Looking beyond the U.S. correction

Stock market is "fighting its way back," says Epoch's David Pearl.

Sonita Horvitch 28 October, 2015 | 5:00PM

David Pearl, executive vice-president, co-chief investment officer and head of U.S. equities at New York-based Epoch Investment Partners, Inc., says that the correction in the U.S. equity market in the third quarter was in response to a range of concerns, most of which are transitory.

"Most importantly the U.S. economy continues to grow, albeit at a modest pace, and the correction in the U.S. equity market has left a number of key sectors and stocks offering good value."

An ongoing investor concern, says Pearl, is the strength of China's economy. The latest numbers point to an annualized GDP growth rate of 6.9% for the third quarter, the weakest rate since the 2008-2009 global financial crisis.

Pearl says any slowdown in China most directly affects Asia-Pacific countries, Europe and Brazil. "The United States has less direct trade with China than does Europe and key emerging markets, but it is indirectly impacted by the slower global economic growth resulting from a slower growth rate in China."

Still, says Pearl, China's consumers are responding to their rising wages and spending more. "In China, the consumer accounts for 30% to 35% of GDP." This positive trend is boosting the sales of some major U.S. multinationals, he notes.

For example,  Apple Inc. (AAPL), is reporting robust sales of iPhones in China. Another example, he says, is  Boeing Co. (BA). "The country is fast becoming Boeing's most important market, a reflection of the Chinese consumer's increasing demand for travel."

Pearl says the expectation is for U.S. GDP growth to be 2% to 3% this year. This will be largely driven by the U.S. consumer, which accounts for more than 70% of U.S. GDP. "U.S. consumer purchasing power is increasing, with job growth positive, though not robust, and wages rising slowly."

The U.S. equity market has been weak so far this year, says Pearl, culminating in the correction in the third quarter. The market has improved since the end of the quarter and "is fighting its way back," he says.

The U.S. Federal Reserve Board's decision in early September not to raise its policy rate should have given the equity market a boost, he says. "But the language used by the Fed, which pointed to a potential weakness in the U.S. economy, resulted in a pull-back in the stock market."

Subsequently the Fed clarified its statement in a move to reassure financial markets, says Pearl. The expectation is that there is a less than 50% chance of the Fed raising its policy rate in December, he says. "It is possible this decision will be pushed out to March."

Following the third-quarter correction and its recent uptick, the U.S. equity market currently trades at 15.5 to 16 times forward earnings-per-share estimates, says Pearl, versus 17.5 times earlier in the year. Corporate U.S. earnings growth is expected to be in the low single-digit range, he says.

David Pearl
David Pearl

Epoch manages assets for both Toronto-based TD Asset Management Inc. and CI Investments Inc. Funds managed include Epoch U.S. Large-Cap Value under the TD Asset Management banner and CI American Value. This portfolio, which has some 50 stocks, holds significant weightings in financial services (24%), technology (19%) and industrials (11%).

In stock selection, Pearl and his team look for companies that generate free cash flow and can grow cash flow profitably. There needs, he says, to be some sustainable advantage to ensure that the company can continue to grow its free cash flow. Value is defined as a low stock price relative to discounted future cash flow. The average holding period is three to four years.

In industrials, Pearl and his team have added a new name,  General Electric Co. (GE). "This major U.S. conglomerate has been refocusing the company to concentrate on its wide-ranging industrial businesses," he says. At the same time, "it is selling off the majority of its financial-services businesses and is raising cash."

General Electric, says Pearl, has been using its cash to institute large share buybacks, raise its dividend and make strategic acquisitions. The stock was under-owned by institutional investors because of the difficulty in valuing it as a conglomerate, he adds. "It is now becoming a pure industrial play and is more attractive."

Also in the industrial sector, Boeing continues to be a significant holding in the U.S. large-cap portfolio. "The company is over its capital-spending hump and is generating significant free cash flow." The stock, he says, represents average value on a price-earnings basis, but is attractive on a price to free-cash-flow basis.

In technology, a new name in the portfolio is Alphabet Inc., the recently listed successor issuer and parent holding company of Google Inc. Alphabet has two classes of shares: Class C, non-voting shares which trade on NASDAQ under the ticker GOOG, and Class A, voting shares which trade on NASDAQ under the ticker GOOGL. The U.S. large-cap value portfolio owns the Class C shares.

Alphabet, says Pearl, is reorganizing its operations to make them more transparent. The company is more committed to enhancing shareholder value, he says. The appointment of Wall Street executive Ruth Porat as chief financial officer in March "was seen as a move in the right direction." Porat is undertaking "to introduce budgeting systems and control costs."

Apple is the largest holding in the U.S. large-cap value portfolio. The stock, says Pearl, is currently trading at a price-earnings multiple of around 11 times, "a big discount to the market at 16 times." There is skepticism about the company's continued ability to grow, he says.

Pearl counters that Apple is increasing market share in the premium iPhone market in important markets such as the United States and China. Apple Watch sales are taking time to build, he says, "but this is to be expected with a new product." Finally, he says, the recently announced Apple TV promises to be a considerable success.

 Microsoft Corp. (MSFT) is the second largest holding in the portfolio. The company continues to transform itself into an enterprise/cloud company, says Pearl. Some two-thirds of Microsoft's business comes from its enterprise business, he notes. "Microsoft is a major player in the cloud business and its cloud platform is rapidly growing revenues." The stock trades at a P/E below that of the market, says Pearl.

Alphabet Inc. Apple Inc. Microsoft Corp.
Oct. 26 close $712.78 $115.28 $54.25
52-week high/low $730.00-$486.23 $134.54-$92.00 $54.32-$39.72
Market cap $488.6 billion $657.4 billion $433.3 billion
Total % return 1Y* 32.4 11.4 20.3
Total % return 3Y* n/a 11.8 26.8
Total % return 5Y* n/a 22.4 17.9
*As of Oct. 26, 2015. All figures in U.S. dollars

Source: Morningstar

U.S. financial-services companies offer particularly good value, says Pearl. "Investors are focusing on the tighter regulatory environment and the ongoing claims on some of the financial institutions, as a result of their role in the problem mortgage-backed securities market during the global financial crisis." Yet, he says, these companies will benefit from the steadily improving U.S. economy.

The portfolio has a "large holding" in  Citigroup Inc. (C), which is expanding its global private-banking business and shrinking its exposure to the riskier sides of banking, says Pearl.

Another major holding is  BlackRock Inc. (BLK), a leading global manager which has US$4.5 trillion under management and is the world's largest provider of exchange-traded funds. The company has been gaining ETF market share globally and has significant economies of scale "in what is a scalable business."

BlackRock stock is correlated with the market and it declined in the August-September period with the market correction, Pearl notes. "But it has been improving since the beginning of October, as the market climbs back up."

Pearl and his team have sold the portfolio's holding in  American Express Co. (AXP). The company has announced that its U.S. co-brand and merchant-acceptance agreements with  Costco Wholesale Corp. (COST) are set to end on March 31, 2016. "Amex was unable to make sufficient money on this arrangement to retain this business," says Pearl. "But it was a significant relationship for Amex and it will take time for the card company to replace the business."

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Alphabet Inc A1,466.17 USD-1.25
Alphabet Inc Class C1,466.71 USD-1.34
American Express Co135.11 USD2.85
Apple Inc318.31 USD-0.29
BlackRock Inc536.84 USD-0.94
Boeing Co323.05 USD1.66
Citigroup Inc78.42 USD-1.73
Costco Wholesale Corp310.51 USD-0.76
General Electric Co11.71 USD-0.51
Microsoft Corp165.04 USD-1.01

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Sonita Horvitch

Sonita Horvitch