Aubrey Hearn is vice president and senior portfolio manager at Sentry Investments. He’s been with the firm for eight years and manages the Small/Mid Cap Income Fund, the U.S. Growth and Income Fund, and the U.S. Balanced Income Fund. He has a Bachelor of Commerce degree from Memorial University.
A Toronto resident, Hearn is married with two small children. On weekends he enjoys playing basketball with friends.
What’s your assessment of current conditions?
All U.S. data points to improvement, though at a fairly slow pace (see “U.S. confidence hits five-year high,” this page). Retail sales, consumer sentiment, the housing market and consumer lending are all moving in the right direction. Companies are still hesitant about making big investments, but every month their confidence improves.
The Small/Mid Cap Income Fund is about 75% Canadian, but our U.S. allocation is growing.
In Canada, household debt levels are high. And where’s growth going to come from if consumers are close to being tapped out? We’re also concerned about the housing market—affordability has deteriorated considerably.
One of our barometers for gauging the health of the economy is data we get from trucking and railway cargo companies. By looking at the volume of goods being shipped you can get a pretty good idea of the state of the economy.
When volumes are high, it usually means the economy is active and strong; when they’re low, fewer goods are moved around and that usually means a less-vibrant economy. Currently, shipping volumes are sluggish in Canada, which tells us suggests the economy is moving at a similarly slow pace.
What’s your investment process?
We’re bottom-up investors, so we don’t focus on broad economic indicators. Our emphasis is industries where there’s a relatively small number of competitors operating in an oligopolistic market, like the waste management industry.
We spend a lot of time looking into whether the industry’s margins, cash flow and revenues are sustainable 10 to 20 years from now. Once we’ve found the strongest sectors, we drill down on the best players.
This involves finding out which firms have the highest EBITDA margins, gross margins and operating margins. We also look at P/E ratios, free cash-flow yields, return on equity and return on invested capital (ROIC). Even in an oligopolistic industry, management teams can distinguish themselves [with strong ratios].
In waste management, two big players are Republic Services and Waste Management, which control about two-thirds of landfill volumes in the U.S. We own Republic Services because the management team focuses more on ROIC. This is evident from the company’s financial statements; it also comes through in meetings we have
with management.
We also look at which companies pay dividends. On this criterion Republic Services is a clear winner. More than 90% of the names in our funds pay dividends and raise them over time. If you look back over the last 50-to-70 years, a large portion of overall returns has come from dividends. It ranges from 60% to 70%.
Balance sheets are important to us. We refuse to buy anything with high levels of debt, whether it’s debt-to-EBITDA or debt-to-cash flow. These ratios should be below 2.5 times. This helped us during the downturn of ’08 and ’09. We lost money like everyone else, but we didn’t blow up like some did. Companies with good balance sheets will avoid a lot of trouble in these situations.
The ideal company for us operates independently of what’s going on in the economy. A good example is K-Bro Linen Systems, which we’ve owned for many years. The company has 10-year linen management agreements with hospitals around Canada. So it doesn’t matter if Cyprus implodes or the rest of Europe takes a spill—they’re still going to be washing dirty linens.
With the small-cap fund we focus on companies that aren’t on a lot of people’s radars. If you’re willing to look outside of materials and the oil and gas sectors there are plenty of good companies in the industrial and consumer sectors.
A lot of these companies don’t get much analyst coverage, and they don’t necessarily trade a lot. But many have 3%-to-5% dividend yields, low payout ratios and trade at reasonable valuations.
Focusing on companies that operate independent of the overall market gives us a low correlation with the small-cap index.
Your outlook on U.S. equities?
We get a lot of push back because the S&P 500 is at record levels—people think it’s going to go down. In 2000, the index traded at about 31 times forward earnings; now it’s at about 13.8. In 2000, the dividend yield on the S&P 500 was 1.1%; now it’s about 2.2%.
In 2000, 10-year treasuries were higher than 6%; now they’re sub-2%. Finally, if you look at the overall economy, American GDP was roughly $9 trillion; now it’s about $14 trillion.
Valuations are not that stretched. True, there are a lot of expensive companies. But we’re bullish on U.S. equities because you can still find high-quality multinational companies trading at 10-to-13 times earnings.