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"Hakuna Matata! What a wonderful phrase!
Hakuna Matata! Ain’t no passing craze!
It means no worries, for the rest of your days………."
The Lion King, 1994
BY MARK BOUSFIELD
Whilst political angst continues to spiral higher – think Trump, UK Election, BREXIT and the like – equity markets appear to have adopted a "no worries" attitude and have continued to propel themselves higher, unencumbered by the surrounding political mayhem. And very nice too: the MSCI World Index finished the first 6 months up 5.3% in Sterling terms. But while this has been largely reflected across our range of investment strategies, we would caution against adopting such a "problem-free" philosophy.
As noted in our Q1 commentary, we have also witnessed plenty of FOMO (Fear of Missing Out) investing. Speaking to some fund sales personnel, the message has simply been "just get in, don’t wait; the market is going up, you’ll miss out." To which we can only respond "Yikes!"
We have repeatedly pointed out that equity markets are no longer cheap. In terms of PE ratio, the MSCI is trading on a PE of approximately 17x. Its 15-year average is closer to 14x. Whilst this is an imperfect measure, it does highlight the fact that equity valuations are becoming more expensive. With that in mind we have continued to run with lower weighting to equity markets within the multi-asset strategies.
A Hakuna Matata/ FOMO backdrop, allied to high valuations and unruly political discourse, is not – at least to our minds – a good environment for aggressive asset allocation. Of course, our multi-asset strategies retain the option to adopt a more cautious stance by reducing equity weightings. But what about our Global Blue Chip strategy? The Blue Chip Fund, as ever, is crammed with high-quality stocks that have strong balance sheets, strong dividend policies, strong thematic tailwinds and strong global revenue streams. So, while no companies are immune from a pull-back, the portfolio is built to weather a storm.
To be clear – while sounding like a broken record – this is not an attempt to predict a retrenchment in markets. However, there are elements of today’s market that remind me of the ex-CEO of Citigroup, Chuck Prince’s, 2007 quote in the FT: "as long as the music is playing, you’ve got to get up and dance." We merely seek to highlight that markets are not risk free. And are positioned accordingly.
CAUTIOUS PORTFOLIO: LOWER RISK
BY BOB TANNAHILL
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 of approximately 35%. The cash generated can be re-invested to provide capital or taken as an income stream.
One of the most common statements in the office at the moment is that "valuations are high." Since this is a significant factor in our current thinking – a direct result of the steady march higher in markets we have seen thus far in 2017 – we thought we would dedicate this commentary to expanding on what we mean.
First, a bit of jargon busting. When we talk about "valuation", we are referring to measures of the price you are being asked to pay today for future returns, such as equity earnings or bond income. The classic example of this for equity markets is the ratio of share-price-to-company-earnings, known as the price/earnings or "PE" ratio. Historically, we have, on average, been asked to pay around £14.50 for every £1 of expected earnings when investing into global equities. Today, that number for the stocks held in our cautious portfolios and Income Fund is modestly elevated at around £16.60. So what does that mean for us as investors?
Well, valuations reflect a mixture of investor sentiment (currently positive) as well as more fundamental factors, such as the historically low level of returns available on other assets – like bonds. As valuations fluctuate over time they produce either a tailwind (rise) or a headwind (fall) in investment returns. This behaviour exaggerates changes in fundamental factors, such as company earnings, since improving economics tend to align with improving sentiment to produce strong rising markets – and vice versa when the outlook inevitably deteriorates again. In the very long term – think decades – these fluctuations average out and the key driver of investor return reverts to that being delivered by the underlying assets. In the case of our equity example, this relates to the earnings and dividends produced by the underlying companies. In the short term, however, changes in valuation can have a material impact on returns – and as such we need to factor them into our thinking.
To put current equity valuations in a bit of historical context, the last big peak in this ratio was seen at the height of the tech boom at the turn of the 21st Century when it hit a colossal 28.5. On the down side, the last major trough was formed in the depths of the global financial crisis ("GFC") in early 2009 when it bottomed out at just 10. In these extreme cases, we can see, with the benefit of hindsight that in the years after these highs and lows valuations had a significant impact on returns.
In the wake of the tech bust, equity valuations dropped sharply from 28.5 to around 14.5 and this played a significant role in the major fall in global equities that we saw in the first two years of the new millennium. At the other end of spectrum, the rise in valuations from 10 to 16.6 that we saw after the GFC was one of the factors that helped global equities to produce their impressive 200%+ return, including income, from the low.
Today, equity valuations are not levels that are going make market history. Accordingly, you will not be surprised to hear that we are not positioning client portfolios for the extreme cases outlined above. We are, however, mindful that while valuations are somewhat middle-of-the-road, they are also on the wrong side of the centreline! As such, and while valuations could remain at these levels for some time, their current elevation implies an increased chance that future returns will be muted – or that bad news could have an exaggerated downside impact. It is also worth noting that the strength of this effect is proportionate to altitude. Consequently, while equity valuations have drifted higher, we have been incrementally reducing the equity allocation in all of our strategies. Today, the cautious strategy has a 25% equity position.
While we have focused, here, on equity valuations, this process applies equally to other assets, such as corporate bonds. In that case, the compensation offered to investors for risks, such as credit quality, behaves in a similar manner to equity valuations. More importantly, whichever asset class we look at today seems to show the same pattern of elevated valuations. As investors, we always try to tilt portfolios towards those parts of the investment universe where we believe we are getting properly compensated for the risks involved. At present, where few assets classes offer genuine bargains, we are led by process to position portfolios on the defensive side of their historical range. Looking forward, if markets continue to drift upwards driven by higher valuations (as opposed to stronger fundamentals) then we will continue to reduce exposure. On the other hand, if we get any sell-offs – often accompanied by deteriorations in sentiment – then we will be looking to add to any pockets of value.
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.
Our regular readers will know that, be it a song or an investment idea, we do love a theme! "Hakuna Matata",which comprises Swahili words hakuna (there is not here) and matata (plural form of problem ), and was popularized by its use in The Lion King, is heard often at resorts, hotels and other places where people are (at least supposed to be) having a good time. The prolonged strong run of equity markets has seen this "problem-free philosophy" take on a rather new meaning.
Ironically, the upward trend in valuation is causing the well-disciplined investor a matata in that her time-honoured trimming and profit-taking from a rising market simply releases cash with nowhere to go. Equity values may be high, but so are global bond prices… As a consequence, bottom-up and valuation-driven investors are seeing very little by way of purchase opportunity. The market has only corrected a handful of times so far this year and, when it has, falls have been merely incremental. Historically, even the most basic corrections tend to trim 10% from the highs – something we haven’t seen for quite a while now. Every time someone says, "this cannot continue", the market seems to edge a little bit higher!
As valuation-driven investors, we have not adopted this "problem-free philosophy" and have been carefully considering our stance. Our rationale for investing in energy has always been linked to the natural tailwind provided by the evolving population demographics and the impact that a more populous (and wealthier) world has on the demand for energy. Whilst we have witnessed nothing to cause us to believe that the demand for energy will not continue to increase, improvements in technology have not only enabled the extraction of fossil fuels previously thought unobtainable (all while vastly increasing estimated stockpiles), but they have also facilitated a seismic shift towards renewable energy sources – as well as drastically improving the efficiency of the products we use. As a result, we lost conviction that the oil-price-dependent companies underlying the Investec holding were giving us the energy exposure we needed. We reinvested the sale proceeds into the UK Gilt 1-to-5-year ETF in order to shorten the overall duration of our Government Bond exposure, which will mean that volatility is kept to a minimum in the event of an interest-rate hike.
In addition, we also recently made the decision to switch our entire holding in Stewart Asia Pacific Leaders into the First State Asian Growth Fund, the rationale for which was detailed in our Q1 Newsletter.
The Balanced Strategy returned approximately 3% over the quarter, mainly attributable to our core global equity and thematic holdings. Our specialist Technology & Healthcare Funds, both of which are run by Polar Capital, featured in the top performers over the quarter, returning over 8% and 3%, respectively, and beating their relevant sectors. We have learned when investing into smaller companies in sectors like healthcare and technology (and increasingly the intersection between them) that it is enormously beneficial to employ the skills of a specialist fund manager. We believe that with so many new companies where success – and indeed survival – hangs on patent approval, successful drug trials or other make-or-break binary outcomes, a diverse portfolio of these companies managed by a sector expert is the most sensible way to gain exposure. Moreover, we cannot all be experts in every topic and self-awareness is an important discipline of successful investing.
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%.
From a UK political perspective, the second quarter of 2017 was almost entirely dominated by the snap election announced on the 18th April – an event that the British media prematurely labelled a landslide Conservative victory. Oops!
Regular readers will recall that predicting the outcomes of highly erratic, region-specific events plays no part in our investment decisions. You only have to review the recent (disastrous) track record of the pollsters to understand why! At Ravenscroft, we certainly do not profess to be any better at calling the result than these "experts". Rather, our strength lies precisely in the ability to acknowledge this shortcoming and act accordingly, which, in this case, means making a conscious effort to ignore noise. This prevents us from allocating your capital on the basis of political rhetoric and received wisdom – all of which, as recent history has shown, simply may not transpire.
Despite our preference for leaving politics to the politicians, one comment we did appreciate as thematic investors was Jeremy Corbyn’s retort when questioned about what he planned to do in order to secure a Labour majority in future elections. He responded: "Look at me. I have youth on my side." This comment, which immediately went viral, referred to the high proportion of young (18-24) people that voted for his him. His basic premise being that if the Labour Party remained able to appeal to younger voters, then as demographics shifted it would retain an inherent advantage over its opposition – where a diminishing older vote would not be similarly replenished. (Of course, he’s not the first to think this. Just ask Hillary Clinton).
We also aim to benefit from natural tailwinds, albeit in our case provided by themes. Crucially, these themes are far less fickle than the voting habits of young Britons! They represent unstoppable trends, for example: urbanisation and the growing emerging consumer; a combination of increased life expectancy and an ageing population, resulting in an increased demand for healthcare; and, the global drive to improve productivity being brought about at an unprecedented pace by technology.However, whilst we remain confident in the robustness of our themes, the decision on how best to encapsulate them within our strategies is far harder.
This realization led us to sell our position in Investec Global Energy Fund – this quarter’s most noteworthy change and discussed by Sophie, above.
Aside from the Investec sale, we made a number of other, smaller, changes to the Growth Strategy holdings during the quarter. Within our emerging markets bucket, we made the decision to switch the Stewart Investors Asia Pacific Leaders Fund in favour of the First State Asian Growth Fund. We became dissatisfied with the level of manager contact we were receiving from the former, which has grown significantly in size since we first invested. First State offers a very similar portfolio, but provide us with a much better line of communication and a higher level of service.
Elsewhere, within our bond bucket, we reduced the Growth Strategy’s exposure to Gilts and used the proceeds to implement a position in the Schroder Strategic Credit Fund. We had indicated during our Q1 commentary that there might be further changes to the Growth Strategy’s bond holdings as we continued to tweak exposure. These subtle changes are designed to improve the Strategy’s alignment with investors’ growth-orientated goals.
Broadly speaking, bond and equity valuations continue to remain elevated and we enter Q3 cautiously positioned. It is important to reiterate that our defensive allocation should not be viewed as an attempt to call a market top, but is instead designed to allow us the flexibility to add to areas where we see pockets of value should any short-term volatility cause markets to sell-off.
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.
Over the quarter, the Global Blue Chip Strategy fared well against the broader market. The relative out-performance was created by our asset allocation, in particular: the zero-weight to Energy stocks – which had a poor quarter following softening oil & gas prices – and our over-weight to Healthcare, which was the second strongest performing sector overall. This was offset by having zero exposure to telecommunication stocks, which had the strongest performance over the quarter, and an underweight position to technology stocks that also fared well.
From a stock-holding perspective, strong contributions from Consumption, Healthcare and Industrial positions, such as Unilever, Nestle, Novartis, Medtronic and Rolls Royce, were offset by our Technology positions that didn’t fare quite so well.
During the quarter, we carried out a handful of transactions. The main trade was to exit both of our Agriculture stocks, Monsanto and Syngenta. Both companies attracted bid offers from suitors during the quarter. In May, Chinese state-owned agrichemicals company, ChemChina, assumed control of Swiss agri-business Syngenta after a lengthy regulatory approval process and clients received the full cash offer of $465 per share and a final dividend of CHF 5 per share. Meanwhile, the Bayer-Monsanto deal still has some time to go in order to appease all the different regulatory bodies and, with valuations already stretched due to the bid premium having been factored into Monsanto’s price, we decided to take profits.
We also trimmed LVMH and Apple during the quarter, after both had had a good run – pushing valuations towards the top end of their respective ranges. In particular, Apple’s valuation looked especially rich on a relative basis: after years of trading in the low double-digits, it reached the dizzying heights of the mid-to-high teens as the market started to reward strong growth in its Services Division (20%+ year-on-year growth). Two decent product launches in successive years also re-affirmed the iPhone’s prominent market position and aided momentum.
LVMH benefitted from positive improvements across the industry, hinting at an end to the widespread slump in sales growth driven by a downturn in emerging consumerism, particularly China. This is an increasingly important market and one that has garnered much attention over the last decade. Stock-specific optimism was boosted on the news that the Arnault Family was restructuring its affairs by bidding for outright ownership of Christian Dior – all with a view to selling Dior’s couture business to LVMH for €6.5bn. Both Dior’s and LVMH’s shares rose sharply on the news. LVMH was weathering the downturn better than most, due to its diversified business model, and valuations were already high, so we considered it prudent to reduce some of the Strategy’s exposure during this period of optimism.
With the proceeds of both reductions and outright sales, we topped up struggling tech giant Intel, which was coming under investor flak following an announcement that sales would not rise as strongly as first estimated due to headwinds in its biggest market personal computing. Poor sales growth in its Data Servers group – a key growth driver – also added to the negative sentiment. We remain positive on Intel since valuations look very attractive, the company is refocusing on growth trends and the balance sheet and cash flows are incredibly strong. Holly discusses the Company further in this Quarter’s Stock in Focus.
We also topped up Novartis; the Swiss Pharma company had been battling headwinds in its eye-care business, Alcon, which has witnessed a dramatic fall in profitability. However, restructuring efforts are starting to have a positive impact on the division at a time when its generics business, Sandoz, is on the cusp of coming to market with some interesting biologic copycat drugs known as biosimilars. One such drug, Erelzi, is looking to take-on Amgen’s Enbrel and a slice of its $5.1bn revenue stream by offering those with inflammatory diseases such as Rheumatoid Arthritis with a cheaper alternative.
Overall, we continue to hold and monitor a portfolio of incredibly stable businesses that extol the characteristics of quality and have a strong connection with one or more themes. No matter what financial markets choose to throw at us in the coming weeks and months, we remain fully invested safe in the knowledge that we own fantastic businesses with diversified revenue streams and positive outlooks when viewed through the lens of our investment themes over the medium-to-long-term (5yrs or longer).
FUND IN FOCUS: OUR MAN WHO CAEN...
BY SAMANTHA DOVEY
In this quarter’s Fund in Focus, I would like to introduce you to a new holding that the team and I have recently finished researching: Lazard’s Global Equity Franchise Fund – a global equity fund that will form part of the global brand exposure in our Growth strategies. The Fund is managed by Lazard’s well-established Global Franchise team and one of the lead portfolio managers is Bertrand Cliquet. Cliquet is currently based in London; however, as the title suggests, he originated from Caen in France.
Lazard defines a Franchise as:
"A business that has historically shown a proven ability to generate unleveraged returns, at or above its cost of capital, for long periods of time. We consider that franchises are able to accomplish this performance because of competitive advantages (or "moats"), which often arise from intangible, industry, or product-related features such as brand, IP, or customer switching costs".
Their robust, repeatable, process is based around "Intrinsic Value", which is the estimated future value of a company. They seek to profit from the difference between the company’s current value and its intrinsic value, see below:
Expected Return = Intrinsic Value – Current Value
For example, $20 intrinsic value less $15 current value equals $5 (or 33%) expected return
Once the intrinsic values for their "franchise universe" 250 has been calculated, these are then placed into their value rank screen. The graph below shows the outcome of their value rank.
Source: Lazard Global Equity Franchise presentation May 2017
Portfolio construction is based on value rank: the higher the expected return, the higher the allocation to a particular stock. Intuitively, therefore, the portfolio is made up of the stocks on the left-hand side of the above graph. This process helps to ensure that buy-and-sell decisions are not emotional, since stocks move around the value rank (although they are of course assessed qualitatively as well to ensure their intrinsic value holds true, and, if not, dealt with accordingly). Stocks that move from positive expected return to negative are sold and vice versa.
This results in a portfolio that has a bias towards information technology, consumer discretionary and industrials; these three sectors account for 77% of the portfolio. In the portfolio, you will see names that we are all familiar with and that have a strong brand/franchise: companies such as Cisco, MasterCard, and Google/Alphabet, as well as more obscure names such as International Gaming Technology and H&R Block, both of which give exposure to the discretionary spending sector.
To give an example of how this works, during the latter half of 2016, and in particular the final quarter, we saw a rotation out of "defensive" stocks into more "cyclical" sectors. Our existing global equity managers, with their bias to high-quality consumer staples, understandably suffered due to this rotation (to be clear, this is absolutely as we would expect and is a reflection of a broad market movement and not a reflection on the ability of the managers. At some point all managers that stick to their strategy will experience a pain trade when the market moves against them). In contrast, Lazard currently has zero exposure to defensive consumer staples since the expected return for these companies, in its opinion, was minimal, and there were better opportunities elsewhere in their universe – i.e. consumer staple companies were deemed to have reached their intrinsic value.
Whilst Lazard Global Equity Franchise also aims to invest into the highest quality global companies, the investment process brings something slightly different. When we look at the fund in conjunction with our other global equity holdings, this different approach adds a new dynamic to the portfolio – as well as new stocks. The crossover is minimal, in terms of names, and comes in at 8 with our existing holdings, meaning that it brings 19 new companies into the mix.
Now that our rigorous due diligence process has been completed, we are looking forward to strengthening our French relations over time. In due course, the fund will become a meaningful part of our growth strategies.
STOCK IN FOCUS: INTEL
BY HOLLY WARBURTON
Intel is a world renowned technology firm, founded in California in the heart of Silicon Valley. Within the Global Blue Chip strategy, it is one of our purest technology exposures – known for its cutting-edge innovations and market-leading positions in microprocessors or ‘chips’. In addition, over recent years, Intel has been realigning its business to benefit from growing trends in mobile devices, data and storage. In this quarter’s Stock in Focus we will look into its current operations.
It was 1971 when Intel manufactured the first commercially available chip and, due to the subsequent dramatic rise in PCs through the 1990s, it quickly became a household name with its Pentium brand, powering the majority of Windows and Mac OS X-based systems. Today, its chips are utilised by many of the top-branded device manufacturers, e.g. Apple, Asus, Acer, Dell and HP. The PC market continues to be the dominant business segment and it is the largest in terms of both revenue and operating income. However, as more users turn to mobile devices, the Company has seen a slow decline in sales, particularly over the last 5 years. The market had high expectations that Intel would move into the mobile chip production to help offset this, but, as little progress was made, the share price lagged the broader sector. Intel chose instead to focus on tapping into the increased demand for Data and the Internet of Things.
Internet of Things
The Internet of Things (IoT) refers to the inter-connection and communication between everyday items. The Company set up an entire business unit to embrace and develop its IoT capabilities back in 2013 and has been making good progress ever since, connecting ‘things’, building infrastructure and networks and managing and storing data securely. Intel’s IoT Platform (Intel®) begins with sensors that have their own unique identifiers, which can be embedded in an increasing number of physical objects. These objects then have the ability to gather data, which can then be securely routed to base stations where powerful processors sort the incoming data and relay it to other devices such as mobile phones or tablets, so that important or relevant information can be displayed in a viewable, user-friendly format. Intel’s strength in this area lies in the fact that it offers solutions at every point in this cycle for individuals and businesses, from sensors and core processors to data storage. The segment has grown at an average rate of 10% p.a. and, given the increasing opportunities with the retail, transportation and industrial markets, and as IoT becomes more common place, there is potential for this to continue.
Intel’s data operations are centred on cloud storage solutions and communication infrastructure, as well as data analytics. Its focus is to enable businesses and individuals to efficiently capture, process, analyse and store vast amounts of data. The trend in data cannot be underestimated and has a variety of uses: from governments and national healthcare providers maintaining public records to more individual uses such as watching the latest blockbuster online. It is expected that data from internet traffic is expected to double by 2020. As a result of a strategic review, Intel is pushing a "data first" campaign internally to take advantage of the opportunities ahead. The data centre now takes priority above all other business segments. For instance, this means the data centre gets priority access to the latest chips from the personal computing group.
It is Intel’s status as an industry incumbent that puts the Company in a unique position to tap into the potential of these new markets and become far more than a chip manufacturer. As highlighted by Ben in the Quarterly Commentary, the market’s focus on its PC business has resulted in a sluggish share price – one which has provided an attractive opportunity to increase our exposure as we look to what this already ground-breaking company could become.
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