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US Equities: Growth – but at what price?

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US equity managers’ performance has been determined by a long period of convergence between value and growth strategies. Martin Steward outlines these characteristics in four portfolios and asks if this era is coming to an end

Brace yourselves for possibly the most bearish statement ever to make it into the post-crisis pages of IPE.

“We think we are in a long, 15-plus-year secular bear market, starting in March 2000, which will require us to get down to a P/E of around 10 times before we can re-enter a secular bull market,” says Tysen Nutt, senior portfolio manager at Delaware Investments.
“Right now we are in a cyclical bull market. Any secular bull will be unleashed by the market becoming much cheaper than it is today.”

This seems like a pretty extreme, ‘deep value’ perspective, but Delaware’s portfolio does not look ‘deep value’ in either its sector weights or its fundamental metrics. No, this appears to be a genuine top-down view – at least partially derived from a macro-thematic overlay on Delaware’s core bottom-up analysis.

“So many of the many fine value managers with whom we compete tend to be purely bottom-up, so this does make us a little different,” says Nutt.

One dominant thematic idea in the portfolio is that we are enduring “an extended period of de-leveraging”, as senior investment specialist Carl Rice puts it. This is one reason for the 15 percentage point underweight in financials, and the fact that the financials it does hold are the custodian Bank of New York Mellon and the insurance names Marsh & McLennan, Travelers and Allstate. “We just don’t think we’re in that ‘Financial Era’ that persisted between 1981 and 2007,” says Rice.

There are other themes. Its overweight to healthcare is set at the maximum allowed, for example, to capture long-term trends in rising per-capita spending, especially in emerging markets. But this position has been helped by marked under-valuation, thanks to regulatory uncertainty and ‘patent cliff’ concerns, says Rice. Elsewhere, the focus is less on the macro-thematic ideas because that approach is being curtailed by stretched valuations.

“There are times when our process is more driven by the macro side, and vice versa,” Nutt explains. “Right now it’s more difficult: we have a couple of sectors fully overweighted – healthcare and energy – but within sectors we can still add to it is tough to find ideas, making us more sector-agnostic and more bottom-up.”

Of course, the two things are related. Implementing thematic ideas becomes more difficult as individual stock valuations become stretched in a market rally, but those valuations look stretched against depressed earnings expectations – which are partly down to the end of the ‘Financial Era’.

So, while the strategy consistently holds higher-quality value than average, right now it is especially defensively-positioned. Its overweight in telecoms is unusual, for example – as is the fact that it holds any utilities at all. “That’s the top-down decision,” says Rice. “With a pretty full valuation for the overall market we are content to leave these defensive weights in place.”

Similarly, consumer staples, the portfolio’s biggest overweight at 6.2 percentage points, is another sector which, even though all but one of the five stocks that Delaware holds are valued at a level that would still qualify them as new purchases today, Nutt describes as “fully-valued”. Late last year Kimberly-Clark, which had been held for a decade, had to go, for example.

“We are content to maintain our 14% target weight for that natural defensiveness and the room we have to our upside valuation targets for our remaining five stocks,” says Nutt.

Coho Partners arguably run an even more defensive strategy. Its primary concern has always been preservation of principal during challenging periods, says CIO Peter Thompson. “What separates manager returns is performance during the down times – because even the stinkers go up in a rising market.”

Indeed, the strategy has captured 80% of the market upside and just 54% of the downside.
Portfolio beta comes in at just 0.68. While it calls itself ‘relative value’ and gets categorised as a value strategy, its starting point is more of a quality screen that identifies the ‘Coho 250’: companies with earnings-growth stability, high return on equity, high free cash flow, dividend growth and stock repurchases, low debt and low capex requirements.

“These are iconic business models that tend to do well when the market is under duress,” says Thompson. “They are not the kind of businesses you discuss at cocktail parties.”

They are not all in what Coho calls the three ‘demand-defensive’ sectors – consumer staples, healthcare and integrated energy – but the portfolio does consistently hold 60% in these sectors versus 30-35% in the Russell 1000 Value index. The rest is in ‘economically-sensitive’ sectors – but even here Thompson concedes a bias towards “chicken cyclicals”.
The result is significant overlaps with what we see in the Delaware portfolio.
Energy is a sector picked out as important by both. Halliburton and Marathon Oil are Delaware’s top-two holdings.

“We have done a lot of work in energy, which might seem unusual for a value manager,” as Nutt puts it. The company that his colleague Rice picks out is Occidental Petroleum, purchased in 2011 when the stock was down 30% from its peak and offering a yield of 2.4% on dividends that had grown by 18% since 2006.  

“They are particularly good at developing existing wells,” he explains. “Exploitation rather than exploration makes it somewhat less risky, with consistent cash flows.”

Similarly, Coho is explicit about its preference for ‘integrated energy’ – combinations of upstream and downstream refining businesses, to smooth-out sensitivity to the oil price.
“That takes some of the cash flow risk away from us,” says Thompson. “In fact, we hold Conico, which just spun-off its Phillips downstream refining business, so we are trying to decide what we should do with that position.”

The overlaps continue into financials, a 22 percentage-point underweight at Coho, whose holdings are Marsh & McLennan and a Texan bank, Cullen/Frost, which is so unlike the ‘bulge bracket’ that it sailed through the financial crisis without government aid, increasing its dividend.

Cullen/Frost’s dividend policy is emblematic. During 2009, none of Coho’s portfolio companies cut their dividends and all but two increased them. Of those two, Royal Dutch Shell held steady and biotech business Amgen, which had never paid a dividend, continued its stock buyback programme. Coho’s companies’ earnings growth has been steady but not spectacular, but dividend growth has been astonishing: 13%, compared with a contraction of 6% for the Russell 1000 Value index. And it is prepared to pay for that: its valuation multiples are slightly higher than the benchmark.

“We don’t pay any attention to valuation when we are constructing our universe,” says Thompson. “The companies in the Coho 250 have better growth prospects than those held by a traditional value manager. It is only once they are in that universe we become very sharp value buyers, waiting patiently for the day when the expensive ones become cheap enough for us.”

Even here, though, we find the beginnings of the same struggle that we see at Delaware. Coho’s overweight in consumer staples is still much bigger than Delaware’s, but just as Delaware had to sell Kimberly-Clark after holding it for 10 years, Coho has halved its long-held position in Colgate-Palmolive. “This is our lowest weighting ever because its multiples are as high as they’ve ever been,” says Thompson.

Managers with a distinct quality-growth tilt lead the pack in US value over 3-5 years – but managers with a distinct value tilt lead US growth. As Baron Capital portfolio manager Alex Umansky says: “We are growth investors, but ultimately we believe that all investing is value investing.”

Which is not to say that its strategy looks the same as Coho’s or Delaware’s. It has been considerably more volatile, for example – five-year beta is 1.07. The source of that volatility is not immediately clear.

It holds more stocks that the other two, for example, and is a ‘growthy’ collection of “unique companies with sustainable competitive advantages” tilted to business services, technology and staples and away from consumer cyclicals, energy and financials. While its financials underweight is less aggressive than Coho’s or Delaware’s, its holdings are all “de facto monopolies” – exchanges like CME Group.

The answer may lie in the unusual approach to value. Value managers look at stocks’ ‘relative value’ (as Coho’s strategy is named) – relative to their own history, and to other stocks. However, Baron is always thinking against the context of its search for “unique” franchises – so valuation ‘relative’ to peers is beside the point.

“We try to find companies for which it is difficult to find comparables because that’s what leads analysts to mis-value them,” as Umansky puts it. “I would argue that every company we own is truly unique.”

This does not mean a portfolio full of obscure specialists – Baron’s top-five stocks are Google, Apple, Visa, Amazon and Monsanto. Umansky likes household names because they dominate their niches, which improves their chances of being the right companies to exploit sometimes unpredictable secular growth opportunities.

Google is a good example. Umansky disagrees with the perception that it faces a threat from mobile search, which presents less advertising space: search may be moving onto phones and tablets, he says, but that means more search, not less.

“The question really is, who will emerge as the leader?” he asks. “Who is better placed to monetise mobile search than Google?”

If you thought Google wasted $8bn (€6.1bn) buying Motorola Mobility in August 2011 just to fend off lawsuits from Apple and Blackberry against the Android ecosystem, you were badly mistaken, he says. “Google needed Motorola’s mobile-engineering and mobile-market know-how – and is now making its own phones and tablets.”

Is Google a search company or a mobile company? The ambiguity has arguably opened up valuation anomalies. The same dynamic applies to Monsanto, Umansky argues, which gets priced as a chemicals company rather than higher-growth, higher-multiple biotech, even though 70% of its profits come from genetically-modified seeds.

It also justifies some extreme-looking valuations. Amazon is on 170 times forward earnings – but Umansky asks what we should compare that to. A volume retailer like Walmart? A logistics provider like FedEx?

“Amazon is still only $120bn,” he says. “Walmart got to $250bn limited by bricks-and-mortar. I don’t know what the final number for e-commerce penetration will be, but it’s certainly a lot higher than today’s 8% and I know the largest provider will be materially bigger than $120bn. It’s going to happen, and it’s likely to be Amazon.”

The thesis is perhaps most controversial when applied to Apple. Umansky’s case for holding it today is its “massive” discount to intrinsic value.

“Growth investors have lost faith and value investors ask, ‘How do we know that they aren’t going to waste the cash?’” says Umansky. “This period of uncertainty is the reason for the mispricing.”

He acknowledges that investors like David Einhorn are right to worry that one-third of the company’s assets sit, “mismanaged”, in low-yielding securities. But just as he argues that investors should have faith in Google’s unique position to exploit mobile search and Amazon’s to exploit global ecommerce, so he urges faith in Apple’s unique position as a consumer-tech innovator.  

“I believe they have another one or two blockbusters in them – whether it’s a TV, iPayments, iWatches, iCar, you name it – because I don’t think they are holding that cash for acquisitions,” he says. “The problem is that the company doesn’t like to share these things with investors until it is ready to ship the product.”

Umansky insists that at today’s valuation none of that innovation has to happen to make Apple a hold. But he also concedes that Baron bought the stock in 2008 because it was an innovator with a growing ecosystem. “There is a danger of thesis creep, for sure,” he admits.

Contrast this with Coho’s position in technology – four percentage points overweight but holding IBM, payroll processor ADP and low-tech microcontroller manufacturer Microchip Technologies – and one gets a sense of where Baron’s extra volatility comes from.

“IBM grows at 2-3% a year, buys back a ton of stock and will increase its dividend to well over 10%,” says Thompson. “That is a great return with virtually zero chance of blowing up. But the chances of Apple, Netflix, Dell, Intel, or Hewlett Packard blowing up? Much higher, so they don’t make our universe.”

Our fourth manager, American Century Investments, presents yet another twist on the growth-and-value nexus.

“There have been a lot of studies about how using growth in a value space can work well, and by the same token using value in the growth space can work well, too,” says senior portfolio manager William Martin – echoing Umansky’s words. The portfolio has realised more earnings growth than the growth benchmark but carries lower valuation multiples.
But in this case, the value element derives from American Century’s use of quantitative screening and optimisation.

A pure quants approach to growth is likely to fail, for fairly obvious reasons: between 2005 and 2011, the top-quartile of Russell 1000 Growth stocks ranked for expected EPS growth at the beginning of the period had underperformed the index by 0.08% per month by the end, while the bottom-quartile had outperformed by 0.09%.   

“What does that tell us?” asks Martin. “Don’t pay for growth – pay for quality and value. Cheap high-quality outperformed by 0.26% per month and expensive high-quality outperformed by 0.12%. Growth is our beta – our alpha comes from discerning quality and not overpaying. Don’t buy the hype, stick to the discipline.”

This ‘discipline’ delineates differences over the nature of alpha-generation. Umansky’s views at Baron Capital are clear. “We think that large-cap is fairly efficient, so we don’t think we can find 100 large-caps that the market is mispricing at any one time,” he says.

By contrast, Martin says: “One of the strengths of quantitative management is the law of large numbers.” In practice, that means outperformance should come from both overweighted winners and underweighted losers, the implication being that non-systematic approaches inevitably focus on the stocks listed for inclusion at the expense of those rejected and, further, that this risks managers “falling in love” with the stocks they hold.

Martin’s colleague, client portfolio manager Syed Zamil, picks out Priceline.com, which Baron also holds, to illustrate. American Century went into 2012 overweight in this online travel company, which had been enjoying excellent free cash flow for years as holiday bookings moved online – but its models picked up a deterioration in both quality and growth metrics and sold down to market weight. The company then revealed that it expected most of its growth to come from Europe rather than the US. Guidelines started undershooting analysts’ estimates and by late 2012 the model signalled it was time to sell out completely.

“A traditional approach could lead you to fall in love with the great business model and dismiss this as a blip,” says Zamil. “We may agree, but the numbers tell us they could continue to face pressure from weaker European demand.”

The traditional growth manager would argue that they have sold a great company and may never be able to re-enter. Another position that American Century and Baron share, Amazon, makes the case well.

American Century holds about 0.3% in the stock, quite a considerable underweight. The stratospheric valuation (which Umansky at Baron justifies with an appeal to Amazon’s unique franchise) is compounded by deterioration in its quality metrics. The firm delivered below-expectation guidance in every quarter of 2012, but also spent freely on M&A and HQ expansion. But its stock appreciated 45% during 2012.

“They’re financing a lot of their growth with debt, and our models just don’t like the fact that debt and capex are growing faster than earnings,” says Zamil. “Clearly, everyone else is ignoring these numbers and saying that Amazon can grow enough to justify recent expenditure – it’s one that got away. We may have blown it on Priceline, too, for sure. But the systematic approach tends to be right 55% of the time, and that’s all we need.”

As Zamil says, if stocks like Amazon lead a rally, American Century’s portfolio will lag.
None of these strategies has fared well during the latest market rally. Value has outperformed in general, but the ‘growthier’ end of that group has fared worst. Within growth, the more value-focused managers have suffered least. Staid ‘quality’ has not fared well; the more aggressive ‘quality’ of Baron Capital has coped a little better.

If the age of quality-growth constrained by a sensible value discipline is coming to an end as the macro picture improves, the chances are that these portfolios will begin to drop out of top-quartile performance. But if you are anything like as gloomy as Tysen Nutt at Delaware, you should stick it out: you will be expecting much less growth and you will therefore need to buy it at much keener value.

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