While it is unclear when the current bear market may reach bottom, bottom-up stock picker Paul Moroz is searching for attractive stocks, and keeping an eye on central bank inflation-fighting actions and the gyrations of the bond market.
“Inflation is the big question on people’s minds,” says Moroz, chief investment officer at Calgary-based Mawer Investment Management Ltd., where he is co-manager of the $9.5 billion 5-star, gold-rated Mawer Global Equity A.
Manager Describes How to Pick a Stock
A 19-year industry veteran who joined Mawer in 2004, and currently oversees about $19 billion in global equity assets, Moroz notes that his team uses modeling scenarios to determining the discount rate of a stock and hence its attractiveness. Put simply, the team uses a measure known as equity duration to estimate a stock’s value. “The average equity duration for the portfolio is 17-18. Some have companies that have a lower duration, others a higher one.”
Given the market has declined about 18%, is the slump justified or even overdone? “For a one-percent change in interest rates, they would have to move 17-18% either way. That’s for the math to work,” says Moroz, who shares duties with Christian Deckart, deputy chief investment officer. “Some of what is going on is simply mathematical. As central banks have raised interest rates, and inflation and bond yields have increased, it’s pretty likely that the required discount rate for all stocks, globally, has increased. And if interest rates have increased by one percentage point, then the stocks should decline about 17-18% for the math to balance out.”
But the math can work both ways. That was the case in the early 1980s, when interest rates started to go down and the value of all assets was going up because they were pricing in higher discount rates. “Today, we are feeling a bit of the reverse effect. The big question is, how far will this [trend] go?”
Should inflation reach 6%, for example, Moroz says that interest rates may have to rise to 6%, or higher, and consequently higher discount rates. “That could mean a more substantial correction in equity markets. If things really slow down, and we have enough ‘demand destruction’ based on the level of interest rates—and the price of oil starts correcting, for instance---then maybe this is it for the interest rate, or discount rate, move. We just have to worry whether or not there will be an earnings recession as we get to the end of the cycle.”
It’s definitely been a challenging period, as year-to-date (May 22), Mawer Global Equity A has returned -17.82%, versus -19.30% for the Global Equity category. Over the longer term, the fund has out-performed as well. For the past five and 10 years, the fund returned an annualized 7.53% and 12.74%, respectively. In contrast the category returned an annualized 4.62% and 9.19% for the same periods.
I Sold Amazon and Microsoft, Bought World’s Second Largest Coffee Company
While Moroz and his team have been closely monitoring the impact of rising interest rates, and bond yields, they have also been making adjustments to the portfolio, which has about 60 holdings. “Using these duration tools, we did start to manage a little bit of our higher-duration names in the portfolio,” says Moroz. “It’s all about understanding the sensitivity of interest rates to valuations, whether it was reducing our Amazon.com Inc. (AMZN) or Microsoft Corp. (MSFT) positions, we are constantly trying to adjust and manage the portfolio so that it is resilient in whatever environment that we evolve towards,” says Moroz, adding that in late 2021 the Microsoft weighting was reduced by about one-fifth.
“We are not trying to time the market or forecast how the world will turn out,” Moroz continues. “We are trying to weigh and reflect the odds of what’s happening. We felt the odds were starting to shift in terms of monetary policy. We have these tools to measure duration sensitivity and thought it was prudent to shift one of the positions that, although Microsoft is a really strong company and should do fine during a recession, there is probably a little more valuation risk.”
While reducing that holding, he added another in the form of JDE Peet’s NV (JDEP), an Amsterdam-based firm that is the world’s second largest coffee and tea company. The company had been hit by a combination of higher coffee prices, the loss of its chief executive officer and a decision by Mondelez International Inc. (MDLZ) to sell some of its 23% stake. “This was priced into the market, and made it more attractive,” says Moroz, adding that the stock trades at around 17 times earnings, and pays a 2.7% dividend.
From a sector standpoint, the fund’s top weighting is in financial services at 19.29% (as of April 30), followed by 18.39% technology, 14.72% industrials, 13.8% healthcare and 13.84% consumer cyclical. From a geographic perspective, U.S. holdings are the largest area, at 51.88% (as of April 30), followed by 40.39% in international holdings and 6.08% Canada. These sector and geographic weightings, Moroz notes, are by-products of the investment process. Still, he adds that because of the common occurrence of companies that are headquartered in one country but conducting their operations in a host of others, the revenue breakdown, by region, is more accurately one-third USA, one-third Europe and one-third “the rest of the world.”
Pick Well Managed Companies that Trade at a Discount
In searching for stocks, Moroz and his team look for well-managed companies that are earning a return of capital that is much higher than the cost of capital and the stock is trading at a discount to its intrinsic value. “The reason the return on capital is higher than the cost of capital is that you have a competitive advantage. The real trick is to make it sustainable.” Moroz adds that his team uses so-called Monte Carlo methods, which rely on complex algorithms, to create a range of outcomes which help determine how attractive a stock might be.
One top holding is Intercontinental Exchange Inc. (ICE), a U.S.-based company that operates global financial exchanges (such as the NYSE), clearing houses and provides mortgage technology. The firm recently acquired Black Knight Inc. (BKI), which provides so-called end-to-end software for managing the purchase of a home and the mortgage process. “The market is expecting less volume and activity in that business. That’s been discounted a little in the share price, which trades at 13 times earnings for a very high quality business that will be around for a long time,” says Moroz, adding that the stock pays a 1.62% dividend. “The New York Stock Exchange will be around, and so will Brent Futures. They are also developing exchange products around carbon credits and will develop more information around the housing and mortgage units they own.”
Another typical holding and a long-time favorite is Marsh & McLennan Companies Inc. (MMC), a New York-based global insurance broker and risk manager. “When you head into a downturn, how many people will cancel their insurance policies? Nobody. And that’s especially true if you manage a Fortune 500 Company.” asks Moroz. “It is non-discretionary revenue, and recurring in nature because you have long-lived relationships. It is difficult to disrupt because the policies end up being very complex.”
The stock trades at 20 times 2023 earnings and pays a 1.4% dividend. By Moroz’s reckoning the company generates 30% return on equity and 12.6% return on capital for the last 12 months.
Looking ahead, Moroz cautions that the bear market may not be over and volatility may only increase. “The question is, where does it go from here? Some people draw analogies to the 1970s. We have a generation of people that are not used to inflation or making decisions around rising inflationary expectations. It will be difficult for many companies,” says Moroz. “We are emphasizing that people get back to their models. We are running our Monte Carlo analysis to see if margins are lower, what does it mean for the value of stocks? It will be a difficult period because we are moving into a different regime and don’t know how long it will go on. So there will be lots of volatility.”
