Does the U.S. bull market still have legs?

Epoch's Janet Navon says further gains will rely on earnings growth.

Sonita Horvitch 19 March, 2014 | 6:00PM
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 Janet Navon, director of research and a member of the U.S. equity team at New York-based Epoch Investment Partners Inc., says that investors will need to look mainly to corporate earnings growth to drive U.S. stock prices, against the backdrop of the gradually improving U.S. and global economy.

"The ascent of the U.S. equity market from the trough in March 2009, with its exceptional performance in 2013, has largely been driven by the price-earnings-multiple expansion on the stocks," says Navon, interviewed in Epoch's streamlined, modern headquarters in mid-town Manhattan.

The bull market in U.S. stocks can, she says, be sustained in 2014 by both rising earnings and dividends, but the U.S. equity market will generate more modest returns than in 2013.

Over the past few years, the U.S. Federal Reserve Board's aggressive quantitative-easing program drove interest rates down to historic lows and boosted the price-earnings multiples on stocks, says Navon.

At the beginning of 2014, the Fed began its tapering strategy, reducing the amount of securities it purchases in the market. "This tapering creates a headwind for further expansion of P/E ratios."

But Navon emphasizes that the Fed is tapering, not tightening, and while interest rates have risen and will be trending higher, this is from a very low base. Also, she says the new Fed chair, Janet Yellen, was "the obvious choice to succeed former Fed chairman Ben Bernanke, so as to ensure monetary-policy stability." This continuity has been positive for the market, she adds.

Currently, the benchmark S&P 500 Index is trading at 17 times trailing earnings per share, says Navon. "This is not cheap, but not outrageous given that interest rates are still low by historic standards."

Index 1Yr 3Yr 5Yr
S&P 500 35.0 19.4 19.7
NASDAQ 100 45.3 21.4 23.6
Total returns in C$
For periods ended Feb. 28
Source: Morningstar

There are indications, says Navon, that some market participants consider that current valuations are attractive for the sale of stocks. For example, the calendar of initial public offerings of stocks and of secondary and follow-on offerings by companies is quite full. Also, private-equity firms have been looking to liquidate some of their holdings on their premise that "valuations are appropriate for these sales."

Looking at sectors, there are some signs of frothiness in the market, she says, for example in biotechnology and technology. "Here, investors have been chasing so-called concept stocks, where the companies have yet to generate earnings or cash flow, though the products or technologies that they are developing appear to be promising." Some view the current investor enthusiasm for these stocks as reminiscent of the ill-fated tech boom of the late '90s, she notes.

Epoch Investment Partners Inc. manages assets for Toronto-based TD Asset Management Inc. and CI Investments Inc. The funds managed include TD U.S. Large-Cap ValueTD U.S. Large-Cap Value ClassCI American Value   and CI American Value Corporate Class.

Janet Navon

In stock selection, Epoch focuses on companies that are growing free cash flow and are allocating it effectively. The companies create value by reinvesting the free cash flow in the growth of their business, making accretive acquisitions or returning it to shareholders.

The U.S. large-cap strategy has 40 to 60 names. At the end of February, the portfolio's biggest sector weighting was in technology at 20.5%, slightly above the sector's weight in the S&P 500 Index.

The largest holding in the fund at the end of February was Microsoft Corp. AAPL, followed by Apple Inc. MSFT. "These brand-name, established tech stocks have been challenged in the first couple of months of this year as investors in this sector chased concept stocks rather than cash-flow generators," says Navon.

Of Microsoft, she says that "it has a strong, recurring revenue stream as an enterprise provider and it is unduly being penalized for its lack of strength in consumer electronics." Apple, says Navon, offers an ecosystem and has loyal customers. "We continue to see growth from this company, but not at the same pace as in the past."

In the consumer-discretionary sector, a recent new position in the portfolio is the auto-parts maker Delphi Automotive PLC DLPH. This global company specializes in electrical and electronic power-train products, and safety and thermal technology components for auto manufacturers around the world. "Auto sales should be strong in the developed economies as their fleets are getting long in the tooth," says Navon. Also "the emerging markets are a growing source of demand for vehicles."

Delphi emerged from bankruptcy in late 2009 and the company's strong cash flow has not been fully appreciated by the Street, says Navon. The company was domiciled in Jersey in 2011 and is "an example of the ongoing trend for U.S. companies to be domiciled in lower tax jurisdictions."

Turning to the industrial sector, Navon highlights the building-products manufacturer Masco Corp. MAS as a company that stands to benefit from the broadening of the recovery in the U.S. housing market across the country and the revival in the renovation market. "We have held the stock for some time." The home-renovation market, she notes, has been lacklustre. "As house prices recover, there is a greater incentive for owners to put money into their homes."

Also in the industrial sector, Epoch's U.S. equity team continues to champion companies in the aerospace industry. "There is a multi-year (order) backlog in aircrafts," says Navon. "This aircraft cycle is likely to last longer than in the past, given the fuel-efficiency drive and the pressure to upgrade existing fleets in the developed world and the drive by emerging economies to develop their aircraft fleets."

The firm's significant aerospace holdings are Boeing Co. BA, United Technologies Corp. UTX which owns the aircraft-engine manufacturer Pratt & Whitney, and Rockwell Collins, Inc. COL, which makes products for aircraft manufacturers.

In the latter half of 2013, Epoch sold its long-standing holding in Ventas, Inc. VTR, a leading health-care real estate investment trust. "Ventas' excellent management team has diversified its portfolio from its single-tenant skilled nursing facilities to a multi-faceted health-care REIT," says Navon. This REIT has been most successful in growing its business over the years, she says.

"Nonetheless, in keeping with our strict valuation discipline, we sold the stock." Investors, in their pursuit of yield, "had driven the stock price to levels where the opportunities relative to the risks, were no longer attractive."

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Sonita Horvitch

Sonita Horvitch  

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