In search of healthy returns

Jim Young, vice-president investments at Invesco Canada Ltd. He is responsible for Trimark U.S. Companies and Trimark U.S. Companies Class.

David Pearl, executive vice-president, co-chief investment officer and head of U.S. equities at New York-based Epoch Investment Partners, Inc., which manages assets for Toronto-based TD Asset Management Inc. and CI Investments Inc. Funds managed include Epoch U.S. Large-Cap Value under the TD Asset Management banner and CI American Value.

Glenn Fortin, portfolio manager at Beutel, Goodman & Co Ltd. Fortin is a U.S. specialist and member of the firm’s global equity team. This team’s mandates include Beutel Goodman American Equity.

Q: Another sector of the U.S. equity market where there is significant innovation is health care. It had a 14.2% weighting in the S&P 500 Index at year-end and produced a total return of 25.3% in 2014. Jim, you had 14.6% in health at the end of December.

Young: A biotechnology company that’s a big holding is Celgene Corp. (Nasdaq:CELG). The company has good growth products. A key drug is Revlimid, which treats cancer, but Celgene has added three additional products. Most importantly, Celgene has partnerships with 28 smaller companies and it funds their research and development. There are three or four companies that have advanced to a fairly mature stage and their stocks have gone up five to tenfold, in some cases.

Q: Jim, both you and Glenn continue to own Johnson & Johnson (NYSE:JNJ).

Fortin: We’re overweight health care. JNJ is more globally diversified by geography and by product mix than any other health-care company. The company has been well run over time. It generates a great return on capital and a great return to shareholders. It probably has one of the best dividend-growth track records in corporate America. More recently, it’s been divesting assets that may not fit its business any longer. It has also been seeking opportunities with acquisitions.

Young: It’s a good cash-flow generator. A little like Celgene, JNJ is funding smaller companies and it’s had some success with that. The stock is a top-10 holding.

Fortin: Baxter International Inc. (NYSE:BAX) is in the top-10 holdings in Beutel Goodman American Equity. Baxter specializes in products and therapies for chronic diseases. Its businesses have high barriers to entry. It has a strong track record of returning cash to shareholders. Baxter is splitting into two global health-care companies, one a medical-device company and the other a bioscience company. This is occurring this year and will create value for shareholders.

Q: David, the U.S. Large-Cap Value portfolio had 7% in health care at the end of the year.

Pearl: We own UnitedHealth Group Inc. (NYSE:UNH). The stock has done well. The United States has a new set of health-care regulations and the large health-care insurance companies have been the beneficiaries of this. Economies of scale do matter. There has been consolidation in this business. It was a contrarian stock idea, at the time. We continue to like it, barring a Supreme Court ruling this summer that could invalidate some of the law, the Affordable Care Act. One of the portfolio’s biggest weightings is CVS Health Corp. (NYSE:CVS).

Fortin: This major drugstore chain is still classified as a consumer staple. It will be moved over to the health-care sector, eventually.

Q: The financial sector represented 16.6% of the benchmark at the end of December and produced a total return of 15.2% for 2014.

Fortin: The current low-interest-rate environment is not good for this sector. The U.S. financials are also still dealing with regulatory issues. They are being required to maintain high levels of capital, which is inhibiting their ability to grow. There are some decent opportunities from a valuation standpoint. Our two big weightings are in global financial-services player JPMorgan Chase & Co. (NYSE:JPM) and BB&T Corp. (NYSE:BBT), a large regional bank. The portfolio had 15.2% in financials at the end of 2014.

Young: Our two big weights in this sector are Ace Ltd. (NYSE:ACE), the insurer and Wells Fargo & Co Ltd. (NYSE:WFC). Both companies generate lots of excess capital. These stocks are not expensive. They are good total- return stocks. The portfolio had 14% in financials at year-end.

Pearl: The U.S. Large Cap Value portfolio is overweight financials. We had been underweight financials until about a year ago. This overweight fits our idea that economically sensitive stocks are the place to be and they are cheaper. With financials, the other consideration is what is going to happen with the yield curve. We pay attention to this. We own BlackRock Inc. (NYSE:BLK). The growth in ETFs is strong. BlackRock is a dominant company in a growth business, where scale matters. It is a low-cost provider. Another holding is Morgan Stanley (NYSE:MS). The company transformed itself from an investment bank into a wealth manager. It has more than two-thirds of its business in wealth management and this is growing. Wealth management is a great business.

Q: Consumer staples? They are defensive stocks. They represented 9.8% of the benchmark at the end of the year and produced a total return for 2014 of 16%.

Pearl: We are underweight consumer staples in the U.S. Large-Cap Value portfolio. The stocks are expensive.

Fortin: We have had the greatest number of sales in this sector over the past 12 months. We sold down some CVS, which is a long-term holding. The company’s cash flow is substantial. On a price-earnings multiple, the stock looks to be expensive, but it is attractive on a free-cash-flow basis. We are underweight consumer staples.

Young: The portfolio is underweight this sector. I continue to own PepsiCo (NYSE:PEP). It has good cash flow.

Pearl: We also own PepsiCo.

Q: Consumer-discretionary stocks? This sector was 12.1% of the S&P 500 Index and had a total return of 9.7% in 2014. Let’s focus on the retailers.

Young: I own Nordstrom Inc. (NYSE:JWN). It is coming to Canada. It is a well-run company. It invests for the long term and has a big investment in technology. It has incorporated the Internet into the mix of its business. Nordstrom has high-end department stores. It also has Nordstrom Rack, which is its discount offering. The stock has done fairly well recently, because investors see some payoff for its investments. The fund had 17.4% in this sector at the end of 2014.

Pearl: We have a holding in TJX Cos. Inc. (NYSE:TJX), a discount retailer. It is a value concept and is dominant in this category. The company has taken market share from some of its competitors, attracting consumers that are both higher end and those that are less so. The portfolio had 11.4% in this sector at the end of last year.

Fortin: We own Target Corp. (NYSE:TGT). We bought it back in 2012, when its Canadian initiative was first being rolled out. We bought it when everyone was skeptical about its Canadian initiative and this turned out to be right. We are attracted to the culture of Target’s management. It has traditionally been conservative, which probably explains why, when management moved outside of its comfort level, this did not work out. The company is a strong cash-flow generator. The portfolio had 12.9% in consumer-discretionary stocks at the end of the year.

Q: Finally, industrials, which had a 10.4% weighting in the S&P 500 Index and produced a total return of 9.8% in 2014.

Fortin: We had 12% in this sector at the end of the year. Our biggest industrial holding is Ingersoll-Rand PLC, which trades on New York under the ticker (NYSE:IR). We have owned the stock for more than six years. In late 2013, management spun off the commercial and residential security businesses into Allegion PLC, which trades on New York under the ticker (NYSE:ALLE). We still own both stocks with Ingersoll Rand, the bigger position.

Pearl: We own Ingersoll Rand.

Young: I own Ametek Inc. (NYSE:AME), which makes instruments for industry and Honeywell International Inc. (NYSE:HON). The latter has a large number of businesses including aerospace, building controls and process controls. Honeywell has been improving all its businesses for a long time and this is starting to show up in its profits. Trimark U.S. Companies had 11.3% in this sector at the end of 2014.

Pearl: Aerospace stocks did well last year. We sold some positions down. We still have Boeing Co. (NYSE:BA). Back to our investment philosophy, the company spent a lot of money developing the Boeing 787. That has ended and it is selling the plane. The company has a seven-year backlog for this new plane. The stock represents average value on a price-earnings basis, but it is attractive on price to free-cash-flow basis. The portfolio is underweight this sector.

Coverage began on Tuesday and concludes on Friday.