Disciplined approach finds mispriced opportunities in U.S. equities

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Welcome to Advisor to Go, brought to you by CIBC Global Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject-matter experts themselves.

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Sandy Sanders, managing director, senior portfolio manager, CIBC Global Asset Management

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My core investment philosophy and process has remained relatively steady over the last 25 years. We look for companies that have a sustainable competitive advantage. We want to go through a detailed fundamental assessment, which we call our seven-step process, and then we want to buy at the right price, and that’s 70 cents on the dollar. So that’s our philosophy.

And then, in terms of executing our process, it really starts with looking at businesses that have good returns on invested capital through a full cycle.

We look at a system called HOLT, which is a database that’s owned by UBS. And it has a stream of over 30 years looking at adjusted returns on invested capital. So, it’s a way to measure a management team’s track record for allocating capital. Do they do a good job and invest in high-return projects and therefore get great returns on capital? Or are they often at or below, and they’re money losers?

We go through essentially a month of work. It’s called our seven-step research process.

The first step is competitive advantage. We zero in on the Porter Five Forces, trying to understand: Does this company have high barriers to entry, high switching costs, power of buyers, power of suppliers, and what is the competitive intensity like? So, we want to make sure in the front part of the research process, is it going to be here for the next, you know, five, 10 years? Does it have a sustainable competitive advantage? In other words, a moat.

Assuming that checks out, and we agree that there is a moat, then we’ll move on to step two, an industry analysis where we look at all the competitors, growth drivers.

Step three: a minimum five-year forward forecast. What’s going to grow revenue over time? And we’ll break it down by the various components.

Fourth step is a financial statement analysis. So, there we’re looking at your traditional income statement, balance sheet, cash flows, looking to see if there’s leverage on the company.

Step five is a management team assessment. Here’s where we’re going to look at the company’s CEO, CFO, and look at their track record for allocating capital. We want to understand how have they done in the past? And that really goes back to that return on invested capital history, making sure they do a great job.

And then step six — this is really our critical process — we do best case, base case, bear, and then we added a worst case. We improve the process by getting stronger, by increasing our range of values, thinking about if things really go great and much better than we expected, that’s the best case, but if things go really badly, that would be the worst case.

All the cases are a five-year minimum discounted cash flow model. We use a 10% discount rate and a 3% terminal growth rate. Then the base case is the 100 cents on the dollar, so that’s what we think the stock is worth right now. In other words, in our base case, if we think the stock is worth $100 and the stock is trading at $70 this morning, 70 divided by 100: it is 70 cents on the dollar. So that allows the team to have a list of vetted names in this seven-step process, ranked every morning by cents on the dollar.

The last step is step seven: risks and sensitivities. And that really is in ESG considerations. And so this is really where we look to see what could go wrong. How does that impact the value of the company? So, we think about things mathematically. And then ESG really is about sustainability, just trying to understand, does a company do a nice job with regards to environmental, social, and governance?

After a month of work, the analyst on the team presents to the entire team. Everybody comes into the room, and that really raises the bar. Think of it as like there’s eight sets of eyes on the analysis versus just a one-way conversation between myself, as the portfolio manager, and the analyst.

So that process creates an accelerated learning environment for the entire team because there’s a lot of great ideas, there’s a lot of very constructive debate. And once we’ve done the follow-up work on the company, it goes into our active inventory, where we basically wait for the right price to pay. That’s the only thing that we can control as an equity investor. You pay the right price.

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In terms of balancing growth versus value in a very uncertain environment, with regards to interest rates and other macro events, the big picture is that we are an all-cap core investor. We can buy growth stocks. We can buy value stocks. We can buy large-, mid-, and small-market capitalizations. Essentially, the mandate is: take advantage of the volatility out there using your investment process, and stick to your conviction and your strategy. Whether it’s a higher interest rate environment or lower interest rate environment, the flexibility is key.

Having the ability to invest in growth stocks, particularly in a period when interest rates are coming down is obviously going to be beneficial. And then having some periods where you can invest in value areas, when interest rates are going up, also is quite helpful.

So, in general, to me, this strategy allows us the flexibility to be nimble in an environment that certainly has been moving up and down.

The big picture for me is that, look, over the last 50 to 100 years, the S&P 500 has, on average, gone up 9% to 10% a year. In today’s environment, we feel relatively constructive about the U.S. economy. Even though the Iran war is going on, and there’s a lot of uncertainty, the general takeaway is that the U.S. consumer is in good shape. They’ve got good balance sheets. Household debt service ratio is near a 40-year low at 11%. You have a relatively full employment — unemployment is only at about 4% or so — and then you’ve got rising wages, which are growing basically 3% to 4%.

So big picture, with all those negative headlines out there, and having the ability to use an all-cap core strategy, where we can do growth, we can do value, it really gives us a lot of tools in the toolkit to execute our investment process: buying great businesses at $0.70 on the dollar.

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Over the last decade, growth stocks have done well, and the companies like the Magnificent Seven have expanded their market capitalizations and grown as a percentage in the S&P 500. And in fact, if you look at the top 10 names, you are near 30%, 35%. So almost a third of the benchmark is in the top 10 names.

Now that, to me, is OK, because these companies, we’ve invested in a lot of them over the years. In fact, I was able to invest early into Amazon in 2003, when I first met Jeff Bezos in his office. This is a company that has continued to expand in value, and they are growing at rapid clips. Their cash flows are growing well north of 10% at this point, and this is a company that has tremendously wide competitive advantages. Very strong sustainable growth rates. And it’s really driven by their business in cloud and digital advertising that has higher margins and is growing faster than its traditional online retail business.

If you look at Nvidia, this is a company that has over 80% market share of AI semiconductors. They are really doing quite well with regards to innovation, as the data centres are less than 20% built out based on our projections. So, there’s a tremendous amount of runway for companies like Nvidia to continue to expand their overall addressable market, as their customers are spending dramatically to be first in the AI race.

It really is an arms race at this point, and so these companies are not slowing down. I think that the concentration and the benchmarks in general are going to stay relatively at this level, perhaps even grow a little bit higher, and we are invested in these appropriate areas to take advantage of that.

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In terms of the mispricings in U.S. equities today, we all know that growth stocks have done extraordinarily well over the last decade. And we’ve seen a significant amount of growth in the AI-related trades, whether it be semiconductors, whether it be hardware manufacturers, whether it be supply chain. Anything to do with a data centre, basically, has done extraordinarily well.

However, what people are underestimating is likely the sustainability of this growth. If data centres are only 20% built out, and you have these enormous amounts of capital deployed to build out even more capacity, it’s likely that these companies are going to continue to see significant earnings expansion, which means their valuations are likely going to stay in check. So, I do think that earnings growth is really going to continue to drive stocks, as it always has.

We think that there are some attractive areas. I mentioned Nvidia earlier, but I do think there is a tremendous amount of potential for growth stocks going forward, particularly as the data centre footprint is really less than 20% built out at this point.

On the value side, I think there’s some tremendous opportunities in financials, and I do think that [given] the capital markets activity, you’re seeing a significant amount of demand for recent IPOs. There’s three IPOs coming this summer, which are basically the largest in history, with SpaceX, Anthropic, and OpenAI. There’s a tremendous amount of other activity going on in the marketplace. And that’s going to benefit the capital markets companies, which are value ideas like Goldman Sachs and Morgan Stanley.

In addition to that, on the private side, as well as the alternative side, companies like KKR are very well positioned in this capital market cycle to benefit, as you see increased pricing realizations from a lot of their private holdings going public.

And lastly, the most underpriced area right now — because it’s cyclically depressed, but they’re showing some signs of life here — is the home builders. So, home builders, a company like Lennar, which we like a lot. This is the second-largest home builder in the country, and they build close to 80,000 homes a year. They have a great balance sheet. This is a potentially a nice opportunity to buy at the cycle low, and getting a really great entry price here. So, we do think that is an area where we see some pricing opportunities.

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Sandy Sanders is a Senior Portfolio Manager with CIBC Private Wealth Advisers, Inc., providing portfolio management responsibilities for the Renaissance U.S. Equity Fund.

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