You may know Epoch Investment Partners because the firm’s CEO, William Priest, sits on the Barron’s Roundtable. Time to get acquainted with David Pearl, too. Pearl is one of the firm’s most accomplished stock pickers, the person responsible, among other things, for Epoch’s early and hugely profitable investment in Apple (AAPL). Pearl describes himself as more optimistic and “more patient” than Priest. But the two men, who co-founded Epoch in 2004, both believe that looking at growing free cash flows is the way to pick stocks.
They’ve been proved correct: Over the past 10 years, Epoch’s U.S. All Cap Value strategy, net of fees, is 10.9% a year, versus 9.8% for the Russell 3000 Value index (.RAV). Recently, Barron’s checked in with Pearl about his market outlook and why free cash flow remains his yardstick of choice. Oh, and he shared some promising stock picks, as well.
Q: What was most interesting to you about the midterm results?
A: We are in one of the best economic periods since World War II. The U.S. economy is 70% driven by consumers. Now, we have high consumer confidence because more people have jobs. There is the beginning of wage growth. Corporate confidence is high. Not a single leading economic indicator shows a slowdown. It’s hard to believe that we can get a heck of a lot better. We have to include the one-time sugar high from the tax cuts.
Now, splitting Congress means having a little bit of gridlock. Nothing will really change regarding economic policy because the administration controls regulation. Very few different laws will get enacted. There may be [something on] infrastructure or health care, but no big change that would affect the course of business, economic growth, jobs.
An all-out trade war with China would be bad. The probability of that result is lower than 50%. If you can do a deal with Canada, you’ll eventually figure out a deal with China. [The market] will be volatile, but valuations are actually more attractive after this correction. We’re still relatively bullish because corporate earnings will definitely be able to improve.
Q: Your firm expects 5% to 7% annual stock market returns over the long term. How does that square with our strong economy?
A: The irony of this is that the market went up something like 100% from 2012 to 2016, and corporate earnings went up like 3% a year. The Federal Reserve inflated all financial assets. When you bring interest rates to zero, the future value of a dollar is really high, and therefore price/earnings ratios went from 11 times to 19 times. Now rates are going up, so P/Es are flat to down. We would never assume that a company’s going to have P/E expansion while rates are going up. The return [forecast] is almost all driven by earnings growth. It also assumes return of capital.
We think price discovery comes back to some degree. You know, the effect of passive has been really onerous on active managers. People who buy a passive fund are making a huge but unintended bet on market cap, on size. Because most of the passive indexes are market-cap-weighted, the 10 largest stocks have an unduly big effect, and in fact they’ve outperformed whether or not they really were good companies.
Q: Your long-term performance looks great, but the fund that you run, MainStay Epoch US All Cap (MAAAX), is less exciting.
A: We are categorized as blend, a catchall Morningstar category, so if you lean to value, you’re not going to look as good. The majority of our clients use us for value.
Q: How do you define free cash flow, and why is it so important?
A: It’s all the cash generated from the business that has no mandatory use to keep the business running or for an obligation like debt or a dividend. It’s all the cash flow that is discretionary. What mucked this up for accounting purposes is if a company’s in a business that its managers want to grow. If they reinvest 100% of their free cash flow, it may not show up as free cash flow in the FactSet database, because FactSet can’t determine the difference between maintenance capital expenditure, which is the amount of money you’ve got to spend to keep your factories running, versus discretionary growth uses of cash, like building new factories, buying equipment.
We find lots of opportunities where companies have higher free cash flow than earnings, where the accounting has hidden how profitable they might be. Accounting is like baseball. It’s a game with rules. If everyone plays by the rules, you can compare company A to company B. But more than half of the public companies do not play by the rules, and you can’t even look at their history, because they adjust [their results] differently every year. Free cash flow is much harder to change. Cash is real. You run a company on cash. Once a quarter you translate it into this earnings thing, which you can do in all sorts of ways. Accounting leads to lots of anomalies, and looking at the cash is a much better and more precise way to see if a business is healthy.
Most Wall Street analyst reports don’t really spend a lot of time on free cash flow, and the number contained may even be incorrect, frankly, because you have to talk to a company to actually know what is discretionary and what is mandatory.
Q: Let’s talk about Apple, which you bought for your clients when Epoch first started in 2004. Would you buy it at these levels?
A: Yes. It’s closer to our price target. But when you add return of capital, you’re going to get a double-digit return, and their margins keep going up. We’ve trimmed it several times, bought it back at least twice. The reason we still own it is that Apple has continued to innovate and has become one of the most profitable companies. And during this whole period we’ve owned it, the stock has never been at a premium to the market.
How about that? The market has always been skeptical. And Apple is now a better company than it used to be, because 30% of its profit comes from services, which are recurring. They are the largest music service in the U.S. They will clearly have a TV service within the next year. Sales of the Apple Watch, a stealth hit, are now bigger than the Swiss watch industry combined. I wish they were a little more transparent and shareholder-friendly. But it has gotten better, and they are now paying a dividend and returning capital. A big part of the story for next year is they are repatriating more of the $200 billion of offshore cash.
Q: What’s the investment thesis for Hexcel (HXL)?
A: They make the carbon fiber that goes into all of the new airplanes from Boeing (BA) and Airbus (EADSY), which are a duopoly. That carbon fiber replaces aluminum and makes the plane lighter, which makes it up to 25% more fuel efficient. They fabricate the main body and parts of the fuselage. This will become the standard for most airplanes over a period of time, and as the company transitions from spending a lot of money to build factories and perfecting the carbon fiber to selling into the new 787 and Airbus planes, they’re going to be a huge free-cash-flow generator. Free cash flow per share will grow faster than earnings per share for the next 10 years because of all the non-cash charges from the previous 10 years.
So that’s the thesis. What will they do with the free cash flow? Will they buy back stock? Will they acquire? There are only five uses of cash. Two are to grow. You reinvest, hire people, build factories, new products. Or you acquire other companies. You do that if your return on invested capital is higher than your cost of capital. If you can, you return the cash. Don’t keep it. Pay a dividend, buy back stock, or get rid of expensive debt. The stock is at $60. The target is $76. The P/E is 21, and it’s 16 times our analyst’s free-cash-flow estimate. He’s the guy who talks to Hexcel and knows what’s discretionary. Free cash flow will grow faster for the next few years than earnings. Most people, looking at the company, don’t see it as inexpensive. This is a really good opportunity.
Q: You’ve said that financials are “ridiculously discounted.” Which ones do you like?
A: Morgan Stanley (MS). Most investors think of Morgan Stanley and Goldman Sachs Group (GS) as the same kind of business, but they are no longer. Morgan Stanley used to be like Goldman, a black-box trading house. Now it has de-risked the company. They’re the biggest wealth manager, the biggest brokerage firm, a huge money manager. That’s a very sticky business. Obviously, the stock gets impacted if the market goes down. That just makes it more attractive today. They have record earnings. More than two-thirds of profit comes from wealth management and money management, not from trading and investment banking, which are more volatile and harder to predict.
It trades at nine times earnings. The market is 17 times earnings. The bar is low. Expectations are low. Yet the company is doing great. They even benefit by rates going up because of all the client cash held in money-market funds, which a year ago they couldn’t charge anything on. Now they can charge a fee on it. That’s a big deal. And they make more money when they can lend out at somewhat higher rates for margin. It’s a great business. They generate cash. They pay a 2.5% dividend. They were a big taxpayer, so the tax cut had a very positive effect. We have 25% upside on the stock. We think it can get to almost $60 very easily.
Q: Finally, why do you like CVS Health?
A: CVS (CVS) is about to consummate the merger with Aetna (AET), which makes it one of the largest integrated health organizations in the country. It will be very close in size to UnitedHealth Group (UNH), which has been a great stock. But CVS has a much more upside if they do everything right here. CVS trades at a very low 11 times earnings. It’s treated like a retailer: Everyone worries about growth. They own a pharmacy benefit manager, which themselves are controversial because it’s not always transparent how they make money and for whom.
But when they consummate this merger, they will have huge competitive advantage. Now they can offer preventative care, immunizations, vaccines. They already have nurse practitioners there. It will be low cost and a very convenient delivery unit for health care from the Aetna insurance unit. And to be integrated as a PBM means that they’re more aligned with lowering drug costs, as well. So, basically, it’s a competitor to UnitedHealth at a discount. And it’s really the future of the market. Medicare is a huge growth business, demographically. But it is a growth business, because under the current system, unless we go single-payer, this is where you can control costs. So we think that CVS will be revalued once the merger takes place.The stock is $81. We think it goes to $117.
Q: What books are on your bedside table?
A: "The Culture Code", by Daniel Coyle, is about corporate culture. Another is "Move Fast and Break Things: How Facebook, Google, and Amazon Cornered Culture and Undermined Democracy", by Jonathan Taplin.
|For more news you can use to help guide your financial life, visit our Insights page.|