Epoch manager is unfazed by U.S. market volatility

David Pearl expects earnings growth to drive stocks higher this year.

Sonita Horvitch 18 April, 2018 | 5:00PM
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David Pearl, executive vice-president and co-chief investment officer at New York-based Epoch Investment Partners, Inc., says that while the United States' trade confrontation with China is unsettling the U.S. equity market, the fundamentals of the U.S. economy are the best that they have been in many decades.

"The tax cuts are accelerating U.S. economic growth, business confidence is rising, the labour market is strong and corporate profits are expected to rise significantly in 2018," says Pearl.

The government continues to be pro-business, he says. "In addition to its tax package, it is looking to reduce regulation in key areas of the economy such as energy." The tariff spat between the United States and China is a "wild card and has been causing a scare," he says. "So far, the consensus in financial circles is that this confrontation is unlikely to develop into a full-fledged trade war between the two countries."

But he cautions equity investors that the higher volatility in the U.S. equity market that has been evident in the last few months might persist. The long period of low volatility in the U.S. equity market, coupled with the market's strong performance in 2017, had made investors "somewhat complacent," says Pearl. (The benchmark S&P 500 Index posted a total return of 21.8% in U.S.-dollar terms in 2017.)

The first scare in the equity market this year, he says, was in early February. The tight U.S. labour market raised concerns about wage inflation and a possible aggressive tightening response from the U.S. Federal Reserve Board. But the overall U.S. inflation rate is under the Fed's 2% target and the more recent expectation is that the central bank, which raised its policy rate on March 21, will continue to do so gradually, he says.

Still, the U.S. equity market was in negative territory for the first three months of 2018, with the S&P 500 producing a total U.S.-dollar return of -0.8%.

David Pearl
David Pearl

Pearl argues that of all the asset classes, equities continue to offer the best prospective returns to investors in 2018. The U.S. equity market, he says, could deliver a double-digit total return this year, when you take into account earnings growth, dividends and share buybacks. On valuation, it is unlikely, he says, that there will be much price/earnings multiple expansion in 2018, "but it is unlikely that multiples will go down by much either."

Epoch, a subsidiary of Toronto-Dominion Bank, manages funds for both TD Asset Management Inc. and CI Investments Inc. Its mandates include Epoch U.S. Large-Cap Value under the TD banner, and CI American Value.

In stock selection, the firm focuses on free-cash-flow generation as an important source of value creation. The emphasis is on companies that have a sustainable competitive advantage, "as they are well placed to continually grow free cash flow over time," says Pearl. Disciplined capital allocation by management is important to Epoch in assessing the attractiveness of a company, he says. "As value managers, we try to find businesses that are mispriced."

Epoch U.S. Large-Cap Value held 55 names at the end of March, with its two biggest sector weights being technology (28.5%) and financial services (19.2%). Also, given the favourable global and U.S. economic backdrop, Pearl says he is enthusiastic about the industrial sector.

The fund has sizeable holdings in three large brand-name global technology companies. They are Google, through parent  Alphabet Inc. Class C shares (GOOG),  Apple Inc. (AAPL) and  Microsoft Corp. (MSFT).

Google is the dominant Internet search engine, Pearl notes. He considers that any government move to regulate this branch of the Internet industry after recent privacy breaches at Facebook Inc. FB is likely to be less onerous on Google than Facebook. "Google does collect data on its users, but this is far more modest than the data collected by Facebook." These two players are, he says, likely to continue to take the lion's share of the global digital ad market and online ad revenue will remain key to their business models.

Pearl notes that a challenge for his firm with Alphabet/Google in the past was its capital allocation. Google, he notes, has ventured into a number of new businesses, such as Google glasses, self-driving cars and biotechnology, "with mixed success." A plus, he says, is that "in more recent years, the company has shown greater discipline in this regard under the helm of a new chief financial officer."

Apple is one of the few companies in the world to make profits on cell phones, says Pearl. "Buyers are willing to pay a premium for its range of products and its customers are sticky." Importantly, its subscription-based products, such as Apple Music and Apple TV, are major sources of recurring revenue for the company. "We have held the stock for more than 10 years and the company's capital allocation has improved over the past five years," he says.

Alphabet Inc. Class C Apple Inc. Microsoft Corp.
April 16 close $1,037.98 $175.82 $94.17
52-week high/low $1,186.89-$824.47 $183.50-$140.45 $97.24-$64.89
Market cap $742.8 billion $904.8 billion $741.3 billion
Total % return 1Y* 26.0 26.4 47.5
Total % return 3Y* 24.9 13.1 32.8
Total % return 5Y* n/a 25.1 28.3
*As of April 16, 2018. All figures in U.S. dollars
Source: Morningstar

Pearl points out that the government's recent tax package includes a provision that makes the repatriation by global companies of their overseas cash more attractive. Apple, which has large overseas cash holdings, is expected to take advantage of this. "Some of this repatriated money is likely to be returned to shareholders and the valuation on the stock is not reflecting this prospect."

Microsoft is to be commended, says Pearl, for its "major transformation" to an enterprise-focused company and for its success in building its business in The Cloud. "The Cloud is profitable and there is a long runway for Microsoft's profit growth." The company is a "disciplined allocator of capital and it is also likely to repatriate foreign cash holdings, which in turn will probably benefit its shareholders." The stock offers good value, says Pearl, as it trades at 15 times free cash flow per share.

Pearl and his team have sold the portfolio's holding in  F5 Networks Inc. (FFIV), which provides products and services to help companies manage their Internet traffic and storage infrastructure. "While the investment thesis remains intact longer-term, we consider that the company may take time to realize the benefit from its product upgrades."

Banks are significant beneficiaries of a rising interest-rate environment, says Pearl. "This widens their net-interest margins, the difference between what they pay on deposits and charge on loans." Also, a stronger economy boosts loan growth and reduces loan losses at the banks.

A sizeable holding in Pearl's portfolios is  Bank of America (BAC). This bank has been reducing its overhead and culling its less profitable businesses, he says. In addition, Bank of America, which has had to pay hefty penalties to the government for the bank's role in the 2008 financial crisis, has completed this process. "This will allow the bank to use its cash flow for other purposes, including returning money to shareholders."

A major holding in the industrial sector is the aerospace giant  Boeing Co. (BA). The positive global economic environment is generating a strong demand for its product, says Pearl. There is a secular case for Boeing too, he says, in that emerging economies, including China, are upgrading their aircraft fleets and there is also robust global demand for Boeing's new, more fuel-efficient aircraft.

The global aircraft-manufacturing industry is a duopoly, says Pearl, with Europe's Airbus Group the other major player. Boeing is a significant generator of earnings and free-cash-flow growth, he says. Furthermore, "Boeing is over a peak in its capital-expenditure cycle and this is going down, thus enhancing the free cash flow it generates." Finally, he says, the company is a good allocator of capital.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Alphabet Inc Class C156.88 USD0.56Rating
Apple Inc168.00 USD-0.81Rating
Bank of America Corp35.23 USD1.59Rating
Boeing Co170.21 USD-0.20Rating
F5 Inc181.30 USD-0.96Rating
Microsoft Corp411.84 USD-0.66Rating

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Sonita Horvitch

Sonita Horvitch  

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