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U.S. Equity Roundtable: Part 3

Value plays include cable TV, cruise ships and toothpaste.

Sonita Horvitch 23 September, 2011 | 6:00PM
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Editor's note: Our three-part U.S. equity roundtable discussion, moderated by Morningstar columnist Sonita Horvitch, concludes today with investment ideas in consumer discretionary, consumer staples and health care, three sectors that are much better represented in the United States than in Canada.

Our panelists: Gavin Ivory, vice-president, global equities and head of the global equity team at Toronto-based Beutel, Goodman & Co. Ltd.; Janet Navon, managing director, director of research and a member of the U.S. investment team at New-York-based Epoch Investment Partners, Inc., and Peter Moeschter, executive vice-president, Franklin Templeton Investments, in Toronto.

Q: Consumer-related stocks constitute 22% of the S&P 500 Index. Let's start with consumer-discretionary companies.

Navon: I analyze retail stocks at Epoch. We have a bifurcated market in the United States, where the high-end retailer is doing very well and the low-end retailers are struggling.

We own names like TJX Cos. Inc. TJX. It can grow its cash flow in the mid-teens per share and pays a dividend. It will do well when other retailers do poorly as TJX can buy up those retailers' merchandise cheaply. It will also do well if retailers do well. The stock trades at low multiples to its free cash flow.

There are a lot of companies in the U.S. consumer-discretionary sector that are not significantly cyclical. For example, Comcast Corp. CMCSA, a major U.S. cable and communications company, is one of our largest holdings. We believe that the cable providers will be winners in reaching the home with digital content. Comcast has finally started to perform better than it has done in recent years.

Ivory: It is more utility-like. We own it. It has moved from growth investors' to value investors' portfolios because the growth of its customer base has slowed down. Its cash flow has become more predictable and sustainable, and it can pay a greater portion of it to shareholders. For us, this is critical.

Q: Gavin, you have a substantial exposure to consumer-related stocks at 32% of your global portfolio and 37.8% of your U.S. portfolio.

Ivory: This is characteristic of our portfolios, year in and year out. This best fits our definition of value, which focuses on sustainable free cash flow.

Moeschter: One of the sectors that I cover for Templeton is consumer staples. At present, these are a low weighting in our representative global portfolio. U.S. discretionary stocks are a higher weighting and include media companies. They are stocks like News Corp. NWSA and Time Warner Inc. TWX. They are more cyclical and we bought them a few years ago on some of the dips.

Navon: We own Time Warner.

Moeschter: These companies are fairly cash-generative. We like Time Warner. It's doing some good spin-offs and has become more focused. News Corp. tends to continue to acquire companies. These stocks have rebounded in the last couple of years and are not all that cheap. We're not building positions in them. A recent sale in this sector is The Walt Disney Co. DIS, which has done well.

Ivory: A new addition to the portfolio in this sector is TRW Automotive Holdings Corp. TRW, one of the bigger auto-parts companies. This is a contrarian call. The company is a tremendous operator, its balance sheet is good and the valuation is stunning. The stock is down to five to six times earnings. The company should generate free cash flow of US$1 billion a year in a couple of years. TRW's market cap is US$5 billion. The stock is disliked. It is 80% exposed to European and U.S. autos, where sales are under pressure.

Navon: U.S. auto sales in the United States are below replacement. All you need to do is to return to the replacement rate.

Ivory: Another new holding for us is the cruise-line company Carnival Corp. CCL. The industry has become more disciplined. Two players control 80% of the market. The largest player is Carnival at 50%. The next is Royal Caribbean Cruises Ltd. RCL.

Q: Consumer staples?

Navon: We have only one position, Colgate-Palmolive Co. CL. Consumers have been trading down into value brands and store brands. But this has not happened with toothpaste. Colgate-Palmolive is one of the few staples companies that we thought would be insulated from cost pressures.

Ivory: We have a significant exposure to staples in both our global and U.S. core portfolios. We have been trimming our staples, with the exception of the drugstore chain CVS Caremark Corp. CCS. The valuation on staples generally is not compelling.

Moeschter: Agreed. One staple that is held at Templeton is Procter & Gamble Co. PG. We picked it up under two years ago, when the company was going through a rough patch and the stock had sold off. It has solid brands and is moving into developing markets. We do hold some still in our representative institutional global portfolio.

Q: Health care, which is 12% of the S&P 500 Index?

Moeschter: Within our global portfolios, we have more health-care exposure in the United States than in some other parts of the world. The U.S. health-care sector has a lot of range and depth. It is a fairly heavy weight for us within a U.S. context and within a global portfolio. There is a lot to choose from.

One of our large holdings is the biotech giant Amgen Inc. AMGN. The stock trades at about 10 times earnings. Amgen's products are not easily replicated by generics. Its business is protected. Amgen's cash flow is good. The stock valuation reflects its base business, but not its ability to grow. You are getting a great company with some defendable businesses, and not paying that much for it.

We also own pharmas. Pfizer Inc. PFE is a holding.

Ivory: We own Pfizer too. It's in the top 10 holdings of Beutel Goodman American Equity Class. The pharmas are generally over their patent-expiry hump. It's still going to be tough. But big drug companies will continue to cut costs and make their pipelines more creative.

Moeschter: A medical-device company that we own is Medtronic Inc. MDT. It makes such products as pacemakers and spinal implants. This is a good business to be in. There are barriers to entry. The stock is less than 10 times earnings. Again, you're not paying for any growth.

Navon: Our largest health-care holding is DaVita Inc. DVA, which provides kidney-dialysis treatments. The reimbursement environment in the United States for this company is likely to remain reasonable. This is one of the things that we focus on in analyzing health-care stocks. A name that we like and have held for years in varying amounts is the diagnostic-testing company Laboratory Corp. of America Holdings LH.

Ivory: We're still overweight the health-care sector in our U.S. fund, but it's not as big an overweight as it used to be. Our largest health-care weight is Covidien Ltd. COV. [The company is based in Dublin for tax purposes, but operates mainly in the U.S.] It makes small surgical devices. It's going to sell its drug business, which is probably worth US$4 billion.

Covidien has a market cap of US$26 billion. Covidien is a strong cash-flow generator. The market has not given it credit for all of this. This company really stands out in terms of its ability to continue to increase its return on capital employed, even in a difficult environment. We have a target price that is much higher than the current market price.

Janet Navon, Peter Moeschter and Gavin Ivory

Additional coverage of the Morningstar U.S. equity roundtable

  •  Part 1: Our panel of value managers looks beyond the lost decade

  •  Part 2: Our panel's value picks in financial services and technology

Photos: www.paullawrencephotography.com

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Sonita Horvitch

Sonita Horvitch  

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