hurt the fund in the long term, notes Morningstar analyst Achilleas Taxildaris. But he adds that longer-term results are strong, compared with its mutual-fund peers and with strategic beta exchange-traded funds with similar exposures. "The fund's low price adds a lot to its appeal since it's competing in the very efficient market of large-cap U.S. stocks," Taxildaris says.
