Where next for the US stockmarket? Invesco’s Laing comments

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Simon Laing, head of US Equities at Invesco, explains how testing assumptions is a key part of the investment process for the Invesco Perpetual US Equity team.

“Sell in May and go away”

While there must be historical evidence that this well-used Wall Street adage has resulted in strong investment results, it has a poor record over the last 10 years. And so far in 2014, the S&P 500, in the months of May and June, has given investors a price return of over 4%( in US$ terms). In fact, the strong market return, so far this year, has had us reviewing the valuations of all our holdings in the Invesco Perpetual US Equity Fund very closely.

We had felt that a market return of mid to high single digits was appropriate for 2014. There was no rocket science involved in coming up with that estimate. Corporate earnings growth for 2014 is expected to come in at 7%-8% and, with a poor Q1 GDP figure because of the weather, this requires economic acceleration through the year, which we see as achievable.

And after a year like 2013, where a near 30% price return by the S&P 500 index (in US$ terms) was driven entirely by valuation expansion, we felt that it would be prudent not to expect further growth in the market PE. So with the S&P 500 index up nearly 7% year to date, we are either going to see the market enter a holding period or our assumptions are going to prove wrong.

Valuation is of paramount importance

Clearly, the most likely outcome is that our assumptions are going to be wrong. In fact this is one of the most important tenets in our investment process; that despite our abilities with Microsoft Excel, our immersion in the industries we invest in and our understanding of management strategy, it is very unlikely that our assumptions will prove correct. Thus, valuation becomes of paramount importance.

If we recognise that we will be wrong, we won’t commit the error of over emphasising the potential upside in an investment. This upside usually requires many things to all go right and basic probability theory tells us that the higher the number of required events, the worse our odds become. However, if we can buy into investments where we have spent time attempting to evaluate the downside risk, we can make a proper risk/reward judgement. If everything goes right, we should see a lot of upside. If a few things go right we should make a decent return. And if things don’t pan out as we expect, we should know what our downside is likely to be.

So, back to the market and our assumptions.

We see no reason to change any of our expectations from the beginning of the year. Therefore, we would expect to see a more muted second half performance from the market. More importantly we need to look at the investments in the Invesco Perpetual US Equity Fund. We are very upbeat on the potential returns from our holdings, particularly after a tricky three months of performance.

Fund Changes

We have had to shift some capital in recent weeks to reflect diminishing returns in some areas and growing potential returns in others. We have reduced our positions in Wells Fargo and PNC significantly. We still see a favourable backdrop for these high quality banks, with improving economic growth helping loan demand and the anticipated benefits to net interest margins as interest rates start to rise (we would assume some time in 2015). However, after strong stock price performance this year, we believe there just isn’t enough upside to justify the large position sizes we have had earlier this year.

Microsoft is another stock that we have been reducing for the same reason.  We will still hold on to these three investments, but with smaller weightings. We have introduced two new positions in the fund, MasterCard and Gilead.

MasterCard is a stock that has been on our Watchlist since March. It is a company that we have wanted to invest in but had been waiting for what we believe to be the right entry point.

We are often questioned over our resource and idea generation capabilities, and we view MasterCard as a prime example of how we can leverage others into our process.  Our Global counterparts at Invesco Perpetual, Stephen Anness and Andrew Hall, were the first to meet with MasterCard management. We are always comparing notes with them, so, armed with their reports, we arranged a visit with MasterCard at their US Headquarters and came away with a similarly favourable view.

After thorough due diligence and formerly adding the stock to our Watchlist in March, we concluded that, for us, whilst the company was a highly desirable candidate for the portfolio, its relative valuation and risk/ reward was not quite attractive enough. Fast forward to today, and after a period of underperformance, the stock featured as one of the more attractive opportunities on our Watchlist and accordingly, we invested.

MasterCard is a pure-play on the secular growth in the transition away from cash towards card and digital transactions. Surprisingly these represent only 15% of global transaction volumes (and roughly 40% by value). Even more surprising is that in the US, one of the most mature markets for debit and credit card penetration, cash transactions still represent around 40% of volumes.

Growing penetration of non-cash transactions paves the way for visible high-single-digit revenue growth at MasterCard for the foreseeable future, in our view. Importantly, MasterCard and their larger competitor, Visa, dominate the payments industry and have highly attractive margins as a result. Furthermore, we believe that MasterCard is actively restraining margin expansion in favour of growth reinvestment, and yet we still expect consistent mid-teens earnings growth over the next 5 years of more. We believe few companies can boast this level of visible growth with operating margins above 50%.

We have also bought a position in Gilead Sciences, a large cap biotech. Gilead has had remarkable success over the last two years due to the emergence of a drug, Sovaldi, that cures Hepatitis C within 8 weeks and with limited toxicity (current standard of care is a very toxic, year-long course of injections).

Gilead acquired Pharmasset at the end of 2011 which is where this drug came from. Sovaldi has just come to market and it has been one of the most successful (if not the most successful) drug launches of all time. As the data came out on Sovaldi, through the last two years, Gilead shares have risen fourfold. It’s never easy to buy a stock after such success but we try to avoid looking at stock charts in the rear view mirror.

While we have been guilty of underestimating the opportunity of Sovaldi, we now believe the market is missing the dramatic cash flow implications of this drug to Gilead due to its high gross margin and Irish tax domicile. Our expectations suggest Gilead could generate over $100bn in free cash flow over the next 10 years compared to its current market cap of around $130bn. Capital allocation, in our view, is going to be the biggest issue for Gilead over the next several years.

Using discounted cash flows for Gilead’s pipeline and the Hepatitis C drug in isolation, we can estimate a downside scenario if things don’t pan out as we expect. This is why we felt the stock offered a great investment opportunity, despite being such a strong performer over the last two years.

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