To download the newsletter as a PDF, please CLICK HERE.
We can’t predict the future
Or resist the inevitable urge to try
And we want to know the answers
To understand the infinitude of time
And if that’s just the way it is
And all that will remain unchanged
We cannot rearrange all the universe
To suit our ways
The Flaming Lips, 1999
BY MARK BOUSFIELD
Equity markets have made a strong start to the year and this has been reflected in the performance of our investment strategies. Most notably, our Global Blue Chip portfolio rose by more than 8% over the quarter, benefitting from very strong returns in both Consumer Staple (which we often describe, simplistically, as “shopping trolley stocks”) and Healthcare sectors.
This is perhaps contrary to what was expected in the run-up to Trump taking the reins – and another indication of our poor ability to predict – although where he will take us next remains a mystery! A recent light-hearted tweet by investment manager Barry Ritholtz suggested an auto-format for Trump headlines as: “Trump, Citing No Evidence, Suggests _____ [something terrible]”.
On the predictive front, pundits and strategists have largely embraced Trump and, in particular, have focused on his strategy to strip-back red tape and bureaucracy and dramatically reduce tax. This is entirely speculative and, as we have said many times before, mixing politics with your investment strategy is more-often-than-not a recipe for disaster. We would highlight, for instance, that two of his biggest political promises to date have been as yet unsuccessful: controlling immigration and then a (disastrous) effort to repeal Obamacare. We will wait to see how successfully his other policies are executed, but we certainly won’t be building an investment strategy based on their outcomes. In fact, it still amazes me, given the consistently poor results provided by pundits and forecasters, that investors pay any heed to such speculation.
Sidestepping the political minefield for a moment and reflecting on our current positioning, in the last two years we have gradually reduced the equity allocation within the three multi-asset strategies (Global Blue Chip strategy will, of course, always be 100% equity focused). This was based on valuations: simply put, equities looked relatively expensive and we therefore trimmed our positions slowly over time – sensible portfolio management. While it sounds simple, this sort of behaviour takes discipline. Discipline, which, in the case of many of our fund and portfolio managers, has been learnt the hard way (for example, through the pain of watching tech stocks plummet from ludicrously heady valuations in the early 2000s). To sell when markets are rising, overruling human nature’s greed, can be difficult to execute. In the words of my 8 year-old son, we are all naturally prone to FOMO (fear of missing out)!
Source: Google Images
Whilst focusing on valuations does not always provide a very good market-timing tool (since markets can remain overpriced and even excessively overpriced for a very long time), it does enforce a strong investment discipline and helps to reduce the impact of any market excess. Currently, the MSCI World Equity Index is trading at a premium to its long-term average – as is the consumer staple equity index among many others. In light of this, and taking into account that almost anything could happen on the political stage, we remain cautious in our allocation.
We continue to look for opportunities. Should volatility rise on the back of pricy markets – and the very real potential for policy errors, both economic and political – we are well placed to benefit from any buying opportunities.
CAUTIOUS PORTFOLIO: LOWER RISK
BY ALEX CHAMBERS
Objective: The Cautious Portfolio’s objective is to increase its value by predominantly allocating capital to fixed-income investments. The portfolio can also invest into global blue-chip equities with strong cash-flows and progressive dividend policies. A neutral position would be a 75% bond/25% equity split and the maximum equity-weighting is approximately 35%. The cash generated can be re-invested to provide capital or taken as an income stream.
The start to this year, compared to last, might be described as its polar opposite. The first quarter of 2017 has been a very docile period, contrary to what some may have predicted given Trump and the changes implemented (or, at least, attempted) over the short time he has been in the Oval Office. If you take a look at some of the most widely used measures of volatility for investors globally, it can be seen that so far this year volatility has been near the lowest levels it has been since 2002.
Focusing on how the portfolio has performed over the quarter, two clear trends can be identified: the first is that global equities have had a relatively uninterrupted positive run; and the second is that bonds have experienced steady gains across the credit spectrum as a result of both stable spreads and falling yields.
During the second half of 2016, the Consumer Staples sector had a period of relative underperformance compared to some of the more cyclical sectors in the market. This has somewhat reversed over the first quarter of 2017 with Consumer Staples being a favoured sector over the period. Perhaps one of the most significant bits of news for us over the quarter was Kraft Heinz’s and 3G Capital’s bid for Unilever. Despite the fact that the offer was not accepted, and talks were ended very quickly, this highlighted that – even at seemingly elevated Consumer Staples valuations – big players in the market are still prepared to pay-up to own high-quality, global businesses.
The second trend is more a continuation of one seen over the past 12 months or so. It is particularly resonant since, approximately a year ago, in February 2016, we topped up our high-yield allocation in the Fund as a result of spreads reaching abnormally wide levels. The ‘spread’ is the additional yield received (for the additional risk taken) over a government bond with the same length of time to maturity. This time last year, the market was extremely worried about bonds issued by energy companies, many of which have credit ratings below BBB, i.e. in the high yield space; however, this caused a wider sell-off in bonds issued by companies with no link to energy whatsoever – essentially, they were simply tarred with the same brush. This widening of spreads was therefore unwarranted since the inherent risk in owning non-energy bonds had not increased as a result of a collapsed oil price. Accordingly, we decided to top up our allocation. Just over a year on from making this decision, spreads have tightened significantly; for example, in the US they were as wide as 800 basis points over the risk-free rate. They are currently just under 400 basis points over. With the inverse relationship between bond yields and bond price, the prices of the underlying bonds have risen materially, enhancing the capital value of the holdings. Inevitably, this sector now looks relatively expensive – so we will be keeping a close eye on this allocation going forward.
BALANCED PORTFOLIOS: LOWER-TO-MEDIUM
BY SOPHIE YABSLEY
Objective: The Balanced Portfolio’s objective is to provide capital appreciation through a balance of fixed income and global equities. A neutral position is a 50% bond/50% equity split and the maximum equity weighting is 65%. The cash generated can be re-invested to provide capital growth or taken as an income stream.
Markets remained strong during Q1 with new highs reached in major market indices. Many clients have asked “when will it end”? The answer is, of course, that we simply cannot know. At some point the market will sell-off; however, that point could be tomorrow, in 3 weeks’, 3 months’, or even 3 years’ time. We often quote the world’s most successful investors and this highly topical market-timing observation comes from Warren Buffet:
“(You are) making a terrible mistake if you stay out of a game that you think is going to be very good over time because you think you can pick a better time to enter it.”
So far this year, there has been little change to the Balanced strategy; however, we will shortly be making an outright switch within the portfolio. Long-time clients will know that we have been investors in Stewart Asia Pacific Leaders (formerly First State Asia Pacific Leaders) for many years. We remain very positive about the potential for growth in emerging markets, which remains one of our core investment themes. Today, Stewart’s strategy has, to its credit, grown to be enormous – almost £10bn in size. When taken together with a recent restructuring and reduced levels of contact affecting previous levels of transparency, we have become dissatisfied with our lack of contact with the fund manager. For us, this is an unacceptable change: direct manager contact is one of our key considerations when selecting fund houses. We have therefore been working to identify a suitable alternative, recently completing our customarily rigorous due diligence process on the First State Asian Growth Fund. Over the coming weeks, we will look to switch our holding in Stewart Asia Pacific Leaders into First State Asian Growth. It holds a very similar portfolio, but provides us with a much better line of communication with the manager and hence a higher level of service.
GROWTH PORTFOLIOS: MEDIUM RISK
BY SAM CORBET
Objective: The Growth Portfolio’s objective is to provide long-term capital appreciation by investing predominantly into global equities. A neutral position is a 35% bond/65% equity split and the maximum equity weighting is approximately 85%.
It’s remarkable to think that it was only this time last year that we were mulling over “the worst start to a year” modern markets had ever encountered – what a contrast the start of 2017 has been in comparison. According to statistics, consumer confidence is the highest it’s been since the early 2000s and equity markets have rallied steadily throughout the quarter. This is probably best illustrated by the impressive run-up of the two leading US equity indices – both of which experienced 110 consecutive days without posting a single day with a decline of greater than 1%. To put it into context, this achievement places the latest run (which ended on the 21st March) comfortably within the top 10 of all similar occurrences; the last time each index surpassed this streak was in the mid-90s.
The Growth Strategy returned approximately 6% over the quarter. The star performer was, once again, Polar Capital Global Technology – returning over 15% to investors and beating the MSCI World Information Technology sector by almost 5% year-to-date.
Elsewhere, our exposure to the Healthcare sector and the Emerging Markets performed strongly as the “Trump Trade”, which had caused these areas to underperform following Trump’s election in November, showed signs of unwinding. The Healthcare sector was one of the worst performing sectors last year, so we have gradually been topping up the Strategy’s exposure via our preferred fund, Polar Capital Healthcare Opportunities, as valuations began to look comparatively attractive. This took the weighting from approximately 5.5%, as at the end of December 2016, to 7%.
We also made the decision to introduce the Alquity Asia fund into portfolios. Alquity Asia has a significant exposure to Indian equities and events conspired to make the valuation attractive. During November, in an attempt to combat the amount of criminal money in circulation, Prime Minister Modi announced that the country’s two largest bank notes would immediately cease to be legal tender. These two notes accounted for over 80% of the currency in circulation and, as a result, Indian equities suffered indiscriminately over fears as to how this decision would affect the population’s ability to spend.
We were early supporters of Mike Sell and the team at Alquity; the Asia Fund has been a holding within our own Huntress Global Growth Fund since December 2015. The serendipitous combination of the macro issues highlighted above and general sentiment towards the region meant that the fund was looking cheap when compared to its own history; accordingly, it presented an attractive opportunity to incorporate the holding throughout the client base.
After conducting a review of the Growth Strategy’s bond holdings, we made the decision to alter the bond mix. Historically, the bond allocation has been designed to act as a buffer during periods when equities drawdown. As a result, the bond holdings have been especially defensive in nature; in the past we have often referred to a number of them as “posh cash”!
Whilst we still want to maintain the defensive qualities of the bond portion of the portfolio during times of market turmoil, we have recently become of the opinion that (particularly in our Growth Strategy) our bond holdings should be working harder for our investors. Having carried out an extensive review of fixed income assets and considered various “blends” of our preferred bond funds, we have made the decision to increase exposure to corporate debt by adding to our existing holding in PIMCO’s Global Investment Grade Credit Fund. At the same time, we have also made the decision to switch our holding in Muzinich AmericaYield Fund in favour of Oaktree Global High Yield Fund.
Over the coming months, there are likely to be a few more changes as we gradually tweak the composition of our Growth Strategy.
GLOBAL BLUE CHIP PORTFOLIOS: MEDIUM-TO-HIGHER RISK
BY BEN BYROM
Objective: The Global Blue Chip portfolio invests into approximately 25 -30 global blue chips that are in line with our long-term investment themes. The aim is to invest into such companies at an attractive valuation and hold them for the long-term. The cash generated can be reinvested to provide capital growth of taken as an income stream.
The Global Blue Chip portfolios have experienced a strong start to the year returning 8% in sterling terms. This compares favourably to the MSCI World Index which returned 4.8% over the same period. While some of the market momentum is due to a strong belief (hope) that President Trump will come good on his campaign promise to ‘Make America Great Again’, we were pleased to see good underlying growth rates in many of the strategy’s holdings during the fourth quarter’s earnings season.
One of the best reports came from Apple Inc., which announced revenues that hit all-time highs and record unit shipments across all of its products and services bar the iPad. The iPhone 7 was hailed a success and built on the innovation of the iPhone 6. In addition, the Company reported continued success within its Services Division that recognises the revenue from app sales and subscription services that customers utilise through the Apple ecosystem. Apple is now back in favour with the market: earnings upgrades are coming through thick and fast as it’s anticpated the Company now looks forward to releasing the iPhone 8, which is slated to turn the dial again on phone innovation.
Richemont S.A. won the best surprise announcement award as the luxury goods maker reported strong sales, particularly from its Jewellery segment, while the expected declines within Watches and Europe weren’t as bad as first feared. This has led to the belief the worst is over for the luxury industry. The stock is trading at 26x earnings and pricing in a recovery, so we will want to see a continuation of the good news in future reports.
The two themes that have consistently driven performance over the quarter have been Healthcare and Global Brands. The strategy’s preference towards these themes has certainly been a contributing factor with roughly 65% of the portfolio invested across consumer staples, consumer discretionary, large cap pharmaceutical and medical device companies. Stock selection within these themes also aided performance.
The main contributor within Global Brands was the strategy’s holding in Unilever, which was subject to a takeover bid from Kraft Heinz – the food conglomerate backed by Berkshire Hathaway (think Warren Buffet) and 3G Capital, the Brazilian private equity firm. On news of the offer, the stock rallied up to the offer price of £40 per share; however, the excitement was only short-lived since the offer was hastily withdrawn. Subsequently, the stock has stabilised around the bid price, as Unilever’s management has subsequently announced an acceleration of their cost cutting program to improve margins and the possible disposal of some of its slower growing brands.
With most of our Healthcare holdings returning approximately 10% or more, it was generally hard to go wrong in healthcare this quarter as the sector showed signs of life after having been ravaged by concerns about Capitol Hill intervening in a bid to drive-down drug prices. However, we managed it with our holding in Novartis, the Swiss-based drug-and-eye-care specialist. The Company is being hit by operational losses at its eye-care unit, Alcon, as off-the-ball management opened a doorway to the competition. Despite increasing investment in a drive to grow sales, the unit has yet to see a return on this investment. CEO Jose Jimenez suggested that all options for the unit are now being considered, including an outright sale, spin-off, IPO or retaining it. This came at a time when pharmaceutical sales were struggling – the solid progress being made by its portfolio of new drugs being offset by generic competition on its blockbuster oncology drug Gleevec.
It’s not all doom and gloom, though, the Company trades on low P/E and there are reasons to be positive – namely, generic division Sandoz. The Company is having reasonable success in obtaining approvals on bio-similar drugs, the generic version of biologic drugs, enabling the company to enter markets with huge potential, such as auto-immune diseases – where the company has plans to copy versions of AbbVie’s Humira, Biogen’s Rituxan and Johnson & Johnson’s Remicade. The combined sales of these drugs totalled roughly $25bn in 2016 and all of them have either come off-patent or are likely to do so in the near future.
We have seen little need to make any major changes to the portfolio over the quarter. As such, the only decision actioned was to sell the entire holding of Deere. Earlier in the quarter, it was infrastructure and construction associated stocks which benefited most from the ‘Trump Rally’. Deere’s share price hit all-time highs in both price and valuation, with its price earnings ratio hitting 24x, which is double its 5-year historical average of 12x. In order to bring Deere back towards its longer term average valuation, earnings would have to double at a time when the analyst community thinks they will fall further. In our opinion, this left Deere vulnerable to a sharp decline should reality not meet expectations and it thus felt prudent to exit the position. With the proceeds we added to some of our new stocks in the portfolio and our healthcare holdings.
FUND IN FOCUS: OUR MAN IN ASIA
BY SAMANTHA DOVEY
When constructing portfolios, we often refer to our preferred holdings as “operating levers”. What we mean by this is: if we see value in a particular area, then we can pull the lever to increase our exposure. Similarly, we can push the lever if valuations look stretched. In the Growth Strategy, for example, we have several different levers within our emerging market allocation: two examples are a specialist developed-Asia manager (Richard Jones of Stewart Investors) and a specialist emerging-Asia manager (Mike Sell of Alquity Investment Management) – the latter of whom will be the focus of this article.
Sell has nearly 20 years’ experience investing in the Indian subcontinent and Asian markets and it is our view that such experience is paramount when investing into these regions. Many think that it is easy to transfer skills across from developed-market investing to the emerging markets or Asia, but this is rarely the case. Traditionally, the cultures that are intertwined with these markets place great emphasis on relationships, so a longer and deeper knowledge of the markets, people and traditions of business is of the utmost importance. Sell’s portfolio is structured around key themes such as demographics, urbanisation and structural transformation – synonymous with our own global investment themes.
Some of the biggest risks investors face when investing into emerging regions are what are known as environmental, social and governance risks – “ESG”. Most developed-market companies have strong corporate governance since they are bound by rigorous regulation and supervised by authoritative bodies. Can you imagine what would happen if the boss of a FTSE 100 company tried to employ children to work in factories, placed polluted waste water directly into the ecosystem or decided that they would like to buy a football team with company money? Any of these issues would be instantly detrimental to their reputation and credibility, the share price would tank and shortly be accompanied by the exit of said CEO. But while it may sound rather fantastical, these are real problems facing investors in emerging markets.
When Sell is looking at his universe of investable stocks, ESG is one of his first screens. Specifically, he is looking for transparency of information, alignment of interests between owners and shareholders and the quality and consistency of management behaviours. He will not own firms that fail their overall quality assessment and will sell those stocks that fail to maintain the required criteria.
ESG specifically delves into areas such as:
Environment – covers areas such as energy and climate change, nonhazardous waste, toxic emissions and waste and water stress.
Social – covers the customer. For example, product safety and quality, customer relations, human rights and the community in which the company operates. Labour rights and the supply chain cover areas such as health and safety, child labour and collective bargaining.
Governance – looks at areas such as bribery and management fraud, controversial investments and the actual structure of the company. There have been two instances where Alquity has sold on the back of a change in ESG circumstances and I have included one example:
An Indian logistics company founded by two partners (with one leaving last year). The board was reconstituted and involved a large proportion of family members – apparently inadequately qualified – which Alquity deemed to be insufficiently independent and lacking experience. The founder’s wife was placed on the board because, and I quote, ‘we needed a woman on the board’. Accordingly (and unsurprisingly!) Alquity was not confident in the management competence going forward.
This is not necessarily typical of the region and reform in India has doubled since Modi was elected. He has introduced demonetisation, increased foreign ownership limits, reduced fuel subsidies, passed the bankruptcy bill and instigated the goods and services tax – to name but a few. All of these changes should benefit the region in the longer term as its businesses become more “developed” and the government stamps out illegal activities (such as non-payment of taxes). India is just one region where Sell sees exciting long-term investment opportunities and exposure to the region makes up almost one-third of his current portfolio.
ESG is just one example of a trait that Sell will look for when selecting suitable investments for his fund. The Alquity team is both hands-on and often on the ground. While screening companies for preferred characteristics narrows the universe and helps to identify well-managed candidate companies, nothing substitutes for visits to the physical operation and to speak face-to-face with management. In a region where there are so many investment challenges, Alquity is a safe pair of hands.
STOCK IN FOCUS: L'OREAL
L’Oréal, the French cosmetics giant that coined the phrase ‘because you’re worth it’, celebrates its 20th anniversary in China this year. The world’s largest beauty group has invested heavily in this region, and the rest of the emerging world, over the years and in this ‘Stock in Focus’ we look at how the Company has been able to establish itself as a leader in this vast, diverse market and how this might translate into other new markets.
L’Oréal’s journey into China coincided with many of the reforms that opened up the country to the rest of the world. It was L’Oréal’s dream to capitalise upon this opportunity to make its lipsticks accessible to every Chinese woman. Since this initial inspiration, China has become the second largest market for the Company in terms of sales, with the Asia Pacific region accounting for 22.5% of group sales last year. Much of L’Oréal’s success has come from understanding the differences in Asian beauty standards when compared to the Western world and adapting their products to suit. Historically, L’Oréal found that make-up wasn’t the focus of the Chinese cosmetics industry but rather skincare – with women (and men) favouring products that have scientifically proven results (and contain natural ingredients) and beauty rituals, such as the very popular face sheet-masks. In 2014, L’Oréal took steps to tap into this market by acquiring China’s own Magic Holdings, a market leader in the facial-mask industry, in its largest regional investment to-date.
L’Oréal continually strives to understand the wants and needs of its customer base: researching how different cultures view beauty, their rituals, and physical difference such as skin tone and hair type. L’Oréal collects these observations via a science it calls ‘geo-cosmetics’. In Shanghai, the Company has established a Research and Innovation Centre where these findings can be used to create regionally-specific innovations such as cosmetic cleansing waters (Japanese-inspired) and brightening creams. This R&I Centre is supported by L’Oréal China’s headquarters, also in Shanghai, and two production sites, which show the firm’s commitment to China.
The Company recognises that the beauty industry is ever changing, with younger generations in Asia now showing more interest in makeup. Much of this has been driven by the rise in social media, which has allowed shoppers, primarily millennials, to track the latest trends and review the newest products from Japan and South Korea, as well as globally. L’Oréal has kept up with this with its strong online presence, using popular social networking sites such as WeChat and Weibo. L’Oréal China has led the way with the Group’s e-commerce, launching the first L’Oréal Paris boutique on Tmall, a Chinese online retail website. In addition, it has also been working with Alibaba since 2013.
It isn’t just China where L’Oréal is making a mark. In 2016, 39.5% of sales revenues came from ‘new markets’, including broader Asia, the Middle East, India and Africa, amongst others. It is estimated that the middle classes in these countries will increase from 1 billion to 2.5 billion people over the next ten years and it is the Company’s goal to connect with this growing population by creating cosmetics which meet their diversified beauty aspirations. The success it has experienced in China will no doubt form a blueprint for new-market expansion.
L’Oréal is a recent addition to the portfolios, but there are many reasons why we believe it is worth including in the strategy. Not only does it bring exposure to some of the world’s most recognizable brands – eponymous products, Lancôme, Garnier and Maybelline – but it provides investment access to the emerging consumer and their increasing wealth. With cosmetics becoming a daily staple for many, L’Oréal provides consistent revenue streams and healthy cash flows allied to opportunity for still further growth.
To download the newsletter as a PDF, please CLICK HERE.