Stocks are fully valued, if not overvalued, and the creeping rise in interest rates, all else remaining equal, will only contribute to make stocks more expensive, say two veterans at Mawer Investment Management, who describe their firm's approach as "boring, but profitable."
"Only five or six years ago, we at Mawer could still find stocks that we believed could deliver a 10% to 12% rate of return over the long term," says Jean-Philippe Giguère, institutional portfolio manager at Mawer in Toronto. "Not any more, he adds. Markets are not what they used to be. What we see going forward are 6% to 8% returns for new opportunities that we find."
In the present context of rising interest rates, which constitutes the key risk factor, "it's not obvious that companies will be able to increase profits enough to compensate for the headwinds of higher interest rates and potentially higher equity risk premiums," continues Giguère. "So prices could go down, yet valuations would not necessarily become that much more attractive."
An obvious reaction is to move to cash and wait for markets to correct, admits Giguère. "We could have a big correction, but that is pure guess. So, Mawer stays invested and builds portfolios for all seasons."
Of course, an important part of an all-season portfolio is bonds, which presently occupy 33% of Mawer Balanced, slightly below their long-term target of 35%. "Sure, they might not perform at this time," recognizes Giguère, "but we want that protection if markets turn down. Since interest rates will not move overnight, the odds of getting negative returns over a two- to three-year period on bonds are pretty slim."
The Mawer teams starts its portfolio-building process by performing a classic discounted cash flow analysis over 15 years to determine the present value of stocks that catch their fancy. But they do it with a slight twist: "We don't establish a single value, but target a range of possible values," explains Patrick Fournell, also an institutional portfolio manager at Mawer in Toronto. "If we're at the lower end of our range, we buy; if at the high end, we sell."
Projecting over 15 years is obviously "iffy." The idea, notes Fournell, is to establish a general valuation trend over a long-term horizon, but to produce reliable and detailed numbers over a five-year period.
The objective is simple: to identify "wealth-creating companies that do well whatever the rates or the political context, says Giguère. Even if rates go up, they will be resilient." Adds Fournell. "And even if their valuations appear temporarily high, they will grow into them."
With that valuation tool in hand, the team goes shopping in international waters for companies that reside at the lower range of their valuation model.
Mawer managers are bottom-up stock pickers, but still perform macroeconomic country analyses to determine where the catch might be more abundant. That lands them in a number of more or less unexpected countries. For example, the United Kingdom share of Mawer International Equity stands at a surprising 23%.
Another country with promising perspectives is India. "It has a lot going for it on the macro side," says Giguère. He notes that the middle class numbers 280 million households and is growing, that housing is lacking, and that 53% of existing houses don't even have a toilet. "The mortgage market is very low, at about 9% of GDP. Compare that to 68% in the U.S. and 18% in China. The potential for growth is huge."
When asked what their "pet" picks are, Giguère and Fournell point mostly to stocks from the Indian sub-continent. For example, because the mortgage market is so promising, they particularly like LIC Housing Finance, the third largest provider of housing loans in India, which has "low operating costs and prudent underwriting," says Giguère.
Another Indian gem is Balkrishna Industries, a manufacturer of off-highway tires (golf carts, construction machinery, etc.). "They manufacture in India, which gives them a cost advantage, but they ship globally, says Giguère. We often try to find companies that dominate a niche market, which is the case with Balkrishna."
Japan, the "forgotten" giant, is another country toward which the team is starting to turn its attention after a long neglect. "Our managers kept going there," recalls Giguère, "and they would come back with the same verdict: not worth buying."
The Japan portion is still underweight compared to the benchmark MSCI All Country World ex-USA Index, but "there's a change of mentality in managing teams in terms of governance," says Fournell. "For a long time, management was set on building empires, not necessarily profits. We see the change at a company like the Japan Exchange Group and mostly in retail businesses. In one company that we bought, they ousted an old hand who was not appreciated by investors and replaced him with a younger guy attuned to a better capital allocation."
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