Fund managers bullish on U.S. equities

Blackstein notes that the benchmark S&P 500 composite index has made little progress since the heydays in 1998. Although there have been rallies in the past 14 years, the bear market declines in 2000-02 and 2007-09 had wiped out those gains; the index today is where it was in 1998. “But some stocks have done exceedingly well – and that’s where the opportunities lie,” adds Blackstein, a bottom-up investor.

He cites Apple Inc., which has gone to about US$553 ($535) a share from US$24 ($23.30) in 14 years. “Typically, great growth companies are anomalies,” he says. “But that’s the kind of company we’re trying to find.” (Even though Blackstein regards Apple highly, he sold the Dynamic fund’s holdings in Apple last year and found opportunities elsewhere.)

Running a concentrated portfolio of about 25 names, Blackstein favours three sectors: information technology, consumer discretionary and health care, which together account for about 90% of the Dynamic fund’s assets under management (AUM). “The secular change we’re undergoing in technology is probably one of the most dramatic I’ve ever seen,” he says. “The move to mobility, whether it’s with iPads or iPhones, and cloud-based computing is ‘re-architecturing’ technology. It’s the most dramatic thing we’ve seen since we went from mainframes to personal computers.”

One of the Dynamic fund’s top holdings is F5 Networks Inc. A global leader in managing data traffic, this firm helps large corporations and Internet service providers make full use of so-called “virtualization” cloud computing (which enables companies and consumers to benefit from remote servers) and on-demand information technology.

Nasdaq-listed F5 is trading at about US$124 ($120) a share, 28 times forward earnings. Blackstein has no stated target.

Another favourite is Whole Foods Market Inc., the upmarket food retailer. “Initially, it grew rapidly through acquisition,” says Blackstein. “But [it] messed around with square footage, and had different-sized stores. So [it] went through a difficult time.” Lately, management has restructured and developed a stronger focus on format, merchandising and pricing.

Whole Foods, listed on Nasdaq, is trading at about US$88 ($85) a share, 31 times forward earnings.

Roger Hamilton, Senior managing director with Manulife Asset Management (U.S.) LLC in Boston and manager of Manulife U.S. Opportunities Fund, says he is mildly bullish: “The U.S. economy is on a firmer footing, housing and unemployment are not as bad, and central banks around the world have been easing.”

Meanwhile, he notes, stocks are trading at around 13 times earnings, which is a low price/earnings (P/E) ratio relative to interest rates. But Hamilton doesn’t expect an expansion of P/E multiples, mainly because “the problem of debt by all these industrialized countries puts a damper on long-term growth prospects, and puts a lid on valuations.”

Although a market correction is possible this summer, even a prolonged sideways trend, Hamilton doesn’t believe it will be severe: “I don’t think we’re going to roll over as hard as we did last year because the economy is in better shape. The rebound that we might have expected in 2010 or 2011 – maybe we’re getting it now. Long term, we could be looking at a period of slow, steady growth. In that environment, [in which companies are] returning cash to shareholders, the market won’t be too bad.”

A bottom-up growth investor, Hamilton looks for strong businesses that are trading at a discount to their intrinsic value. “We

try to buy companies that have the potential for high invested returns on capital. That’s the best long-term driver of shareholder value,” says Hamilton, adding that he also looks for companies with a sustainable competitive advantage.

Hamilton favours technology stocks at the moment – they account for 26% of the Manulife fund’s AUM vs 21% in the S&P 500 – as well as industrial stocks, at 13% of fund AUM vs 10% in the index. There also is a benchmark-weighted 15% in financials and an underweighted 8% in consumer staples.

One top holding in the 70-name Manulife fund is Qualcomm Inc., which makes semiconductors for smartphones and generates revenue from patents. “[Qualcomm] spends a lot on R&D, which creates barriers to entry,” says Hamilton. “And the licensing business is a nice one. You don’t have to organize staff or worry about the cost of goods sold.”

Qualcomm is trading at about US$61.50 ($59.50) a share, 16 times forward earnings. Hamilton has a target of US$76 within 12 months.

Another favourite is Microsoft Corp. The software giant had missed out on the tablet and smartphone trend, but Hamilton believes it is making up for lost ground through initiatives such as Windows 7 and the Bing search engine: “They’re doing a lot of stuff right. And now they will roll out Windows 8, which appears to work on all devices. These are high-margin products.”

Microsoft is trading at about US$30.20 ($29.20) a share, 10 times forward earnings. It also pays a 2.5% dividend. Hamilton has a 12-month target of US$36.

Although some critics have questioned the U.S. market’s rapid ascent year-to-date, Larry Puglia, vice president of Baltimore-based T. Rowe Price Group Inc. and manager of TD U.S. Blue Chip Equity Fund, argues that it is justified: “We are more circumspect on the market because it has performed well. Having said that, we believe that stocks that have performed very well – such as Apple Inc., for instance – are not valued in an egregious way. Stocks such as Google Inc., are also valued quite reasonably.”

Puglia notes that when the free cash-flow yield on stocks was recently about 7%-8% and treasuries’ yields were 2%, “most of the time that kind of differential in yields has augured very well for stocks. In my view, valuations are reasonable.”

Still, Puglia admits that U.S. corporate earnings have been slowing, mainly because of weakness in Europe and a slowdown in China: “Just how dramatically earnings will slow will be dictated by how Europe mends, or how much China slows. The U.S. economy is not growing as quickly as we would like, but it is strong enough to foster earnings growth in selected companies. I’d be less comfortable saying that the broader S&P will grow at some double-digit rate, because the math says it’s difficult.”

From a strategic viewpoint, Puglia favours tech stocks, which represent almost 33% of the TD fund’s AUM, followed by 23.5% in consumer discretionary, 13.4% in industrials, 9.8% in health care and smaller weightings in sectors such as financial services.

A bottom-up growth manager running a 140-name portfolio, Puglia likes companies such as Starbucks Coffee Co., the world’s largest specialty-coffee chain. “We got involved initially,” says Puglia, “when [Starbucks] transformed its European business and re-engineered how its stores operated. Margins improved dramatically. Over time, we saw that it also had an important strategy to improve its consumer products, such as the introduction of Via – the instant, single-serving coffee.”

Coupled with other innovations and a moderation in coffee prices, he adds, Starbucks should be able to grow its earnings by 20% a year for next few years.

Starbucks is trading at about US$53.40 ($51.60) a share, 23 times forward earnings. Puglia has no stated target.

Another favorite is EMC Corp., a dominant player in the data-storage industry. “There’s been an explosion of data,” says Puglia, “due to the growth of handheld devices, the expansion of social networks and the procurement of data through cloud-based computing.”

A long-term holding, EMC is trading at about US$26.10 ($25.20) a share, 15.5 times forward earnings. However, Puglia notes, the multiple is lower when EMC’s stake in VMware Inc., a cloud-computing firm, is excluded. IE

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