Equity markets seem to be shrugging off ongoing U.S.-China trade and tariff wars and uncertainty about the policy moves by the Federal Reserve Board. Yet Prakash Chaudhari is an active investor who tends to avoid macro-economic developments and focuses instead on a group of companies that have high returns on capital and are well diversified to reflect a conglomerate approach to stock selection.
“The index is clearly indifferent to valuation and fundamentals and weights are typically related to market cap. Following the index makes for a passive approach. But we far from complacent. The fund has just less than 20% cash, versus 15% in early December,” says Chaudhari, Senior Portfolio Manager and Managing Director at Toronto-based Manulife Investment Management and lead manager of the five-star rated $1.8 billion Manulife Dividend Income Plus F.
Flexible, tactical cash
“When the market corrected in the fourth quarter a number of opportunities became available with limited downside. We deployed the cash and were down to 3% in late January. We are very active investors and respond to opportunities. Nor do we hesitate to sell when we no longer have the asymmetry in our favor,” says Chaudhari, a native of Peterborough, ON who joined Manulife in 2000 after graduating with a MBA from York University. “That’s part of the reason we are back to just under 20% cash.” Among the holdings that were disposed of were WestJet Airlines Ltd. [WJA], which was acquired by Onex Corp. [ONEX], and Solium Capital Inc., a software-based equity plan administrator which was acquired by Morgan Stanley [MS].
A member of the Value Equity team that has nine investment specialists that oversees about $22 billion in assets, Chaudhari says the team does not concern itself with economic forecasts and potential downturns “We prepare our fund to be resilient. The way we do things is very much a bottom-up approach. Irrespective of what the financial media says we have a very strong opinion of when we see attractive opportunities and respond to those. We are very unconventional,” says Chaudhari, adding that the fund’s so-called active share is over 90%. “If we find something interesting we will deploy some of the cash.”
Manulife Dividend Income Plus Series F owns about 65 companies which results in a very diversified blend of businesses. Chaudhari likes to call it a conglomerate approach to investing. “The way we see things is that we put together a collection of diversified businesses that get their top-line revenue from different industries. In the event of a systemic downturn, typically our businesses are strong and taking market share so they can remain profitable in a downturn. We think of our total portfolio as a conglomerate of publicly-traded companies, but with no discount. That’s unlike the discount usually associated with a conglomerate.” Chaudhari regards the companies as “divisions” that trade on an exchange and are liquid so that he can take profits when they are doing well, or liquidate if they disappoint.
Diverse, but part of the same quality flock
Chaudhari seeks four key corporate attributes: high returns on capital, low levels of leverage, an ability to grow revenues and profits, and a management team with a history of understanding how to use capital wisely so that incremental returns on capital are high. “We sift through a lot more names than many of our competitors. We rapidly discard all the businesses that don’t meet the high bar that we set. Then we are able to focus our time on those few businesses that are interesting,” says Chaudhari, adding that while the market may take a temporarily dim view on a stock the Manulife team sees otherwise and builds on its position.
“If every company that we buy has those four attributes then in aggregate the total portfolio has those attributes. We monitor the portfolio quite closely and always ensure at the conglomerate level that our portfolio has these features,” says Chaudhari. It’s not the case, however, that all the companies have all four attributes at the same time, he adds. For instance, if a company has a history of high returns on capital it may use debt to makes an acquisition. “But if the management team has a history of paying down debt before they do another acquisition, it’s that ‘finger-print’ that we understand about this management team. That company can make an acquisition given the stability of its earnings.”
A case in point is long-time holding, Alimentation Couche-Tard Inc. Class B [ATD.B], the convenience store owner and operator of 15,000 stores around the world. “They have had this process of taking on a little leverage, and keeping in mind the stability of their business. As they pay down the debt they have been able to re-deploy that strong balance sheet to use leverage to make another acquisition,” says Chaudhari. “But we don’t have these hard-and-fast rules of where leverage is unacceptable. In aggregate we want to be clear that we are building a portfolio of businesses that are very conscientious of the leverage they use.”
A dynamic, 'worst-case' approach to valuation
Even though Couche-Tard is trading at 19 times trailing earnings, according to Bloomberg, Chaudhari tends to avoid measuring a stock based on price-to-earnings valuations. Instead he follows a present value methodology. “We look at a worst-case scenario based on a company’s earnings power and that is considered the buy price. This is dynamic because as time moves on the company is increasing its earnings power as it expands its business. Our sell price is based on discounting a more normal profit environment and allowing for what is more normal for their growth,” says Chaudhari, adding that Couche-Tard has a return on equity of about 20%.
Another favorite is Spirit Airlines Inc. [SAVE], a so-called ultra-low cost airline based in Florida which operates scheduled flights throughout the U.S., Caribbean and South America. “Unlike a lot of airlines that try to compete with existing airlines on routes that have a lot of passenger traffic, it has grown by creating new markets for travel,” says Chaudhari, noting, for example, a newly announced route between Nashville and Baltimore. “It has deployed its capital by adding new aircraft and having the competency in understanding where there might be demand for new routes and where it might compete with other modes of travel such as car, bus and train and where their value proposition makes sense. That’s how this business has been able to grow over time.”
Spirit Airlines has grown its revenues at a compound rate of return of 15% over the last five years. Its trailing p/e ratio is 10.5 and its return on equity is 13%.
Categorized as Canadian Focused Equity, the fund has about 55% of its assets in Canadian stocks, 25% U.S., and the balance in cash. From a performance standpoint, it returned 20.5% year-to-date (as of July 18), compared to 12.6% for the category. On a five-year basis, the fund averaged 11.9%, versus 4%. While the fund’s running yield is 1.11%, the fund is managed on a total-return basis.
