Why Not Ignore the Noise?

Global equity markets are in a ragged state, with issues from the Russia-Ukraine conflict to looming rate hikes. Yet for stock-pickers David Siino and Steven Bleiberg, who oversee the 4-star silver-medalist $5.2 billion Epoch Global Equity F series, bang for your buck comes first.

“Our process for managing the fund doesn’t require us to think about questions concerning market volatility. We’re just focused on finding companies that can earn a good return on invested capital [ROIC]. That’s our key metric,” says Steven Bleiberg, managing director at New York-based Epoch Investment Partners Inc. (a subsidiary of The Toronto-Dominion Bank), and co-manager of the fund. “We don’t profess to know, honestly, what the market is discounting, or has already discounted.”

Discount Rate Raises Uncertainty

Bleiberg, and David Siino, lead manager of the fund, are reluctant to comment on whether markets are troubled by central bank monetary tightening or volatility in the commodity sector. “It all comes back to the discount rate,” says Siino, managing director, and a 23-year industry veteran who before joining Epoch in 2007 was a research analyst at Gabelli & Company, in New York, and in 2000 earned an MBA at City University of New York’s Baruch College. “With the risk-free rates going up as sharply as they have, the equity risk premium is going up on the back of global volatility. That raises the cost of capital for companies and raises the discount rate. It raises uncertainties of their cash flows.” The other members of the team include William Priest, William Booth, and Michael Welhoelter.

Even though markets have dropped and valuations have similarly slipped, Siino argues that his team does not change its process, whichever way the wind happens to blow. “We are long-term investors,” emphasizes Siino, adding that the strategy behind the fund was conceived a decade ago and has remained consistent ever since. Moreover, the average equity holding period is between two to three years. Indeed, the most recent regulatory document indicates the portfolio turnover ratio was 19.6% for the six months ended June 30, 2021. “There is nothing that we have changed significantly.”

Market Moves Mean Selling, If Anything

“We are not the kind of managers who say, ‘Oh, that stock is down 5% since last week so let’s pick up a little bit more. If it goes up, we can sell a little bit,’” says Bleiberg, a 38-year industry veteran who earned a BA at Harvard University in 1981 and a MS with a concentration in finance from the Sloan School of Management at MIT in 1984. “We identify stocks that we believe are good companies and hold them for several years, or until something significant changes---and not just because of small price movements or because of some unrelated news in the market.”

Over the long term, the fund has outperformed the Global Equity category. For the past three, five and 10 years (as of March 29), the fund had an annualized return of 14.83%, 11.05% and 13.19%. In contrast, the category had an annualized return of 9.67%, 8.40% and 10.31%.

On a short-term basis, however, the fund has lagged the peer group. For the year-to-date, the fund returned -11.29%, versus -5.99%. Siino attributes that to a combination of limited exposure to utilities and energy names that have performed relatively well and individual stocks that have disappointed.

At the same time, Siino acknowledges that macro-economic factors, such as inflation, have little impact on the stock selection process. “To the extent that they influence the profitability of a company, and its cost of capital, yes, they are affecting us,” says Siino. “But are they influencing which stocks we buy, or sell? No. We are very much focused on the ROIC. The return on capital is the dollar of profit that you earn per dollar that is invested.”

Inflation Calculation’s Implicit

Labour and energy costs have been rising, Siino notes. Yet he argues that their group of companies have unique attributes that give them pricing power and the ability to raise one’s prices to compensate for higher input costs. “I noticed that this morning mortgage rates are at a five-year high. It has not done so yet, but you would think that somewhere down the line it would impact the demand for housing. That would affect one business that we own, The Home Depot Inc. (HD). But the question is, are these macro inputs, such as the rising cost of capital, implicitly impacting the type of stocks that we will buy, or sell? No. We are looking for long-duration franchises.”

Given the adherence to stock-picking, the geographic and sector weights are an outcome of the investment process. As of Feb. 28, the U.S. accounted for the largest weighting, at 57.87%, followed by 39.4% in international equity and 2.1% in Canada. On a sector basis, technology accounts for the largest sector at 22.11%, followed by 19.54% healthcare, 15.44% consumer cyclical, 13.14% industrials, and 13% financial services.

In searching for companies, Siino and Bleiberg focus on three factors: high returns on invested capital, unique characteristics that support the sustainability of those returns, and the opportunity to reinvest the cash flow and grow the enterprise. “It’s not enough to just have high returns on capital and unique attributes,” says Siino. “The Empire State building is profitable and has unique attributes. But you can’t re-invest the profits to make it any taller. We want to identify those companies that have opportunities to re-invest their profits and grow the terminal value of the enterprise.”

Companies that make the cut have demonstrated a ROIC at least five percentage points above their cost of capital, says Siino, “That’s our explicit floor. We would consider anything above that.”

Do They Punch Above Their Belt?

However, Bleiberg notes, using profits to grow a business is not proof that the company is creating value for shareholders. “The question is, ‘What did the growth in profits represent relative to the money they had to spend to get that growth?’ That’s what return on invested capital is measuring. That’s what matters more. If you can earn a return that is higher than the cost of the investment, you are adding value for your shareholders.”

Running a portfolio of about 230 holdings, the managers use portfolio optimizer software to improve diversification and reduce volatility. The top 25 names account for about 26% of the portfolio, with single holdings limited to about 1.5%.

One representative name is Constellation Software Inc. (CSU) a Canadian firm that is a diversified software consolidator. “They own companies that make software for golf courses, gymnasiums, and municipal courts,” says Siino, adding that the stock has been in the fund since 2013. “Their business model involves buying smaller software providers that have very attractive characteristics in terms of margins, market share and free cash flow generation, and their returns on invested capital.” Constellation uses a very rigorous formula to value companies, and then use the free cash flow to buy additional software providers.

Look for Likeminded Management

 “Their management team thinks like we do. They are very much focused on the ROIC and reinvest the free cash flow to create more long-term value for shareholders,” says Siino, adding that chief executive officer Mark Leonard encourages an entrepreneurial culture within the firm. “They follow the Warren Buffett model: leave managers to run their business, but also charge them for their capital. Managers are rewarded on the degree of ROIC they can generate in their business units.”

Siino and Bleiberg estimate that Constellation has a ROIC of 22%. Its stock, which is trading at 26 times enterprise value to earnings before interest depreciation and amortization, has a 2.5% free cash flow yield.

Another favourite is FinecoBank SpA, an Italian bank that specializes in online investment brokerage and wealth management. “Management is very much focused on ROIC relative to its cost of capital,” says Siino, “There are three legs to this stool. There is an online bank. There is a wealth management side with about 400 wealth managers spread around Italy. And they have an online stock-trading platform. It’s not a high-volume business model. They are focused on a younger customer who has been raised digitally and does not want to go to a bank branch. FinecoBank does not have the legacy costs that other large banks do.” Acquired in 2017, the stock is trading at 22 times price to earnings and 4.9 times book value. The bank has a return on equity of 22%.