Editor's note: It's been a dismal decade for investing in U.S. equities, and the bad economic news continues to pile up. Looking beyond the current gloomy investor sentiment, our panel of U.S. and global portfolio managers think the worst is behind us. They're encouraged by U.S. market valuations that are historically modest, and by the widespread availability of attractive dividend yields.
Our panellists:
Peter Moeschter, executive vice-president, Franklin Templeton Investments. Recently returned to Toronto from a three-year posting for the firm in Edinburgh, Moeschter's responsibilities at Templeton, a traditional value manager, include global mandates for institutional investors.
Janet Navon, managing director, director of research and a member of the U.S. investment team at New-York-based Epoch Investment Partners, Inc. Navon also employs a value approach. Epoch's mandates include managing assets for Toronto-based CI Investments Inc. Epoch is responsible for CI American Value 
and CI American Value Corporate Class.
Gavin Ivory, vice-president, global equities, and head of the global equity team at Toronto-based Beutel, Goodman & Co. Ltd., which is a value manager. Ivory and his team manage a number of mandates including Beutel Goodman American Equity Class and Beutel Goodman World Focus Equity.
They spoke with Morningstar columnist Sonita Horvitch, whose three part-series continues on Wednesday and concludes on Friday.
Q: Can we discuss the total return of the U.S. equity market, from the beginning of the year to the end of August?
Moeschter: In Canadian-dollar terms, the S&P 500 Index had a negative total return of almost 4% on an annualized basis.
Ivory: Over three years to the end of August, the total return was minus 2.2% on an annualized basis in Canadian-dollar terms. Over five years, it was minus 1.7%. The 10-year performance to the end of August was minus 1.9%.
Q: Is this a lost decade?
Moeschter: Unfortunately, most equity markets have had a difficult decade.
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| Peter Moeschter | |
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Ivory: A notable exception is emerging markets, with the MSCI Emerging Markets Index producing a total return of 10.7% on an annualized basis, over the past 10 years to the end of August.
Navon: The decade's performance is really a story of developed markets versus emerging markets.
Moeschter: Most developed markets have been moving more or less in sync.
Q: Investors have been buried in so much bad economic news of late.
Navon: Economies generally don't go from a recovery phase into a secondary recession, unless there is an external shock. The real question is whether the economic problems in Europe or the political challenges in the United States create the shock that leads to that secondary downdraft. I think that in Europe, there will be support for peripheral Europe, because the German and French banks, for example, are so entrenched there.
In terms of the United States, I was encouraged by the speech by President Obama on the proposed job creation legislation on Sept. 8. Also, the Republicans did not aggressively attack the Democrats' position on this. The stand-off between the Republicans and the Democrats on the debt ceiling earlier this year was detrimental to consumer confidence.
Longer-term, given the large debt in developed countries and in the United States specifically, global economic growth will be lower than potential.
Q: Janet, what do you see as the biggest challenge facing the U.S. economy at present?
Navon: Structural unemployment. One of the focuses of Obama's job speech was on infrastructure. This is because two million of the eight million jobs we lost are in construction. At the same time, U.S. energy companies are experiencing difficulty in finding employees.
Ivory: There are some immovable headwinds in the United States. One problem is the country's demographics, the aging population. This is a longer-term issue. Some 40% of Americans are approaching retirement with a mortgage.
Navon: We have not funded retirement programs that the government has promised.
Ivory: In the short and medium term, there is a need to rebuild savings and reduce debt across developed markets, including the United States. The value that we see in the U.S. equity market substantially discounts the known problems.
Navon: We agree. You can find value in the U.S. equity market. We are investing what little cash we have. It is company specific.
Moeschter: Our deployment is across the board in most sectors.
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| Janet Navon | |
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Ivory: In the last two months, we have been moving from companies that have a lower return to target price to a higher return. We have been trimming companies like Procter & Gamble Co. PG, Kraft Foods Inc. KFT and Kimberly-Clark Corp. KMB and moving into industrial companies by adding to existing positions and creating a few new ones. They are more economically sensitive. We have been adding to names like Waste Management Inc. WM and 3M Co. MMM.
Q: Peter, your representative global institutional portfolio has 30% in U.S. stocks, whereas Gavin's core global portfolio has 50%, yet you are both value managers. Why?
Moeschter: We are stock-specific and we will go where the value is. We do not look at the geographic weightings in MSCI World Index or target a weight. We will buy the best value globally and the value tends to be more in Europe, although not in every sector. Our U.S. weight at roughly 30% has been at this level for the last couple of years.
Ivory: I agree with Peter that Europe demonstrates more deep value than the United States. Our discipline requires that we find companies from the bottom up that demonstrate both an ability to generate cash and to use their capital wisely. Based on our screens and applying our criteria, we find that the United States offers more candidates than Europe. That is why we end up with 50% in the United States and 50% in the rest of the world. Our weighting in the United States is close to the country's weighting in the MSCI World Index, but we are widely different from the index on sectors.
Q: Coming back to the U.S. equity market, what of its recent behaviour?
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| Gavin Ivory | |
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Navon: We have seen in the recent downdraft, that there is very little differentiation among investors between companies. There is a significant correlation in the performance of the stocks. You are, therefore, getting opportunities to buy good companies that are trading down with the rest of the market.
Moeschter: What really stands out is that almost all sectors have been selling off. As Janet says, investors have been selling indiscriminately, not differentiating between good and bad companies.
Ivory: To some extent, this reflects the role of exchange-traded funds, which represent 40% of trading in the U.S. equity market. There have been huge moves in the equity market on an intra-day or on a day-to-day basis. This certainly scares investors.
Moeschter: This negative sentiment is a reflection of the news. It is hard to say when the sentiment turns. In the past, you have experienced some periods like this and it was somewhere near a turning point. We could be approaching that.
Navon: Remember, markets tend to overshoot.
Q: What is the valuation of the S&P 500 Index?
Moeschter: Looking at price/earnings multiples, this index is trading at about 13 times trailing 12-months earnings and 12 times forward earnings.
Ivory: Looking back 25 years, the median is about 19 times.
Moeschter: You can pick up some great companies, at this stage, at current multiples of eight to 10 times. These companies have decent dividend yields and cash-flow yields. If you go out three or five years, as we do, the earnings are likely to be higher. Companies currently trading at eight to 10 times current earnings might trade at 14 to 16 times in a more normalized investor-confidence environment.
Navon: You can buy some stocks today with dividend yields that are higher than bond yields.
Ivory: The dividend yield on the S&P 500 Index is slightly more than 2%. The yield on 10-year U.S. Government bonds is just about the same.
Moeschter: There are companies that are increasing their dividends, so you will get a higher dividend yield on your cost base.
Ivory: Looking out three or four or five years, stocks will prove to be far better investment than say bonds, cash or gold.
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