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 | Mid-caps still look attractive: MFC sees positive background for equities
by Sonita Horvitch
National Post p IN3
January 23, 2004
U.S. mid-cap companies are likely to produce significantly stronger earnings growth than their big cap counterparts in 2004, says Mark Schmeer, managing director of equities at MFC Global Investment Management based in Toronto, who is looking for more modest returns from both U.S. big caps and U.S. mid-caps in 2004 after their stellar performance in 2003.
Schmeer and colleague Noman Ali, portfolio manager, U.S. equities, expect U.S. mid-caps, (as represented in the S&P 400 Index) to produce earnings per share growth in the 19% range and U.S. big caps (which comprise the S&P 500 Index), to chalk up an 11% to 12% increase in earnings.
The S&P 400 index currently trades at 20 times expected earnings per share of the constituent companies for 2004, while the S&P 500 Index trades at 18.8 times.
"This is line with the historic valuation premium placed on U.S. mid-caps," says Schmeer.
The valuations on both segments are on the high side, he notes, and will likely keep returns in the high single digit range, he says. The backdrop for equities is still clearly positive, says Schmeer.
"Good earnings growth expectations, U.S. economic growth for 2004 in the 4% range and historically low interest rates."
MFC Global Investment Management is the investment management arm of Manulife Financial Corp.The MFC team manages US$180-million in U.S. mid-caps. Their target is companies with a market cap between US$1-US$10-billion. Included in its mandate is the Elliott & Page U.S. mid-cap fund which has assets of US$51-million. This fund was up 34.3% in 2003, slightly above the benchmark index, the S& P 400 Index, which rose 34%. The MFC team combine a fundamental approach to stock selection with proprietary quantitative models that rank companies on their earnings growth momentum and their ability to generate positive earnings surprises and upwards earnings revisions. They also examine stock price behaviour.
Based on concerns about the decline in the company's earnings growth rate and its need to make significant changes to an important area of its business, MFC has sold:
- Darden Restaurants Inc. (DRI/NYSE) which closed recently at US$20.42 and trades in a 52-week range of US$22.95 to US$16.74.
Based in Orlando, Fla., this company operates restaurant chains including 640 Red Lobster restaurants and 520 Olive Garden restaurants. "Red Lobster, which accounts for roughly half of Darden's earnings, is faced with declining demand, rising costs and recent management departures," says Ali. Although the stock has pulled back, its historic 17% annual earnings growth rate has been impaired. Analysts are looking for growth this year of 13%. "We think that there is more downside to this stock, especially if the problems at Red Lobster are not addressed quickly."
Schmeer and Ali do like:
- Cognizant Technology Solutions Corp. (CTSH/NASDAQ) US$55.45 (US$55.58-US$17.12). It has a market capitalization of US$3.2-billion. Based in Teaneck, N.J., this company provides customer information technology design, development, integration and maintenance services. It offers these IT services using an on-site/offshore system which combines technical teams at the customer's location with development centers located in India and Ireland. India currently makes up some 70% of its total offshore activity and provides considerable cost savings to Cognizant Tehnology's customers, says Ali. The cost of providing such services in India is almost 30%-50% below the rate in North America, he notes. The company's customers are, in the main, major U.S. companies. Its customer base is diversified with financials accounting for 34%, healthcare (25%), information technology (13%) and retail (18%). "The company has good customer retention." Cognizant has a strong balance-sheet with no debt and cash of US$160- million. "It is not missed consensus earnings estimates since it went public in 1998." It is currently enjoying upward earnings revisions for 2004. The company has a return on equity of 26%, which is high. It is expected to generate earnings growth in the region of 25% per annum over the next five years. The stock trades at 46 times consensus EPS for 2004.
- NetScreen Technologies Inc. (NSCN/NASDAQ) US$29.03 (US$29.97-US$15.32). The market cap is US$2.5-billion. Based in Sunnyvale, Calif., the company develops a family of integrated network security technologoies such as firewall and intrusion detection and prevention technology. It is one of the largest participants in this market which is growing at 20% per annum and NetScreen is successfully increasing its market shares, says Ali. "Security is a high priority in IT budgets and spending on this has been resilient throughout the recent downturn in IT spending." The company will also participate in the expected rebound in IT spending by corporate customers, which account for the bulk of its revenue,he says. Some 40% of its revenue stems from the United States, 38% from Asia and 22% from Europe, the Middle East and Africa. The company was listed in December 2001 and "has only once lowered its earnings guidance due to the outbreak of SARS in Asia,"says Ali. NetScreen is expected to grow EPS by 28% in 2004 and trades at 48 times consensus EPS estimates. "This is cheap relative to its historic valuation." This company could be an takeover target by such companies as network services giant Cisco Systems, he says.
An ongoing favourite in the U.S. health care sector is:
- Caremark Rx Inc. (CMS/NYSE) US$9.27 (US$9.50-US$3.41). This company, based in Birmingham, Ala., provides prescription benefit management (PBM) primarily for sponsors of health-care benefit plans. The company dispenses prescription drugs through a network of third-party retail pharmacies and its own mail-order service pharmacies. "Caremark is the more profitable than its rivals, with the highest margins in the industry," says Ali. The company has been growing through acquisition.Caremark has been producing positive earnings surprises and analysts have been revising their earnings per share estimates upwards. The company is expected to growth earnings at about 20% per annum and the stock trades at roughly 19 times expected EPS for 2004. MFC first highlighted this stock in the column, Jan. 31, 2003. At the time, the stock traded at US$19.16.
The MFC team also continues to like:
- Apollo Group Inc. (APOL/NASDAQ) US$74.60 (US$75.15-US$40.72). This manager selected the stock in the column, May 15, when it traded at US$56.13. Based in Phoenix, Ariz., this company provides higher-education programs for working adults. There are significant barriers to entry in its education niche, says Ali. The company has no debt and a strong cash position of US$900-million. Apollo has "never missed consensus estimates since it went public in December 1994." A recent pullback in the stock, based on concerns about problems at one of its competitors, provides a good entry point. "The stock trades at a P/E multiple of 42 times consensus EPS estimates for the fiscal year to August 2004, well below its peak multiple of 54 times.
The company is expected to grow earnings in the 25% per annum range over the next five years.
MFC Global Investment Management may hold positions in the securities mentioned.; shorvitch@nationalpost.com;Business; Column
Chart/Graph: Bloomberg News / DARDEN RESTAURANTS INC.: DRI/NYSE: Jan. 22 close: US$20.36, -US6 cents, vol. 1,843,100: (See print copy for complete chart/graph.) |
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