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Even though Canadian equity markets have made a dramatic comeback from the stunning lows of March, value investor Prakash Chaudhari is reluctant to forecast where markets may be going and focuses instead on picking companies with strong fundamentals. And that’s led to outperformance.
“Our team doesn’t make forecasts of the market. We really focus all of our time on our portfolios, which are a smaller sub-set of those indices,” says Chaudhari, senior managing director and portfolio manager at Toronto-based Manulife Investment Management and lead manager of the 5-star rated $9 billion Manulife Monthly High Income F. Chaudhari is a member of the Value Equity team which oversees in aggregate $22 billion in assets under management. “The future is unknowable so we try to build a portfolio that is robust in any economic environment. This current economic environment is truly exceptional and rare, where multiple industries are dramatically impacted because they must shut down.”
Despite the harsh market environment, Manulife Monthly High Income has returned 0.91% year-to-date (as of June 9), versus -2.05% for the median fund in the Canadian Neutral Balanced category. Over 5 and 10 years the fund has averaged 5.54% and 8.32%, respectively, compared to 3.48% and 5.56% for the category. Currently, the fund has a running yield of 3.2%, before fees.
Strength in Diversity and Time
Chaudhari maintains that two key factors have worked in the 10-person team’s favour.
First, the team has selected 49 companies across the economic spectrum. “Not being focused in one area has made our fund robust,” says Chaudhari. “If we had all our investments in, say, retailers, with some having an online presence, some having a so-called ‘omni’ channel and some only offline, and there was a dramatic slowdown in discretionary spending, we might be severely impacted. But if we have a limited investment in that area, and the investments are some of the strongest players in that sector, that suits us well. That’s how we invest our money. And that is why we don’t make forecasts on the sustainability or recovery of the market.”
The second factor is that the team takes a 10-year view on the rate of growth that their companies can grow and their return on capital. “We still see a 10-15% upside. But it’s important to remember that this is taking into account our discount rate. We are taking future cash flows and discounting them at about 7.5%, on average. For each company, we come up with a unique discount rate based on the risk of the business. The greater the risk, the greater the discount rate. There is a higher required return if there is more uncertainty around its prospects.”
Long Term Team
Chaudhari and his team seek companies with strong competitive advantages, low leverage, high returns on capital and are trading below their intrinsic value. Importantly the team is also looking at a range of outcomes. “We are not just looking at the best-case scenario, but worst-case scenarios as well,” says Chaudhari, a native of Peterborough, ON, who joined Manulife in 2000 after graduating with an MBA from York University.
“Often, in a worst-case environment and when you own a company with strong competitive advantages, and a downturn occurs, their strength allows them to take more market share or make changes to their business,” adds Chaudhari. “Because they have high levels of profit they can reinvest in their business and make their products or services more relevant to their customers. They become stronger, in terms of widening the competitive moat.”
Maintained, Added, and Profited
From a sector standpoint, financial services are the largest weighting in the portfolio, at 27.6%, followed by 13% technology, 12.8% industrials, 11.6% consumer defensive and 7.1% healthcare. On an asset allocation, basis, there is 59% in equities, 29% fixed income, and 12% cash. Since mid-March, the team has lightened the cash and bond portion and shifted more exposure to stocks. “We have been able to maintain our largest positions,” Chaudhari adds. “When many stocks sold off, we were able to add to them. As their prices lifted, we were able to trim those positions. We made a good return on them.”
Currently, Chaudhari and his team are spending a lot of time talking to management about how their companies are impacted by the economic slowdown and adapting to the new reality. In some cases, they may be an offline retailer that may be increasing their online presence. In other cases, they might be able to continue in their present state. One example is Novo Nordisk A/S (NOVO-B), the Danish manufacturer of insulin products. “Without their medications, there would be dramatic impacts on the health of diabetics. So their business is not impacted.”
One of the fund holdings, which exemplifies Chaudhari’s approach, is WSP Global Inc. (WSP), a Montreal-based engineering and design professional services firm with a market cap of $9.5 billion. “Globally, the industry is very fragmented, so that the top 10 players have less than 15% market share. When you are a global operator, local expertise combined with their ability to apply global best practices becomes a competitive advantage,” says Chaudhari. “These firms need to have good relationships with local government and understand local regulations and how the approval process proceeds. The more of a global view you can take, the better you can serve global operators. The same applies to the local players because they want to know they are with a company that has great experience globally and locally, so they can navigate all the compliance issues successfully. Essentially WSP is selling ‘brainpower’ and they have a lot of experience in making a city or a company more efficient and function better.”
About 40% of WSP’s revenue relates to transportation and infrastructure design, plus 25% in buildings and 18% in the environment (the rest is in areas such as power and energy). The firm has a 20% return on capital. Its stock trades at 27 times forward earnings and pays a 1.7% dividend. Chaudhari believes the stock has a 20% upside. “It’s a capital-light business because it has only offices to house its professionals. It’s a high cash generative business. And over 50% of its growth has been through acquisitions.”
Indeed, the long view is what Chaudhari recommends to investors. “It is very difficult to know where the market will go in the next three or six or 12 months,” says Chaudhari, adding the minimum time horizon is three years. “However, doing what we do is a much sounder way to invest. We’re buying a portfolio of companies that are diversified across a range of industries, with limited leverage, high returns on capital and what we judge have an upside. Over time, you should generate a very acceptable return.”
