The U.S. equity bull market has provoked much speculation on its decade-long run and whether it is vulnerable to a correction, yet Colin Wong, a portfolio manager at Calgary-based Mawer Investment Management Ltd. believes that the signs of fragility are offset by enough opportunities to be cautiously optimistic.
Debt, trade and valuations drive concerns
“There’s a long list [of fragilities] and starting from the top, there’s high corporate debt levels,” says Wong, co-manager of the 5-star rated $6.8 billion Mawer US Equity (in aggregate class A and 0). “It seems like the rating agencies have been giving similar ratings to companies that have ever-higher debt. We are seeing that on a bottom-up basis as well. A company that may be rated BBB now would have more debt than 10 years ago. A company that would be A-rated would have an abnormally high amount of debt, so that it does not look like an A-rated company.” On average, he adds, the average corporate debt is at around two times net debt to earnings before interest, taxes, depreciation and amortization. “It’s not exactly that, ‘Hey, companies will go bust tomorrow.’ They are carrying a lot more debt. And they are more fragile.”
The second worry is the possibility of trade wars expanding on a global basis and drawing in many countries, besides the current conflict between the U.S. and China. “Nike, for example, used to make a lot of garments in China, but have now shifted to Vietnam. What I am worried about is if we have a multi-nation trade war,” says Wong, a native of Hong Kong who joined Mawer in 2009 after he graduated with an honours bachelor of business administration degree from University of Western Ontario. “The World Trade Organization has allowed the U.S. to levy some tariffs on Europe. Now you will have fewer options to shift production elsewhere and this will have a much bigger impact than only two nations going at it.
High equity valuations are the third concern for Wong, who shares duties with portfolio manager Grayson Witcher. “Stocks are trading at 20 times earnings, compared to the long-term average of 16 times,” says Wong. Globally low interest rates are another worry. “If there is another economic downturn, there will be less room for monetary stimulus because rates are already so low.” To boot, there is growing evidence that manufacturing is declining in key markets such as Germany, China and the U.S. “Related to this trend are decreasing commodity prices, especially in areas such as oil, steel and coal.”
Focus on your own risk
In spite of these worries, Wong admits he is not losing sleep at night. “I sleep well,” he laughs. “The reasons are many. We focus on what we can control, versus what we cannot control, such as high corporate debt or declining GDP growth. We can control our own risk management framework and what we do with our client’s money,” says Wong. “Our decision making framework comes down to people, culture and process.”
As a firm, Mawer encourages its portfolio managers and analysts to express differing opinions. “We encourage opposing viewpoints. Opinions can be judged on their merits and the validity of the argument, rather than who is expressing it. The mental model we use is, try to be the judge, not the plaintiff or defendant,” says Wong. “We’re not trying to argue one case over another, in the judicial sense. But we’re trying to get to the right decision. This is our first line of defense.”
More important, the emphasis is on careful stock selection. “We try to buy wealth-creating companies that benefit from strong competitive advantages and are run by capable honest managers. And we like to pay a discounted price.”
There are no hard and fast rules on identifying a stock, says Wong, as it might be cheap on a discounted cash flow basis, yet the same company may be expensive on an asset basis. “You want to hold both ideas up in the air. It’s like being a judge, not a plaintiff.”
Go with global moats
Running a portfolio of about 65 stocks, Wong likes long-term holdings such as Visa Inc. (V), the world’s largest credit card network. “It has a very strong competitive advantage because it’s very difficult to replicate Visa’s global presence,” says Wong, noting that the firm has over one billion cardholders. “Management has been very prudent with its capital. It has returned money to shareholders. And strategically it has made a number of moves that made sense,” says Wong, adding that Visa has benefitted from its partnerships with new entrants such as Apple and Google.
From a valuation standpoint, Wong admits the stock, trading at 33 times historic earnings, is not cheap. The share price is US$175. “We look a range of prices, rather than a specific price,” says Wong, who declines to offer a target within 12 months. He also points to Visa’s track record of growth and limited downside. “We are looking for a company that has a favorable distribution of outcomes. It has a more muted downside, but substantial upside. How do you get that? It comes down to a strong business and strong management.”
In a similar vein, he likes Microsoft Corp. (MSFT), which like Visa, is a globally dominant player in the software industry. “When I look at my own firm, we use over 20 different Microsoft products. Any given product could be substituted with something else. But it would be very difficult to substitute all 20,” says Wong. “At the end of the day, Microsoft provides a lot of benefits for relatively small cost. When I look at how much I use Excel, versus what they charge me per month, it’s still very small. A lot of their products are designed to work with their other products, so it’s hard for competitors to replicate that.”
Under a new chief executive officer, Satya Nadella, the firm has expanded into cloud-computing. At the same time, the firm is still AAA-rated, and has about US$133 billion in cash on the balance sheet. The stock is US$138 and trading at 27 times historic earnings. “It’s not cheap,” concedes Wong. “But it has been growing its earnings at around 10% a year.”
From a performance standpoint, Mawer US Equity has returned 21.1% year-to-date (Oct.4), versus 15% for the median fund in the US equity category. Over the last five years, it has averaged 16.1%, versus 11.06% for the median fund.
Going forward, Wong makes no promises about the future. He also admits that there are not many U.S. companies trading at a discount. “But on the flip side, we are seeing a lot of companies that might be severely impacted by various macro-economic actions. It could be due to trade wars, or health-care reform in the U.S., or monetary policies. We are also seeing companies with stretched balance sheets, or involved in non-money making ventures,” says Wong. “At the same time, we’re seeing companies with solid growth, good management and trading at reasonable prices, or maybe even cheap, given very low interest rates. On a bottom-up basis, we are seeing quite a dichotomy.”
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