US Equities: Still value to be found on upside

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Martin Steward finds some surprising potential for growth at the heart of generally defensive portfolios

Sometimes the fortunes of a single company can influence the mood on stockmarkets across the globe. At the moment, that company is Apple. When its first-quarter earnings soared through expectations in late April, the news boosted Asian and European trading.

Even after appreciating by close to 40% over that first quarter, the reported growth meant that the company was still, on a P/E ratio of some 12-times, pretty keenly valued.
This is how a classic tech growth stock like Apple turns up as the second largest of 13 holdings in Vulcan Value Partners' Focus strategy - the "best and most discounted ideas" from its flagship Value and Small Cap funds. It also explains why its top-10 holdings include no names from its Russell 1000 Value benchmark, but three (Apple, Microsoft, Google) from the Russell 1000 Growth index.

"We can buy a ‘growth stock' that's priced as though it's not growing," says CEO and CIO C T Fitzpatrick. "Apple is growing at rates much higher then we model, which means that every time they report earnings our value metrics on the company go up. It's almost as discounted today as it was when we first bought it."

Fitzpatrick also points to the fact that the firm converts more than 100% of its earnings into free cash flow, and that if you strip out all that cash its P/E drops from 12 times to less than 10 times. This assessment of value applies across the portfolio, which is why one has to look through its P/E and P/B, which are more in-line with the Russell 1000 core index than the Value index, and focus on its low double-digit P/FCF ratio.

Fitzpatrick says that translates into a free cash-flow yield of about 10%, which, combined with a fast rate of growth in that yield, adds up to "mid-teens", returns even before factoring in Vulcan's estimated discounts.

"If you are willing to give up diversification you can find an adequate number of companies that are of extremely high quality but also reasonably discounted," he says. "Warren Buffet talked about his ‘Sainted Seven' 25 years ago. That's the philosophy behind our Focus portfolio, which is for investors who already have plenty of diversification and are now looking for highly-discounted best ideas."

If you were surprised to see Apple as the second-biggest holding in a value portfolio, how about having it as the top holding in a ‘contrarian' strategy? And it doesn't stop there: the Columbia Contrarian Core fund's top 15 holdings also include JPMorgan, Exxon Mobil, GE, Microsoft and - you guessed it - IBM.

Senior portfolio manager Guy Pope's reasoning echoes Fitzpatrick's. "If you look at our top-10 holdings you'd probably be scratching your head," he says. "What's contrarian about Apple, right? Nothing. We want to buy a stock when it's contrarian and sell it when it's fully-valued, and we just don't think it's fully-valued yet."

The other reason the Columbia portfolio doesn't look contrarian at the moment is that it made a significant rotation into mega-caps towards the end of 2010, after riding the small-caps wave up from the lows of early 2009.

This is why the fund stands out in the rankings for the 12 months to end-2011. It would have fared even better had that size bias been paired with a bias towards dividend-paying stocks, which benefited as investors combined a flight to safety with a desperate search for yield.

"Utilities did well and some telecoms," says Pope. "But take away the yield and I think they look a little expensive right now. What I'm more interested in is management teams that have observed this desire for yield from investors and have started to think about, for example, going from stock buybacks to dividend increases."

Apple has famously announced its first dividends for 17 years; IBM has also set out plans to raise its dividend. But Apple will still only trade on a dividend yield of 1.8% and IBM on 1.6%. Microsoft is on 2.5%. Qualcomm, the other IT stock in its top-15 holdings, is on 1.6%.

That is why Miller/Howard Investments' Income Equity strategy has a 12 percentage point underweight in IT - and why it shone in the search for high-quality yield in 2011. In keeping with its income focus, it maintains a lower limit on dividend yield currently set at 3%. That means Intel and Maxim Integrated Products squeak in, and Microchip Technology gets the nod at 4%.

"We like the diversification from the growth potential we get from tech, but we try to add those that won't drag portfolio yield down too much," says founder and CIO Lowell Miller.
"Yields are our primary focus - we are interested in the long-term compounding of income and rising dividends. It's really a kind of real-estate model. We do manage a dedicated Rising Dividend Plus strategy, which does have IBM and Microsoft, but for Income Equity specifically we are evaluating CA - which has suddenly changed to become a high dividend-paying stock."

Last year the business software giant announced a five-fold increase in its dividend and now trades on a chunky yield of 3.8%. Like Pope at Columbia, Miller sees a trend for management to court income-focused investors.

Alongside CA he picks out CME Group, which has a dominant market share in a recurring-revenue business, and growth potential from regulatory pressure to move derivative trading onto exchanges. CME only qualified for the portfolio, however, when it started paying out 50% of revenue as dividend - it was yielding 4.25% when Miller bought in, and still yields 3.4% today.

"Companies have decided to cultivate investors who are more interested in dividends," he says. "This is a big change, and it's really the first time that I've ever seen it. We also have Cliffs Natural Resources in our Rising Dividend Plus portfolio, which is now a 4% yielding stock, and we are even looking at some retailers that are introducing annual dividend policies."

What about banks? After all, it is not long since the Fed lifted its ban on their paying dividends. The only way is up, surely?

Maybe, but not enough for Miller. His portfolio holds Valley National Bank for its secure dividend and its potential as an acquisition target, but even at today's valuations banks generally don't present attractive yields or the recurring-revenues that Miller/Howard likes. Indeed, its slight underweight in financials belies the fact that most of its holdings in that sector are REITS, which fit snugly with the "real estate" model that Miller describes.

Is a contrarian more enthusiastic about banks? The Columbia portfolio is neutral in financials but Pope finds it difficult to see banks thriving in a de-leveraged, low-rate world. He supports regulatory reform, but does not see how higher capital requirements make a good investment case for bank equity holders. And he still worries about systemic risk and potential contagion from the euro-zone.

So where is he finding that neutral weight? JPMorgan Chase is his fourth-biggest holding. Why that bank, trading on a book value of 0.9-times, over the more conventionally ‘contrarian' pick of, say, Bank of America, which trades on 0.4-times book and benefited from the Q1 rotation into risk?

"I think it has the best management in the sector, whom I can trust to allocate capital well for me," he says. "The balance sheet is solid. Something of a strategy right now is to go with groups that have gone a long way to repairing balance sheets, rather than those that are still trying to do it now - JPMorgan, Goldman, Wells Fargo, State Street.

JPMorgan and State Street are showing very solid efforts in terms of announced stock buybacks - State Street, in particular, could be an aggressive buyer."

JPMorgan and State Street also happen to be among a handful of global custodians, as is Bank of New York Mellon - the only bank in the Vulcan Focus portfolio, but its largest holding.

"In general we don't like banks," says Vulcan's Fitzpatrick. "But Bank of New York Mellon isn't a bank. It's a global custodian. This business is really an oligopoly that should be uniquely able to benefit from the growth of financial assets around the world. Local custodians will not be able to compete globally, and that translates to a sustainable competitive advantage."

This is a theme that Fitzpatrick picks up when discussing another financial-sector holding, Franklin Resources. He observes that its history of disciplined capital allocation owes a lot to the longevity of its management, which has built up large amounts of stock in the company.

"But they have a real competitive advantage in that they are one of the few asset managers that truly has global distribution, through Franklin Templeton - a great strength when you consider the future of the growth of wealth," he adds.

In the same vein, he notes that two-thirds of Apple's revenues come from outside the US. But that brings us back to that problem of the asking price for quality global growth - and beyond outliers like Apple, it does start to become an issue.

The luxury end of consumer discretionary and the larger end of consumer staples have become the poster children for this theme, and Fitzpatrick reveals that some have had to come out of his portfolio, including Diageo. "That's a wonderful company, but it was no longer as discounted as we require," he says.

Similarly, Miller holds no discretionaries and only 1.7% in staples, equivalent to a 20 percentage-point underweight to the consumer - despite the fact that staples might be considered a candidate for its portfolio of steady, recurring-revenue businesses.

"At times we've held staples, but at the moment yields are sometimes even lower than semiconductors," he notes. "Right now they are all suffering from cost pressures, too. Heinz is in our portfolios, which has been adding to its bottom line through global expansion - but there is many a slip between cup and lip when you are focusing on such long-term stories. A lot of these companies would love to do more in China, but China isn't quite ready to let them."

All three of our strategists are resolutely bottom-up stockpickers, but all three have put together portfolios that, to an onlooker, seem pretty bearish on the US economy in general, and the US consumer in particular.

Pope's top-15 includes the defensive Philip Morris International in eighth place, but the only other stock that looks even remotely like a consumer name is the third-largest holding, eBay. Categorised as a tech stock, we all know it for its recession-proof online marketplace business. Pope likes what John Donahoe has done to turn around the growth numbers in that business since he joined in 2008, but he is even more enthusiastic about the PayPal division.

"That has always done well online, but we are starting to see some opportunities in the off-line world, too," he says. "A partnership with Home Depot means that you can now go to 2,000 stores and buy all the 4x2 and nails you need through PayPal. It's still in the test phase and not being promoted very heavily, but a number of other retailers are interested and it doesn't require a lot of capital expenditure to roll it out."

And that is really the point: this may look like a consumer play, but it's just as much a play on corporate efficiency drives, as any investor in the broader point-of-sale technology sector will tell you (Pope also owns Mastercard and JPMorgan). Growth here depends less on customer footfall increasing, and more on the simple uptick of inflation and grabbing market share from cash transactions.

Look elsewhere in Pope's portfolio and one sees an overweight in healthcare and an underweight in materials which also reflects expectations of lower economic growth.
"We have a firmer dollar, slow growth around the world, Europe in recession and China slowing down - all after a race to build capacity over the past decade or so," Pope observes. "That's starting to work now - we're seeing it most clearly in natural gas."

The same point is made by Fitzpatrick as he explains how important it is to go beyond the pure numbers of a company's financial position. Asking how past growth rates can be sustained helped investors to avoid piling into newspapers in the late 90s, he says. Today it acts as a warning against "anything that is overtly cyclical", he suggests - especially materials.

"Companies that have a lot of exposure to commodities don't control their own destiny," he says. "There's already an example of what can happen with the natural gas boom in the US. Three years ago, companies were adding to their reserves - fantastic, they've spent a load of capital and now gas prices are down 75%. We fear something similar for a lot of other commodity companies."

These comments throw an interesting light on the Miller/Howard portfolio's sectoral positioning: utilities and energy are both 13 percentage points overweight.

The utility position is not surprising at all - there is that mantra of recurring revenues from stable markets. But there is a surprising growth element. Miller does not mind a bit of leverage - in fact he favours companies that are issuing secondary debt or equity.

The call for capital will depress the price, and the fact that they are making the call shows they see a compelling opportunity for growth-creating investment. You have to know what you are doing - but Miller/Howard has been running a utilities-focused portfolio for more than 20 years.

"This is a great sector if you understand the niches that have the capability to add value, on a foundation of stable core business that makes the dividend safe," he explains.

As an example, Miller cites Northeast Utilities. Five years ago it was an ordinary regional distribution company, before it dumped its minor electrical generation capacity to focus on doubling its size with a large capex programme in transmission. That was a significant risk, but the potential return on that larger capital base rose to equal it: transmission is regulated by the Federal Electricity Regulatory Commission, which allows much higher returns than local regulators, at 12-15%. Miller bought in at a price in the mid-teens in 2009, and the firm now trades around $35. "At the time nobody was really interested - only true utility wonks understood the opportunity," he says. "You don't find them looking at the likes of American Electric Power."

So much for utilities. What about that energy overweight? Miller says the "utility-like" model of recurring revenues persists here, because the portfolio's focus is on infrastructure. But there is also a major tilt towards natural gas, which is likely to define its risk characteristics over the coming months - in fact, one exception, Enerplus, proves the rule.

Enerplus ticks Miller/Howard's income boxes (it used to be a Canadian Income Trust), but it is also an upstream company bought as a result of a bullish house view on oil. Since then it has tried to balance its portfolio by adding gas; moreover, the gas business they added was mostly around dry gas, the price of which has plummeted, while natural gas liquids has enjoyed some support.

"That's really hindered Enerplus," Miller admits. "They've managed to keep the yield up, but frankly we're not sure how long they can sustain it because they are committed to drilling capex to maintain the rights to properties they've leased. Overall, however, our feeling is that we are now very close to a bottom in the dry gas price after a decline in gas rigs and a substantial increase in utility use."

As Miller indicates, those $2-3/mbtu gas prices have benefited some of his utility names. But the opening of new shale gas fields that has led to this bear market is also behind the processing and transportation play that he describes as "the heart of the portfolio today".

Miller cites Enterprise Products, a natural gas liquids processor which has seen demand for its chemical by-products soar. He has added to the similarly-positioned Plains All American, which recently acquired BP's Canadian natural gas liquids business. Not only are utilities choosing gas over coal, new chemical plants are being built in the US. "That fact should make anyone fall off his chair in astonishment," he says.

On the transportation side, Miller has been gathering up companies with legacy pipeline assets and rights of way strategically placed for new gas fields.

One large holding, NiSource, which spent a long time paying off the debt it accrued for acquiring Columbia Gas in 2000, now sits on the largest gas pipeline east of the Mississippi - the bulk of it in the now legendary Marcellus and Utica shale. Would-be acquirers have already come knocking.

"Half the company is pipeline, the other half a utility," says Miller. "The whole company trades at less than the current market value of a utility private company - and yet the half that is pipeline and infrastructure should trade at two-to-three times the private market value for a utility. We think this company is perhaps 50-100% undervalued - but the dividend is totally safe because it's supported by an ongoing utility business."

In a way, this sums up the intriguing position of the portfolios under review this month. Miller says we should think of his as "a bond of infinite duration with a rising coupon". But in a way it also resembles a convertible bond.

The Miller/Howard strategy struggles in our Mercer table over five years, but comes near the top over the tricky 12 months of 2011 - a ‘Steady Eddie' that was unexciting during the rally of 2009-10, but very attractive during 2011.

"There's no real shortage of potential events that would prompt investors to seek safety again, and with interest rates remaining low, we think we remain in the sweet spot," says Miller.

But past performance is not an indicator of future returns - or risk. The utility revenue stream is there, but if the shale gas revolution plays out as it appears set to, this portfolio could turn into one of remarkable, even explosive, growth.

Similarly, one reason why Vulcan's Focus portfolio is within one stock of its maximum 14 holdings is that value is growing as cash mountains build because corporates do not have the confidence, in a low-growth world, to invest.

But, as Fitzpatrick observes, there is no point generating cash unless, at some point, management is going to get a chance to demonstrate its discipline in allocating capital. When that happens, Fitzpatrick is confident his companies have laid down a great track record.

"People, not surprisingly, focus on the bearish macro headlines," he says. "But when you get away from all that noise and look at the underlying growth that we hear about from our business, day-in, day-out, things look a lot better from the bottom-up. Our management teams are feeling pretty darn good about their businesses."


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