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Stocks that pass a value manager's fitness test

Beutel's Glenn Fortin favours health-care providers with a leg up over their rivals.

Sonita Horvitch 11 June, 2014 | 6:00PM
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Glenn Fortin, global equity analyst and portfolio manager at Beutel Goodman & Co. Ltd., says that valuations in many sectors of the S&P 500 Index have become stretched, but there are still pockets of value, particularly in areas such as U.S. health care and U.S. technology.

"The strategy in the U.S. portfolios that we manage has been to increase our weightings in these two sectors," says Fortin. "Health-care companies tend to enjoy high barriers to entry and have commanding shares in the markets they serve," he says. "Technology companies addressing the enterprise market, rather than the consumer market, have similar virtues."

In general, Beutel Goodman's non-domestic equity team is finding better value in international equities than in the U.S. equity market, says Fortin. "We are bottom-up value managers; we look out three years and require at least a 50% total return from a stock over that period, when initiating a new position."

Fortin reports that in the past 12 to 18 months, individual stocks that constituted around half the U.S. portfolio, (27 names) reached their in-house target prices. This resulted, he says, in the sale of one-third of the holding in each of those stocks in keeping with the firm's sell discipline. "It is unusual for so many stocks in our portfolio to hit our target price in such a short time," says Fortin. "This bottom-up experience reinforces our opinion of the valuation of the market as a whole."

After its huge run in 2013, the U.S. equity market was expected to deliver a more modest showing in 2014, says Fortin. This has transpired, he says. "But still, the market has held up reasonably well." This is, he says, "despite the weak first-quarter performance of the U.S. economy, investors' concerns about the financial well-being of the lower-end U.S. consumer and the uncertainty surrounding the health of economies outside of the United States."

Fortin acknowledges that slower growth in major emerging economies such as China, Brazil and India, plus the lacklustre growth in Europe, is a concern for those U.S. companies with a global reach. "For better or for worse, many companies in the S&P 500 Index, which is a large-cap index, have a high percentage of their revenue from outside of the United States."

Fortin's wide-ranging responsibilities in Beutel Goodman's non-domestic equity team include co-managing Beutel Goodman American Equity with Rui Cardoso. This $576-million fund, with 27 names that have an average market cap of around US$80 billion, is decidedly large-cap. The top-10 names account for more than 50% of the portfolio.

Glenn Fortin

In the U.S. consumer-staples sector, an example of a holding that was reduced by one third as it reached Beutel Goodman's target price is CVS Caremark Corp. CVS. "This stock has been in the portfolio for some 12 years," says Fortin. CVS Caremark is increasingly more of a health-care stock as its strong pharmacy benefit-management services business is a "key contributor to its cash-flow growth."

Turning to the U.S. health-care sector, another example of a position being trimmed by one-third over the past 12 to 18 months is Covidien PLC. This has an American Depository Receipt and trades on New York under the ticker COV. Covidien has also been a long-standing holding in Beutel Goodman American Equity and remains in the top 10.

Covidien is a global manufacturer of medical devices and surgical instruments. "The profit margins on its business are attractive," says Fortin. Furthermore, he says, Covidien has undertaken to return at least 50% of its free cash flow to shareholders in the form of dividends and share buybacks. "In the last few years, the amounts returned have been well above that metric."

Johnson & Johnson JNJ, another long-term holding, is a rival of Covidien in the medical-device area, says Fortin. "We also reduced our holding in JNJ by one-third," he says. JNJ remains attractive, he adds, based on its strong pharmaceutical business and a recovery in its over-the-counter medicine sales, "which were plagued by some manufacturing glitches."

Finally, a one-third reduction in Pfizer Inc. PFE was followed by the outright sale of the remainder of the holding, says Fortin. "This was a modest position and we considered the shares to be fully valued."

Beside reductions to existing holdings, there have been three new health-care additions over the past 18 months, says Fortin. In 2013, the team added Baxter International Inc. BAX and Merck & Co., Inc. MRK. Both are top-10 holdings in the fund. Eli Lilly & Co. LLY was added this year.

Baxter has therapies that treat "chronic conditions," says Fortin. For example, it is a world leader in hemophilia and provides a range of kidney-dialysis equipment.

Merck's strength is in diabetes and HIV therapies, says Fortin. It also has a strong presence in the animal-health market, he says. "There is also enthusiasm for its top drug prospect in oncology."

Eli Lilly, a mid-sized pharmaceutical company, has a strong in-house research and development ethic, says Fortin. Eli Lilly is growing its offerings in diabetes and oncology, he says. "The company recently announced that it is buying Novartis AG's animal-health business for US$5.4 billion in cash, so as to strengthen and diversify this side of its business."

Baxter International Inc. Eli Lilly & Co. Merck & Co, Inc.
June 9 close $22.96 $39.49 $457.65
52-week high/low $24.95-$17.10 $40.28-$21.44 $466.98-$293.01
Market cap $27.123 billion $20.334 billion $57.114 billion
Total % return 1Y* 26.30 74.15 44.58
Total % return 3Y* -4.18 37.86 32.04
Total % return 5Y* -10.40 13.69 24.68
*As of June 9, 2014. All figures in U.S. dollars
Source: Morningstar

In all, health care represents some 20% of the fund and is the largest sector weighting, says Fortin. The second largest sector weight is technology at around 17%.

A top-10 holding and the fund's biggest tech weighting is Oracle Corp. ORCL. "This software and services company is one of the most profitable in the S&P 500 Index," says Fortin. "It generates high returns on capital and is a strong free-cash-flow grower." Some 75% of its revenue is of a recurring nature, he notes. "Its focus is on the enterprise market and once its platform is installed, its business customers are unlikely to switch."

Another holding in this sector is Microsoft Corp. MSFT. "We have sold one third of our position in this stock, but continue to hold it," says Fortin. The company has a strong balance sheet including a large cash position. In addition, its dividend is high and growing, he says. Furthermore, he notes that Microsoft's new CEO, Satya Nadella, who replaced Steve Ballmer, is helping the stock's performance.

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Sonita Horvitch

Sonita Horvitch  

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