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Falling oil prices also hold opportunity

Look now for value in the energy sector, says veteran portfolio manager James Morrow, explaining the process behind his picks


Date: January 14,2015

Veteran portfolio manager James Morrow has ridden the roller coaster long enough to be objective about events such as the precipitous oil-price plunge that has left so many investors feeling queasy.

“There will be carnage, there will be companies that end up in financial trouble. So it is a time to be careful, but it’s not a time to run away and pretend that the [energy] sector doesn’t exist. It’s time to do a lot of work,” says Mr. Morrow, who manages Fidelity Investments’ U.S. Dividend Fund – which is available to Canadian investors and is constantly on the lookout for high-quality dividend-paying equities that have the potential to appreciate over the next 12, 18 and 24 months.

Who knew oil prices would dip from $110 (U.S.) a barrel to less than $50 a barrel in six months, he says. Who knows where oil prices will be two years from now?

For Mr. Morrow, who earned his MBA at the University of Chicago, it’s a fascinating time to be in the portfolio management field. He joined Fidelity as an equity research analyst 16 years ago and now manages a number of high-profile funds in addition to the dividend fund.

“The market has gone very, very negative on energy because of the change in the price of oil … so now it starts to get very interesting to an investor like myself. If I can step in and find names I think have good fundamental stories and I also get better price realization off of a low valuation, you start to get real compounding type returns in stocks, which is what I am looking for.

“If you go back to the financial crisis in the U.S. in 2008 and 2009, people couldn’t get away from financials fast enough, and yet, that’s where the best returns were available in 2009, 2010 and into 2011,” says Mr. Morrow, who runs his diverse 206-stock portfolio with extensive analysis and the benefit of experience. (Current holdings include Chevron Corp., J.P. Morgan Chase & Co., Exxon Mobil Corp., General Electric Capital Corp., MetLife Inc., Johnson & Johnson, Procter & Gamble Co., Cisco Systems Inc., Verizon Communications Inc., Wells Fargo & Co.)

The portfolio is always under review, with the fund replacing about 35 per cent to 40 per cent of its equities every year with fresh additions that seem poised for growth.

“If you think about it, that [turnover] is consistent with a two- or three-year holding period. If you are looking at [the prospective value of] stocks two years out, you want to give your thesis time to play out. So I think that two- or three-year rotation of the fund, refreshing of the whole fund over two or three years, is a pretty nice cadence for an active manager,” he says, providing a behind-the-scenes look at the process behind his portfolio picks.

From his bank of computer monitors spanning more than a metre of desk space – “they all have spreadsheets going” – Mr. Morrow casts a wide net, typically scanning 2,500 or so stocks before whittling down the list of prospects. From there, he will delve more deeply into about 1,300 of those names, setting an upside and a downside price target for each one.

“I don’t have a great insight as to whether the market is going to be up or down or be very bullish on a particular security or not, but I want to understand the range that I think a stock can trade in.

“What I do when going through that mechanism – in a bullish scenario – is think if the market gets excited about this particular security, or if it gets excited about this particular sector, what is … the maximum sort of valuation a stock can get, what do I think the maximum earnings power of a stock could be?

“I am looking 12 to 18 months out on a forward basis at any time … because I find the market doesn’t pay as much attention the further out you go. A lot of attention is focused on the current quarter and even the next 12 months, but if you go out beyond that you sometimes get opportunities. I will think about it in the upside case and I will go through the same exercise in the downside case.”

For each company on his radar, Mr. Morrow looks at quality measures such as returns on equity or returns on invested capital. “Does the company generate a lot of income off of the assets that it’s investing? That’s usually a good sign of a quality company. And how consistent are those measures? . . .

“Tied to that – and a metric I look at a lot – would be free cash-flow yield or free cash-flow generation. Just how much free and available cash does a company have at the end of the year, and how does that compare to the enterprise value of the company?”

He also looks for stocks that have been undervalued by the market.

“Whatever I hold today has tended to underperform in the prior 12 to 18 months. I tend to buy things that have underperformed in the hopes that we will get positive performance going forward,” Mr. Morrow says. This is where the U.S. dividend fund’s patient approach has worked to the investors’ advantage, he adds.

“Trying to win every day or week is really hard. Trying to win over two or three years is just an easier task.”

(As of Nov. 30, 2014, the fund had returned 17 per cent over the previous 12 months, and 25 per cent since the fund’s inception in November, 2012.)

While Mr. Morrow builds his portfolio from the bottom up, stock by stock, he also researches industry sectors and subsectors to determine the appropriate weightings for the fund’s various holdings.

Currently, “financials are the largest weighting in the U.S. dividend fund on an absolute basis, the biggest total percentage in the fund,” he says.

“I think the banking sector is kind of coming out of this long winter from the financial crisis. … It is really well capitalized, it’s got loan growth, the balance sheets are clean.”

Fidelity Canada says dividends have historically been a major component of equity returns, and the U.S. dividend fund offers Canadian investors access to some of the world’s most successful corporations, which operate in a much broader range of sectors than are available in Canada.

Mr. Morrow says whenever he gets a chance to talk to investors, “I like to try to encourage them to think longer term.

“It’s hard when the market gets volatile, it’s hard when asset prices go up and down. But if you have allocated the proper amount of your personal balance sheet toward the market, the best thing to do is sort of sit back and let the corporations do their job and compound your money for you. Don’t treat it like a spectator sport where you want to change your mind every day.”

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