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Fund Focus: American growth

James Smith runs the rule over the strong recovery in the Stateside markets

Despite macro challenges, US funds have posted among the strongest returns over the last three years – highlighting the country’s post-credit crunch recovery.
Developed markets have benefited from a significant reallocation from emerging markets in 2011 – largely on valuation and inflation fears – and performance also supports this shift.

Over three years, the average US equity portfolio is up by 18.7 per cent, behind soaring Asian funds but well ahead of UK and European funds and just a few percentage points behind the emerging market sector.

For UK investors, the challenge has always been to find managers that consistently outperform but data shows these rarities do exist.

Top of the pile over three years is Gam North American growth run by market veteran Gordon Grender since launch in 1985.

In basic terms, he focuses on value overlooked by the wider investment community, seeking well-run companies that are undervalued in relation to long-term prospects.

Looking at recent performance, Grender highlights several big positions in the portfolio, with retailer Conn’s and chemicals stock Huntsman making significant gains based on better than expected first-quarter earnings.

His macro view remains cautious, although – as evidence bears out – he expects a portfolio of carefully picked stocks to perform even in a slower-growth environment.

He says: “We believe the end of quantitative easing and likely cuts in fiscal stimulus will cause the US economy to resume a below-trend growth path but the market’s continued rise suggests a more optimistic consensus view.”

Several stocks contributed to Grender’s returns in 2010, including Power One which more than doubled over the year.

He also notes solid numbers from chemicals company Huntsman, auto-parts retailer Autozone and retailer Fred’s, as well as specialist insurance stocks WR Berkeley, Infinity Property & Casualty and Chubb.

He says: “It is difficult to draw conclusions from monthly data but it seems the Federal Reserve’s ultraeasy monetary policy is not really working. Unemployment has been slow to decline while the majority of the new jobs created are relatively low-paid. Consumers remain indebted and troubled by the weak housing market, where the problems are likely to take a long while to solve.

“Such concerns make predictions about the market more difficult but we believe it is possible for the fund to continue to perform well regardless of the overall economic or market backdrop.”

Against this background, the portfolio’s biggest holdings have remained unchanged although Grender added small positions in infrastructure-related companies last year that should benefit from the need for investment in the US.

Elsewhere in the sector, among the most popular US funds held by professional investors is Findlay Park American, which has held a long-term strong companies getting stronger theme over recent years.

With better firms extending their leadership at a faster rate than ever before, this has led to a broader focus on the formerly small-cap-oriented portfolio.

Looking at recent calls, lead manager James Findlay has reduced his industrial weighting and reinvested some on the proceeds into undervalued banks.

He says valuations in the latter sector are reasonable relative to book, even after discounting lower structural returns on equity than seen in the past.

Findlay says: “Delinquencies are falling, along with non-performers and loan growth is starting to pick up. Reserves to loans are close to an all-time high and if the economy does grow by 3 per cent this year and 3 per cent next, as industrials appear to be discounting, fundamentals for banks should continue to improve.

“We reduced some of our industrial stocks as they performed very well in the second half of last year and appeared to be discounting a rosy outlook for the economy at a time when raw material prices are running up.”

On the macro front, he says the US economy continues to recover without much help from housing and a modest amount from an automobile production recovery, the two areas that shed the most jobs.

Against such a background, he stresses that stockmarket valuations are at very modest levels.

”High-quality stocks with strong business franchises and pricing power in a more inflationary environment seem a good place to be,” says Findlay.

With mid and small companies leading the market for much of the post-crisis period, it is little surprise to find Schroder US mid cap among the top performers, fourth over three years to end May and sector topping over five. This popularity led the company to soft-close the fund earlier this year, with strong inflows bringing the overall strategy to its capacity of $4.5bn-$5bn.

Schroder US mid-cap fund manager Jenny Jones is another fundamental stockpicker, driving performance through three separate types of holding – mispriced growth, so-called steady eddies and turn-round stories.

Overall, she is fairly cautious on small and mid-cap prospects – largely that way inclined since early 2010 after such a strong rally the previous year led her to predict a period of large-cap dominance.

She says: “Earnings estimates from sell-side analysts remain too high for small and mid caps in our view and this is likely to create some headwinds in the months ahead.

“Meanwhile, although economic indicators have certainly improved since 2008, recent dollar weakness is likely to add to inflation worries while the consumer still faces pressure from uncertain housing and labour markets.

“We continue to focus on companies with strong balance sheets and a robust investment thesis, as we believe such stocks can perform even if macroeconomic conditions begin to soften.”

Through a volatile 2010, Jones said the fund’s commitment to investing in steady eddies such as property insurer WR Berkley proved beneficial, with these stable companies generating dependable earnings and revenues.

More recently, she highlights stockpicking in areas such as technology and producer durables. “After the end of April’s market correction this year, smaller-cap companies have been outperforming large cap stocks again,” she says. “We believe a key driver for performance will be earnings and sales growth for the rest of the year and also look forward to see fundamentals and quality companies take leadership in the market.”

Perhaps less well known than some of the other top-performers, Stephen Kelly’s Axa Framlington US growth is among the sector’s most consistent funds, ranking sixth over three and five years.

Kelly says: “We believe the Federal Reserve’s second round of QE has succeeded in achieving many of its primary goals and an acceleration in growth is beginning to unfold.

“However, we continue to feel several fundamental factors that acted as tailwinds to growth in the years leading up to the credit crisis are likely to become headwinds in the coming years, preventing a return to the boom times of the last decade.”

On the corporate front, he cites significant levels of pent-up demand, profitability at historically high levels and bank balance sheets awash with liquidity. He adds: “We continue to seek companies with strong secular, as opposed to merely cyclical, revenue growth characteristics.

“This typically results in large positions in sectors such as technology, healthcare and consumer discretionary, as these are areas where innovation and new products or concepts thrive.

“As a by-product, the fund will also have fewer holdings in sectors such as financials, utilities, energy, basic materials and consumer staples where companies are either highly reliant on the economy to fuel growth or already fully mature.”

Kelly’s process also results in a mid-cap bias, which has clearly benefited recent performance.

He says: “In the absence of free, unrationed credit, we believe earnings growth will be a scarcer commodity and this should support the relative performance of growth stocks.

“Low interest rates should also enable the earnings multiple awarded to highquality companies to expand, resulting in outperformance for the growth style the fund follows. Furthermore, mid-cap growth stocks remain at historically cheap valuation levels versus their more cyclically-driven, value counterparts.”

Four US fund managers reveal their investment picks

Virtuous circle

Andy Headley, director and head of research and global investing, Veritas Asset Management

We aim to buy high quality companies with strong and enduring competitive advantages at attractive valuations and hold them for the long term. The US has a disproportionate number of good quality companies, although typically they are not available at attractive valuations.

Two high quality US companies we currently own in the Veritas global focus fund are Google and Varian Medical Systems.

Google is the dominant provider of internet search queries and the bulk of its revenue comes from its adwords business, which sells sponsored links in response to users’ search queries. It benefits from a virtuous circle as its dominance (more than 80 per cent global market share) gives it a substantial revenue stream, of which the company invests a portion to improve its search, relevance and functionality – and maintain its dominance.

In terms of growth, despite the ever-increasing number of hours spent by internet users, internet display advertising is still only worth around $36bn. In comparison, TV advertising is worth around $166bn.
This implies plenty of scope for further growth, demonstrated by Google’s revenues and adjusted earnings, which grew by 24 per cent and 29 per cent respectively over the past year.

Despite this growth, the valuation of Google is compelling. The company has a net cash balance of almost $100 per share and should earn around $34 per share in 2011 and almost $40 per share in 2012. At a current share price of $480, this represents more than an 8 per cent earnings yield for a company that is growing fast, with scope for further growth, and that has $100 per share of cash on its balance sheet.

Varian Medical Systems is the global leader in radiology machines primarily used in the treatment of cancers. The company has a global market share of almost 50 per cent of installed machines and is widely seen as the technology leader.

Demand for radiology continues to demonstrate robust growth from a variety of sources, including increase in incidence of cancer, improvements in technology that allows for more types of cancer being suitable for treatment with radiation, growing health budgets in developing economies and their demand for better treatments and the cost-benefit of radiation versus other types of cancer treatment.

As with Google, Varian has an extremely strong balance sheet, with $7 per share of net cash. The company has demonstrated robust growth over the past 5 years with compound growth in earnings per share of more than 14 per cent, which we anticipate will accelerate slightly over the next five years.

At a recent share price of $67, the shares were trading at a free cashflow yield of around 6 per cent (to September 2012) with strong growth prospects and a robust balance sheet.

Quality street

Cormac Weldon, head of US equities, Threadneedle

Longer-term economic headwinds caused by the consumer, state and federal deleveraging which opens up potential for inflation to roll over as a result of stimulus measures comprises one side of our market outlook. The other is that of tough expense control and a continued reluctance to add capital, which has driven breath-taking near-term momentum in corporate profits.

The corporate sector is fundamentally strong, with low debt levels and high cash-flow, and although consumption is subdued it is not dead. These factors, together with attractive market valuations, produce a great number of stock opportunities.

Given the muted economic backdrop, we favour quality companies with low levels of debt, strong free cashflows, and predictable earnings characteristics.

We are looking for companies with a good track record in managing their capital effectively, which might involve returning cash to shareholders through increased dividends or share buybacks. It may also involve earnings-enhancing corporate activity. Alternatively, companies could choose to increase capital expenditure.

Attractive stocks include software company Oracle and WellPoint, the health benefits company. We believe Oracle shares offer meaningful upside potential from current levels while also having solid defensive characteristics in a very uncertain market environment. Strong software licence growth over the past year and a hardware business with rapidly improving margins should allow Oracle to deliver good earnings growth. Its recurring maintenance revenue stream, which drives the majority of profits, is highly sticky and tends to grow even during times of broad economic distress. For this reason, the shares are also highly defensive.

WellPoint is a healthcare insurer which collects premiums up front while incurring costs during the year. We believe it benefits from healthcare costs which are lower than originally thought, leading to better than expected earnings. WellPoint also generates high levels of cash, has been buying back its shares and has even started to pay dividends.

Up in the air

James Abate, fund manager, PSigma American fund

Airlines have been notoriously bad investments and investors are sceptical about them in terms of generating meaningful returns for shareholders but we are now witnessing some of the restructuring attributes that have enabled them to become profitable for prolonged cyclical periods in the past. We recently saw Delta’s merger with Northwest and United’s merger with Continental. This has created two giant carriers that were cashflow-positive in 2010 and are likely to remain so, provided the economy does not fall into another recession. Southwest also merged with AirTran to further rationalise industry capacity and there could be more deals – American Airlines and US Airways are the only major carriers not caught up in merger activity so far.

Following these mergers, carriers are cutting costs by grounding less-fuel-efficient aircraft from their fleets and shedding unprofitable routes. This lean approach to operations should translate into profit and shareholder wealth creation through what we deem as “wise contraction”. Combined with a stable economy and new sources of revenue in the form of baggage fees and charges for food, this should allow bigger players such as Delta and United Continental to offset high fuel costs.

This wise contraction by the airlines is likely to mean fewer cheap deals for customers. The airlines have been able to raise ticket prices repeatedly while still filling their planes, which has been a lucrative formula despite the drag from higher fuel prices. All this should lead investors to reward the industry with higher ratings.

With summer upon us, traditionally the busiest air travel season of the year, demand for airline seats remains strong and industry groups expect the number of passengers on domestic and international flights this summer to break records. Fares are at their highest since their pre-recession peak. With the stocks of Delta and United Continental depressed this summer due to oil and macroeconomic worries, we expect both stocks to be significantly higher in the next one year.

Starring role for Disney

Joanna Shatney, US large-cap fund manager, Schroders

In the current US market, the Estee Lauder Company is an extremely attractive stock. It is a prestigious cosmetics player which has shown global expansion and cost reductions. The firm manufactures and markets a wide range of skincare, make-up, fragrance and haircare products which are sold globally.

The firm’s competitive advantages lie in three key factors. First, its expansion into developing markets where consumers are becoming wealthier, particularly Asia, excluding Japan. Second, the company’s successful revamp of its top two brands, Estee Lauder and Clinique, and finally, the current management restructuring.

UnitedHealth Group Incorporated owns and manages organised health systems in the United States and internationally. The company provides employers with products and resources to plan and administer employee benefit programs. We view UNH as a best-in-class operator that is leveraged to the cyclical benefits of higher consumer enrolment.

As we await an upturn in economic trends, UNH has been successfully balancing pricing against inflation. In the long term, we believe the company is positioned to help drive industrywide cost reduction under the US healthcare reform.

Walt Disney Company has extremely diversified international operations in film entertainment, theme parks and resorts, broadcasting, and consumer products.

We believe the company has superior growth prospects and is well positioned to accelerate its earnings before interest and tax due to its secular and cyclical growth opportunities.

Consumer products created by Walt Disney have benefited from an increased drive towards branding of content and experiences and, due to growing demand, studio entertainment has the strongest film pipeline in years.

Cyclical growth has recently been boosted since Walt Disney has embraced technology to adapt product and business models to the profound change in consumer behaviour. This has resulted in new opportunities in television and theatre as well as new distribution, both online and traditional.

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