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Where to find growth? Look to U.S. stocks

Portfolio manager Mark Schmehl looks south for companies that have the potential to expand business in the next 18 months

By: SIMON AVERY

Date: January 29,2015

One of the key questions for investors this year is “where do I find growth?”

For several years, stock markets have risen as companies boosted profits by trimming expenses and buying back their own shares. Market strategists say that with North American equities now trading near their highs, companies will need to start generating more revenue to support their valuations.

But from Canada to China, the rate of economic expansion is declining, making it tougher for businesses to sell their products. In parts of Europe and some emerging markets, there are fears of shrinking economies. Expectations for global economic growth in 2015 are now just 3.5 per cent, down from 3.8 per cent in October, according to the latest forecast from the International Monetary Fund on Jan. 19.

The reality is that after five years of market gains, opportunities for growth are becoming more selective. For Mark Schmehl, a portfolio manager at Fidelity Investments, the answer is simple: growth mutual funds.

Growth mutual funds hold the shares of companies that focus on capital appreciation rather than dividend payouts. For these companies, the most important thing to an investor isn’t price; it’s the ability of management to keep expanding the business. This investment style is very different from a value investor’s, who looks for stocks that trade for less than their intrinsic value. As such, growth investing is considered to carry greater risk than other styles.

Mr. Schmehl manages the Fidelity Canadian Growth Company Fund and the Fidelity Special Situations Fund. He describes the former as a core-holding, “vanilla” growth fund and the latter as a niche product that allows him to hold higher concentrations in any single stock than most other fund managers are permitted.

“It allows me to do almost anything,” he says. “It’s a go-anywhere product.”

The Fidelity Canadian Growth Fund has beaten the S&P/TSX Total Return index every year over the past decade, racking up a three-year return of 23 per cent and 10-year return of 8 per cent, after management fees of 2.5 per cent.

The Fidelity Special Situations Fund has also consistently outperformed the Canadian benchmark, returning 21.7 per cent over the past three years and 13.9 per cent since inception in 2007, after management fees of 2.5 per cent.

“I’m really always looking for the same thing: the company is getting better,” Mr. Schmehl says of his investing style. “The more improvement I can find, the bigger the holding in the portfolio.”

Both funds are heavy on information technology, health care and consumer discretionary companies, which account for about two-thirds of all holdings. Energy holdings have been trimmed by about half in recent months, to comprise less than 8 per cent in each.

“People need to put growth in their portfolio. They are massively under-represented in Canadian portfolios,” Mr. Schmehl says. “There is still lots of opportunity.”

Top holdings in the funds at the end of the year included Loblaw Companies Ltd., Bristol-Myers Squibb Co. and Gildan Activewear Inc.

“We are in a stealth growth bull market today,” Mr. Schmehl says.

Much of that growth is being driven by the technology, biotech and health-care sectors. While the IT sector is producing fewer new ideas, health care and biotech are in a “mega-cycle” driven by demographics and an enormous amount of innovation in pharmaceutical development, he says.

A stint as a health-care analyst has given Mr. Schmehl a passion for pharma stocks. He focuses on three kinds of companies: those developing drugs to fight cancer, those that develop drugs to treat rare medical conditions and those that acquire and streamline other players in the sector.

All three categories are hot. Mergers and acquisitions reached record levels last year and the torrid pace will likely continue this year, TD Securities Inc. analyst Lennox Gibbs said in a recent report. That means deal prices should keep rising as well-established pharma companies compete for a shrinking set of valuable assets. But the increased deal flow should be good news for companies pursuing strategic growth, such as Valeant Pharmaceuticals Inc., Mr. Gibbs said.

Valeant is one of Mr. Schmehl’s biggest holdings in both of his funds. While the Laval, Que.-based company failed to acquire Allergan Inc. last year, losing out to Actavis PLC’s $66-billion bid, chief executive Mike Pearson told investors in January that the company still has more than 100 smaller acquisitions in its sights.

Drug development is also on fire. The U.S. Federal Drug Administration approved 41 new drugs in 2014, the most since 1996. Two companies, AbbVie and Gilead Sciences, are having great success with new drugs to treat hepatitis C. And pharma giants such as Bristol-Myers Squibb Co., Merck and Co. and Roche Holding AG are bringing to market drugs that offer “functional cures” to many cancer patients, Mr. Schemhl says.

Investors are excited about a new therapy that genetically alters a cancer patient’s immune system cells to attack tumors. The products are expensive but patient demand will be so strong that governments will have to pay, he says.

Mr. Schmehl has worked at Fidelity since 2000, covering a wide range of industries including health care, utilities, mining, transportation, industrials, insurance and real estate. His style is to look at industries on a stock-by-stock basis and put aside “all the macro nonsense.”

He earned his stripes in 2008 when he sidestepped U.S. financials before the crisis, labelling the sector a “train wreck” months before the sub-prime lending bubble exploded.

Today he is much more bullish on U.S. than Canadian stocks. Not only does the Canadian economy produce a much smaller number of growth companies from which to choose, but the tumbling price of oil could send the domestic economy into recession. At the very least, it will suffer over the next 18 months before catching some tail wind from the United States in 2016, he said.

With the equity markets well into the current bull cycle, this is the time that large capitalized companies traditionally outperform small- and medium-cap stocks. That has led Mr. Schemhl to shift some of his portfolio to include companies such as Facebook Inc., Microsoft Corp. and LinkedIn Corp.

But even as he adds large caps, he doesn’t see the bull slowing. With the U.S. economy getting stronger, the greenback rising and most of the rest of the world suffering from weak or declining growth, the environment looks like the 1990s all over again, he says.

“The opportunity today is squarely in the U.S. The economy is strengthening, it has sound monetary policy, wages are rising and there’s tremendous innovation,” he says.

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