After a "lost decade" for U.S. stocks, prospects are starting to improve as the economy continues the healing process, says Emory W. (Sandy) Sanders Jr., co-manager of Manulife U.S. Large Cap Equity Advisor Series and senior managing director at Boston-based Manulife Asset Management (US) LLC.
"Companies are getting stronger, with regard to their sales and balance sheets. And valuations have come down during this period," says Sanders, who shares duties with senior managing director Walter McCormick. "The average U.S. large cap is trading at 11 to 13 times earnings, compared to the historic average of 15 to 17 times. These companies are on sale. They are well capitalized and have the resources to sustain their businesses over time."
Meanwhile, Sanders argues, the macroeconomic picture is slowly brightening. For example, the housing market is showing signs of life, even though annualized housing starts are at around 500,000, versus a 50-year average of 1.5 million starts.
"This low level is unsustainable. We've done an analysis that suggests if you move forward three to five years, based on normal housing formation, you will need to triple the number of starts," Sanders says. "Companies will benefit from the improving housing economy."
Sanders is primarily a bottom-up investor who takes a long-term view. "We try to buy real good companies at great prices -- and hold them for three to five years."
Using a seven-step process, Sanders and McCormick have a portfolio of about 50 names that meet a number of attributes. First, these companies must have a sustainable competitive advantage. "That's number one. A company must grow its cash flow year after year and reinvest its profits so it can widen the moat around it. The business model needs to be sustainable in rising and falling economies. Owning this kind of company means you are 50 yards ahead of the others still at the starting line."
Second, a company must have growth drivers that will propel it into the future. Third, Sanders and McCormick conduct an internal industry analysis to ensure the prospects are relatively solid.
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Fourth, they analyze the company's metrics such as free cash flow. Fifth, they assess management and its ability to continue to deliver returns above the cost of capital. "We like management with a large ownership stake. Their interest is aligned with ours."
To arrive at a company valuation, the managers conduct a discounted-cash-flow analysis to determine several potential scenarios. Finally, they calculate the impact of risks, such as a management change, that would affect a stock's returns. Holdings are limited to about 6% of fund assets.
Two positions exemplify the managers' approach. Taken together, Home Depot Inc. HD and Lowes Companies Inc. LOW account for 50% of the retail home-improvement sector. "They have significant scale advantage," says Sanders, who generally buys stocks when they are trading at a 30% discount to their intrinsic value.
"Historically, their return on invested capital has been 10% to 15%. Currently, it's around 7% to 8%. But we believe their returns will improve because of the resurgence of the housing market."
A native of Concord, New Hampshire, Sanders is a 15-year industry veteran who had an unconventional career start. After graduating from the University of Vermont with a bachelor of science in forest biology in 1996, he worked for International Paper Co.
As he snow-shoed in the Adirondacks one bitterly cold day in January he realized that he was not meant to be a forest biologist. "I was marking trees to be harvested. But it was not as stimulating as I thought it would be."
Sanders headed for Boston where he landed a post as research assistant at Evergreen Investments. "I worked for a value portfolio manager, Matt Finn, who was a mentor," says Sanders, adding that he completed his CFA designation while working on the large-cap value portfolios from 1998 to 2001.
Sanders met McCormick at Evergreen in 2002 and together they developed their seven-step stock-picking process to manage the US$1-billion Evergreen Fundamental Large Cap Core, which was later renamed Wells Fargo Advantage Core Equity. Between March 2002 and December 2010, the fund outperformed the benchmark S&P 500 Total Return Index by a cumulative 14.8%.
In 2011, Sanders and McCormick joined Manulife, which offered them an opportunity to use the firm's global platform to launch new products. Introduced in August 2011, the Manulife U.S. Large Cap Equity mandate now has about $100 million in all its purchase options.
Sanders is convinced the current market rebound is sustainable. "Valuations are not going to get cheaper year after year," he says.
"It's unrealistic that some of these high-quality companies are selling at five times earnings -- not if their earnings are continuing to grow. To me, it looks like we are going to have a mean reversion over the coming decade, getting back to a 10% annualized return. That is what the S&P 500 has done since 1920."
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