U.S. Stocks are Priced Right as Inflation Cools: Manager

A portfolio manager who favours the U.S. equity market, Aubrey Hearn considers U.S. valuations to be fair. Noting that the benchmark S&P 500 Index was trading a year ago at 17 times forward earnings, the lead manager of the 5-star neutral rated $717.6 million CI U.S. Equity & Income F says: “The index is trading at 20 times forward earnings. That’s more expensive historically, although not insanely expensive at any stretch.”

Nevertheless, Hearn is quick to admit that a handful of stocks, such as Alphabet Inc. (GOOG) are up 40% year-to-date, while Meta Platforms Inc. (META) is up 149%. “The FANG stocks [which include Facebook’s parent Meta Inc. and Google’s Alphabet parent] have contributed a lot to that share price appreciation. If you look at any other name outside of tech, you’re not seeing anything close to that, in terms of returns,” says Hearn, senior vice president, of CI Investments, Toronto. “There are some names that have been left behind and some opportunities there. But overall, I’d say the market is fairly valued.”

Consumers Still Spending as Inflation Cools

From a macroeconomic perspective, Hearn observes that U.S. consumers are in good shape, still spending, and using up some of the savings accumulated during the pandemic. “At the end of the day, wage inflation is good, people are working and spending. So, I would expect a good earnings season [coming up],” says Hearn, a 20-year industry veteran who earned a Bachelor of Commerce degree from Memorial University and joined the firm in 2005. Hearn, who has worked on CI U.S. Equity & Income F for the past decade, shares duties on the equity side with Jack Hall, vice president. “Some of the supply chain pressures are easing and some of the commodity prices are not as high as a year ago.”

Hearn is also confident that monetary tightening is approaching the end and notes that inflation in the U.S. has eased to 3% on an annual basis. “Inflation is heading in the right direction. I’m not going to suggest there will not be another rate hike here or there. But the rapid increases in rate hikes that we saw in the last year, and the pace of those rate hikes, will certainly slow,” says Hearn, “The Federal Reserve has a clear policy of 2% inflation, and we’re not there yet. But we are heading in the right direction.”

Keep an Eye Out for Trump

As for the U.S. political scene and the primaries leading up to the 2024 presidential election, Hearn notes that President Joe Biden has the lead among Democratic candidates, while former president Donald Trump has a commanding lead among Republican leadership hopefuls. “There is more volatility if Trump gets in and that may not be good. But remember that when Trump was sworn in, his policies were pro-business. It’s a non-event for now, but something to follow.”

On the negative side of the ledger, however, Hearn is cognizant of a trend of consumers spending more than usual and making more use of credit cards and home equity lines of credit. “With the high rates they are paying for some that stuff, you have to scratch your head and ask, ‘How long will this persist?’ The secondary worry would be that at some point we may tip into recession because of these aggressive consumers.”

Inflation and Recession Risks Aren’t Over

Chief among these various worries and concerns, Hearn admits, is inflation. “It acts as a kind of gravity on the market,” Hearn argues. “If inflation is high, and interest rates are high, then the discount rate that you have to apply to cash flows goes higher as well, and of course, that reduces the multiple that people are willing to pay for stocks. We saw that in 2022 when multiples compressed so much. It wasn’t necessarily an earnings story, but the discount rate went higher and people were more attracted to fixed income. So, we need to get that [inflation] under control.”

 For the past decade, Hearn has ably guided the fund.  Over the past five and ten years, CI U.S. Equity & Income F has returned an annualized 5.81% and 9.62%, respectively. In contrast, the Global Equity Balanced category returned an annualized 3.90% and 6.14%. Year-to-date (Aug. 21), the fund has returned 11.11%, versus 5.38% for the category.

From an asset allocation viewpoint, the fund has 60% of its assets in U.S. equities (as of June 30), 10.1% in Canada, and 3.4% in international stocks. There is also 22.46% in fixed income and about 2% cash. The fixed income portion, held mainly in short-duration corporate bonds, is jointly managed by John Shaw, senior vice-president and Fernanda Fenton, vice-president.

The U.S. is Still the Best for Stocks

The heavy U.S. equity weighting begs the question: why such a disproportionately large exposure to U.S. stocks? For Hearn, the reasoning is simple. “If you look at long periods of time—and even short periods—U.S. markets tend to outperform,” says Hearn. “Despite all the political back-and-forth and various permutations of what’s going on in the media, the U.S. is the best, most vibrant economy in the world. A lot of that stems from innovation. When you look at U.S. technology, there are major e-commerce companies or AI [artificial intelligence] or health care, and other sectors as well. The best, and most capitalized companies, are in the U.S.”

In general, Hearn also argues that U.S. companies are very adept at expanding into foreign markets such as Europe, India and South America. “Stock returns follow growth and returns on invested capital. U.S. companies definitely have an edge that allows them to continue to grow and take share of the world, especially when it comes to innovation,” says Hearn, adding that it is much easier for him to sit in Toronto and understand the U.S., as well as Canadian firms. “It’s easy to get your head around Visa or Mastercard if you use their products every day—versus some international names that you don’t know as well.”

There are exceptions to the home advantage, says Hearn, pointing to sectors such as fashion, where French global leaders such as LVMH Moet Hennessy Louis Vuitton SE (MC), which he happens to own. But for the most part, the fund is dominated by U.S. names such as Alphabet Inc. (GOOG), Mastercard Inc. (MA) and Amazon.com Inc. (AMZN).

Largely a bottom-up investor, Hearn focuses on companies that have very significant barriers to entry and generate the best returns on invested capital. “We like companies that have the best growth that you don’t necessarily have to pay for,” says Hearn. “For us, it’s about owning a business for five, or ten or 15 years, versus figuring out how the stock may perform over the next quarter.” He notes that when interest rates skyrocketed last year and growth stocks took a big hit, he stuck it out. “Their free cash flows are out years from now and they should have been disproportionately hit. But we held on and averaged down. These companies generate hundreds of billions of dollars in free cash flows and can still grow,” says Hearn, adding that some industrial stocks became more attractive.

Train Stocks Make Inflation-Resistant Bets

Running a portfolio of about 50 stocks, Hearn cites names such as Canadian Pacific Railway Ltd. (CP), one of the leading North American railroads. “They bought Kansas City Southern in late 2021 and over time we believe that it is going to be a big win for them because they are the only integrated railway in North America that touches Mexico, U.S. and Canada,” says Hearn. “They can move goods through wide swaths of the country and have a very powerful system for customers who want to get their goods from point A to point B as cheaply as possible. We also like it because of Keith Creel, president of CPR. He is the best railroader in North America and learned under Hunter Harrison (former CEO of Illinois Central Railroad and Canadian National Railway).” Hearn notes that Creel had established himself as a very cost-conscious executive while leading CPR and he has driven the same high standards at Kansas City Southern.

From a stock perspective, CP is trading at 21 times 2024 earnings. “It is a bit more than the market. But no one is building another railroad, so that’s good,” says Hearn. “Inflation doesn’t really bother railroads because they can pass it through to their customers. In many cases, there is no other game in town. And we think the company can grow much faster than the market because of the pricing they are getting on their existing business and the synergies they will achieve with the merger with Kansas City. We expect some good growth ahead.” Hearn sees about a 30% upside over two years for the stock.

The Return of Home Renos

Another favourite is Home Depot Inc. (HD), a leading North American home-building supplier. “It has a wide economic moat. When you think about home improvement, the only names that come to mind are Home Depot and Lowe’s Companies Inc. (LOW),” says Hearn, noting that Amazon has tried to get into the sector, but it hasn’t really worked out, in terms of the types and amount of inventory and expertise that is needed.

Hearn admits that the firm had its worst quarter in terms of same-store sales, in the last quarter. “Summer demand was pulled forward because of the pandemic because homeowners ended up renovating their houses. Now they’re not spending as much and it’s been generally a slow time,” says Hearn. “Maybe this will continue for a couple of years. But people will keep renovating their homes and do general maintenance and upkeep. That bodes well for their business.” He notes that Home Depot is working hard to engage with professional builders and renovation firms, which has grown considerably in recent years.

Home Depot generates a 30% return on invested capital (ROIC) and is “very smart about capital allocation,” says Hearn, adding that the stock is trading at 20 times 2024 earnings. “But the ROIC is way better than the market, so there should be good growth with some of their initiatives. We believe that it’s a better buy than the market,” says Hearn, who is reluctant to forecast the share price.