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“It is time
It is time
It is time
For stormy weather”
The Pixies, 1990
BY MARK BOUSFIELD
It’s been another long, hot one… In the political arena, the Donald continues to play a dangerous game of power-posturing with Kim Jong-un; both claiming a “declaration of war”. UK and European political headlines continue to be dominated by BREXIT. Despite Theresa May’s best efforts to provide clarity via her Florence speech, the process and outcome seems as nebulous as ever! The point here is that, despite recent results across Europe, politics remain front-and-centre with a strong undercurrent of turmoil. For instance, Angela Merkel has been successfully re-elected – but not without giving ground to the far right in the form of Alternative fur Deutschland. This is unsurprising given the level of immigration in Germany: a million-plus in the last year or so alone. In France, Marine Le Pen took 21% of the vote in the first round of the Presidential Elections.
However, it hasn’t been politics or economics that have dominated most people’s attention over the summer, it has been nature itself. A quartet of Atlantic storms: Harvey, Irma, Jose and Maria have wreaked havoc across the Gulf of Mexico and the Caribbean. Maria, the most recent storm, has literally destroyed vast swathes of Puerto Rico, almost completely wiping out the island’s entire power infrastructure. It is likely that much of the island will be without power for 46 months. Damage caused will take years and billions of dollars to repair and could potentially cause permanent damage to the reputations of jurisdictions like the BVI as finance centres.
As we know, storms are entirely unpredictable – there is no way of knowing where or when next year’s storms will occur. In fact, even once a hurricane has formed, as demonstrated this summer, it is difficult to forecast its exact direction and outcome. Remind you of anything? For me, it’s markets. In a similar way to their natural equivalent, violent storms also tend to hit markets every few years – and, similarly, we can’t predict when or in which asset class that will happen. Nor do we know the trigger or the outcome. Whilst irregular, these inancial storms – like this season’s hurricanes – can cause an enormous amount of damage and, depending on your time horizon, the impact to your pension, retirement fund or saving scheme may or may not be recoverable.
As longstanding clients and readers of our quarterly will know, we are pragmatic investors who:
A. Offer a range of portfolios across a number of strategies. From cautious portfolios that can accommodate investors who are naturally more defensive, or have shorter time horizons, to a focused direct blue-chip equity portfolio for investors with a higher risk appetite and longer time horizon.
B. Invest into long-term themes that will stand the test of time, a typical example of which is the ageing global demographic. The increasing demand for healthcare will persist whether we get hard BREXIT, soft BREXIT or no BREXIT at all!
C. Own, at the core of our portfolios, a selection of global blue-chips, many of which are companies that have survived wars, economic crises and market meltdowns: Coca Cola, Procter and Gamble and Nestlé to name a few.
D. Buy only what we know and understand.
E. Focus on valuations to help us navigate market cycles – aiming, in very simple terms, to own less of an asset when it is trading expensively and more of an asset when it is trading cheaply. All our multi-asset portfolios, within the constraints of each strategy, are currently conservatively positioned, since both bond and equity valuations are trading at a premium to their long-term averages. Accordingly, we are maintaining a reduced allocation to equities and acautious approach to the bond market.
Ultimately, our main priority is to ensure that all of our efforts are focused on understanding our client’s investment objectives and time horizons and ensuring that we always take these into account when we construct portfolios and allocate capital. It is important, therefore, that all of us review our own positions from time to time to ensure that the investment approach we have taken remains appropriate to our current situation. Our lives aren’t static. Situations change, objectives may require modiication. We never forget that no single strategy can possibly it all shapes and sizes.
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 is approximately 35%. The cash generated can be re-invested to provide capital or taken as an income stream.
The cautious strategy finished the quarter roughly flat with falling asset values offsetting the income earned over the period. The first two months of the quarter were positive and this trend continued, in dollar terms, in September. However, sterling-based investors found the conditions at the end of the quarter somewhat choppier. In early September, sterling rebounded over 4% relative to the US dollar on the back of comments from the Bank of England governor, Mark Carney. These comments, which implied that UK interest rates might rise in the near future, caused investors to reassess the attractiveness of sterling relative to other currencies. As regular readers will know, sterling strength acts as short-term headwind to the strategy because of its effect on our global equities, although in the long term it tends to have little net effect. So, while this acted as a drag on performance in September, we were pleased to see the measures we have taken to limit this currency effect working as expected during the month. A knock-on effect of the change in outlook for sterling interest rates was that sterling bond-yields rose, which in turn had a negative effect on their price. This led to our UK corporate and government bond positions ending the quarter showing losses alongside our global equities. On a more positive note, these losses were offset over the quarter by a slow and steady performance from our global bond allocations. It is this global diversiication effect that we seek to achieve in our portfolios, since regions will always have stronger and weaker periods.
During the quarter, we responded to changing asset prices by reorganizing the bond side of the strategy. Over the last 18 months, the income yield on certain parts of the bond market has dropped markedly and this has resulted in signiicant increases in the prices of these bonds. This reduction in the compensation we receive as investors for holding certain bonds got to the point where we considered that change was warranted. The main move was to trim some of our longer-dated bonds, in the form of our UK government bonds and the Stratton Street NFA Bond Fund. On the back of this, we topped up some of our shorter-dated or more defensive positions. These included a short-dated UK government bond ETF and Schroder’s Strategic Credit fund.
At the same time we removed one fund entirely from the portfolio and introduced a new one, albeit in a much smaller position. The fund we sold was the Muzinich Global High Yield fund. High-yield bonds have got significantly more expensive over the last year or so, which has obliged us to reduce weightings; this also coincided with a change of strategy within the Muzinich fund. In light of these changes, the fund ceased to provide for our needs in the space. And, in order to minimise trading costs, we made two changes at once: exiting both the fund and reducing the high-yield allocation. Some of the proceeds from this sale were allocated to a different Muzinich fund, the Asian Credit fund. We believe the Asian credit space offers something a little different to our other bond positions and so its introduction, albeit small at the moment, introduces a bit more global diversification into the strategy – something we are keen to do at a time when bargains are hard to find.
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.
One of the rather obvious outcomes of adopting a long-term, low turnover investment strategy is that we often go for long periods of time without placing any meaningful trades across portfolios. Now this low turnover is absolutely intentional and an approach that we do not plan to change; nevertheless, we often jest within the team that we ought to trade a bit often more so that we have something exciting to report to our investors each quarter! Rest assured that the decision to make no changes to our portfolios involves extensive debate, monitoring and analysis and the choice to keep the balanced portfolio unaltered is a very conscious one. In the words of James Bullock of Lindsell Train (one of our core fund holdings) “that’s not to say we don’t regularly make decisions on our holdings, it’s just that the vast majority of our decisions are to do nothing.”
The world we live in today is anything but low turnover. Our political leaders, social issues, technological trends, scientific discoveries, natural disasters and fashion movements are ever-changing and it can be tricky to keep up to speed with what’s what. That said, underlying human behaviour is often more constant than you might expect – after all, we are famously creatures of habit. How often, for example, do you change the brand of toothpaste that you use? How often to you switch the mobile telephone that you use? Do you try different makes of pet food or do you simply stick to the one that you already know your moggy enjoys? Research supports the notion that actually, in a changeable world, we are very loyal to the brands that we like and this is exactly the reason that such companies form the cornerstone of all of our investment strategies. If the situation between the US and North Korea worsens, will we all stop washing our hair or feeding our pets? It is highly unlikely. Of course, if markets start to correct then the share price of Colgate Palmolive, Nestlé, Procter and Gamble et al will undoubtedly suffer; but, ultimately, the world keeps on spinning and we all keep – for now at least – illing our shopping trollies with the same things week after week.
In the case of Global Brands – or any of our other investment themes – we know that we want to own them for the long term. We are, however, very aware of valuations – buying something when it is relatively cheap provides a much greater potential for upside return than something that is expensive. The Global Brands portion of our Balanced portfolios has provided investors with a phenomenal return over the last few years and, as a result, the asset class is looking expensive on a historical basis. In consequence, we have taken the decision to reduce our exposure, at the margins, to Fundsmith. This has locked in some profit and the proceeds have been added to short-dated Gilts – a further gesture towards our most defensive stance to-date.
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%.
As Mark has touched on in his opening commentary, this quarter’s news headlines have been dominated by the unusually high number of natural disasters. From a geographical perspective, Q3 has proved to be a period of immense volatility. I couldn’t help but be reminded of the documentary The Year the World Went Wild, which recounts the unprecedented number of disasters that occurred in the year following the 2004 Boxing Day tsunami. With that in mind, September proved to be a record-breaking month with 35 hurricane days (each day being the equivalent of 6 hours) experienced within the Atlantic Basin, surpassing the previous record set in 1926: the world looked on in horror as Irma, Jose, Katia, Lee, Harvey and Maria made landfall, leaving a path of destruction in their wake.
Elsewhere, another storm was brewing as tensions rapidly escalated between the United States and North Korea. It’s hard to view the current rhetoric between ‘Rocketman’ and the ‘Dotard’ as anything more than playground antics. When push comes to shove, North Korea’s military capabilities are no match for the US powerhouse and any altercation is likely to be more one-sided than the recent Mayweather bout. Given the threat of having his country reduced to glass, we have to hope that the ‘Great Leader’ deploys a degree of rationality and takes heed. Unfortunately, if we have learnt anything over the past year, rational thinking is a trait that neither man appears to possess. For now, we continue to watch the US President’s Twitter feed (officially the new platform for advocating foreign policy) with bemusement; however, we remain mindful that, if you pour enough fuel on, even the dampest branches will eventually catch alight.
Our growth strategies had an equally busy period and we made a number of changes to the portfolios during the quarter, including the introduction of a new holding – the Lazard Global Equity Franchise Fund. This sits within the strategy’s core global equity pot alongside the likes of longstanding holdings Fundsmith and Lindsell Train. One of the aspects we liked most about the new fund was the team’s strict valuation discipline. Regular readers will know that company valuations are at the heart of everything we do and it was pleasing to find another manager where such awareness formed an equally integral part of their investment process.
As a quick recap, at core, Bertrand and the team rely on a process they refer to as the “value rank”. Out of their investible stock universe, the team then narrows the scope down to approximately 250 companies that meet their stringent quality criteria. Each of these stocks is then given a conservative intrinsic value estimate and the names that are currently trading at the biggest discount to these are included in the portfolio. During times when equities are expensive (and the discount to intrinsic value is limited across the board), the portfolio will contain a smaller number of underlying holdings – where noteworthy discounts still exist. Conversely, when everything looks cheap, and discounts are signiicant, the portfolio will be more thinly spread (up to 50 stocks).
This pragmatic approach to valuations – and the importance this plays in the construction of the portfolio – prevents the team from becoming emotionally wedded to a stock. As a stock performs well, it closes in on its intrinsic value target (assuming this isn’t revised upwards). In doing so, it becomes a less attractive investment opportunity and the value rank process will force the holding out of the portfolio in favour of a cheaper company (i.e. one trading at a higher discount) where the upside return potential is greater.
This acquisition was funded by trimming the strategy’s exposure to Fundsmith and Lindsell Train – both of which are trading at elevated historical valuations. By making the switch, not only have we lowered the overall P/E of the strategy, but also introduced an almost entirely unique list of underlying companies – creating diversfiication benefits without compromising on quality.
Elsewhere, we also made progress on our objective to realign the strategy’s bond holdings with the longer-term goals of our growth-orientated investors. We sold out of the strategy’s gilt holding during the quarter and used the proceeds to top-up the position in the Schroder Strategic Credit Fund. We look forward to implementing the final amendments during Q4.
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 lost a bit of ground compared to the broader market, particularly during the last month as the market rotated away from Consumer Staples. In fact, September proved to be a difficult month all-round, with negative headlines seemingly coming to a head: tensions between North Korea and the US reached new heights; various hurricanes devastated the Caribbean and the US southern states; and Brexit progress faced delays.
The majority of the Strategy’s underperformance came from these Consumer Staples holdings, largely attributed to short-term sector rotation factors and profit-taking. However, our selected staples stocks offset the losses slightly given positive performance from both Unilever and Diageo (on the back of improvements proposed following a failed bid and a better-than-expected trading announcement, respectively).
Other strong contributions came from some of our technology and luxury positions, including: Intel, Microsoft, LVMH and Richemont.
These were offset by declines in Walt Disney (due to concerns over ESPN subscriber growth-rates and the impact that the recent hurricanes have had on its Florida-based operations); General Electric (as the Company threatened to cut short its buyback program); and, Medtronic (whose stock fell sharply after reporting solid earnings, but softer-than expected sales).
Shares jumped to all-time highs after the company was the subject of a takeover bid from Kraft Heinz. Whilst the bid ultimately failed, Unilever hiked its dividend, introduced a €5bn buyback program and promised to increase operating margins by 2020.
GE shares slid over operating performance and cash-low production for most of the year. New CEO John Flannery (an insider) is taking steps to protect cash and improve operating performance while he conducts an assessment of the Company.
Source: General Electric
On top of natural disasters, provoking missile launches and presidential threats there was plenty to ponder as quarterly and half-year trading announcements rolled in. The main theme we discerned was how well our companies were exceeding expectations on an earnings-per-share basis; although, in some cases, sales were not quite so inspiring, e.g. Medtronic. Cost-cutting, restructuring, buy-backs and M&A are the themes of the day, which places a question mark over businesses’ ability to grow top-line sales. In this quarter’s Stock in Focus we look at P&G, the US-based consumer staples company, and how it is improving margins and earnings per share in the face of stalling sales growth (and whether these practices are sustainable).
We’re asking these questions at a time when money continues to flow into the equity market, as evidenced by a series of new market highs through the summer. One of the main recipients of this flow has been passive investment vehicles, such as ETFs. According to a recent article in the FT, ETFs have received net inflows of approximately $391 billion from investors in the first seven months of 2017, surpassing 2016’s total net-inflow of $390 billion. ETFs are big business, an estimated $2.5 trillion is thought to have flowed in since the market low in February 2009 – the largest proportion of which has been from US investors.
This got us thinking as to what influence ETFs may be having on our holdings within Blue Chip and whether ETF ownership should create any reason for concern. In our newsletter Should We Worry about ETF’s Increasing Interest in Our Stocks? we looked at how ETF ownership and valuations have changed across the current selection of holdings in Blue Chip between 2009 and 2017.
We observed through the data that the growth of ETF assets did result in higher ownership of the outstanding share capital of the stocks we held. There was a big difference between ETF interest in US stocks and that of their European counterparts, due largely to the differing sizes of each region’s ETF market. However, we could not draw a definitive correlation between ETF lows and rising valuations. That said, the increased level of ownership raises the risk of increased volatility as their exposure to ‘hot-money’ vehicles grows.
Quality stocks – the type we like to hunt for – have been de rigeur since the financial crash, since their strong balance sheets, dependable proitability and subsequent high return-on-invested-capital have been seen by investors as an attractive way to gain market exposure during uncertain times. We quite agree! However, valuations across stocks that display these types of characteristics are no longer cheap, leaving them vulnerable should expectations be missed, or markets slip, for one reason or another. We remain vigilant and will be keeping a close eye on both valuations and the interest of ‘easy come, easy go’ money.
FUND IN FOCUS: TBC...
BY SAMANTHA DOVEY
The fund management team have had a very busy quarter with some new additions to the various portfolios being signed off and many more undergoing the intense scrutiny of our fund research process. Selecting the right funds is a key driver of performance within our multi-asset strategies. Accordingly, and as you would expect, it receives a lot of time and attention within our team. Meeting fund managers is a key part of this process and a quick glance at the diary shows some 12 fund manager meetings on the books for our research trip to the UK in early-to-mid October.
Notable additions to the portfolios include Asian corporate bonds (in the form of the Muzinich Asia Credit Fund) and frontier market equities (via Ashmore’s Emerging Market Frontier Equity Fund). Also under consideration, at present, we have a number of corporate bond funds that we consider could add something to our current suite of funds. Elsewhere, there are more candidates for thematic positions, this time focusing on innovation and sustainability.
As we are part-way through this review process – and we clearly can’t talk about funds where decisions are yet to be finalized – Fund in Focus will regrettably be taking a break this quarter, but return with lots to say in Q4! Watch this space…
STOCK IN FOCUS: PROCTER & GAMBLE
Source: PROCTER & GAMBLE
Procter & Gamble is a global consumer goods company best known for products such as Gillette razors, Tide detergent and Pampers diapers. Domiciled in the US, the Company generates over $16 billion in revenues a quarter, yet it has come under fire of late for low sales growth and poor returns on invested capital. Over the last few years, management have undertaken a restructuring effort to reduce the number of brands within its portfolio by over 100 to just 7080 ‘core’ brands through divestitures and spinoffs. The theory being that with its poorest performing and least profitable brands out of the way, more time and resource can be spent on improving the performance of those that remain.
Source: PROCTER & GAMBLE
Inevitably, revenues have taken a hit as the divestiture/spin-off program draws to a close. However, the Company is struggling to regain traction in top-line sales of its leaner basket of brands. In years past, the Company has been able to hide its lack of performance behind the veil of currency headwinds. However, with the US dollar’s appreciation slowing, the veil is not only fast disappearing, but exposing more fundamental issues. In a bid to appease investors, the Company has turned to margin expansion and buy-backs to improve both its bottom line and earnings per share.
In its latest earnings announcement, P&G’s revenue growth was flat; yet, net income was up almost 14% and earnings per share rose by 19% to $0.82 a share. The Company achieved its ‘productivity’ gains through reductions in advertising spending and restructuring costs. The increase in earnings per share was due to the buying back of a large amount of shares (roughly 115 million) over the previous twelve months.
The question of course is how sustainable all of this is?
To our mind, P&G’s restructuring into a leaner, fitter, better organized company is largely complete, so any comparable benefits of falling restructuring costs will be short-lived as costs normalize. We doubt that the continued cut-back in advertising is a sustainable practice – especially if the Company wishes to grow its top line over the medium to long-term (which we certainly hope would be the case). As a result, we doubt there is much left in the tank to carry on expanding operating margins through cost cutting without a return to top-line growth and a meaningful contribution from economies of scale.
The gains created at the per-share level are even less likely to be repeated. The Company reduced its share capital by a net 115m shares through a $9.2 billion share exchange in its Beauty Brands transaction that was completed in October last year and a further $5.2 billion-worth of direct share repurchases made over the last twelve months. Given that the Company’s free-cash-low has averaged around $910 billion per annum – and is currently committed to paying at least $7.2bn out in dividends (based on the amount paid last year and the fact that P&G prides itself on having raised its dividend for 61 consecutive years) – this doesn’t leave much headroom in the capital reallocation program to reinvest earnings back into the Company while buying back gargantuan blocks of shares. Unless, of course, the Company opts to borrow money, which is a real red flag. Thankfully P&G has not had to expand its balance sheet in order to fund the $22 billion ‘giveaway’ in dividends, share exchanges and repurchases over the last twelve months. However, commitment to the dividend and future growth initiatives should, in our minds, trump stock repurchases – especially at a time when valuations are towards the higher end of their range. Moreover, buying-back stock does little to build long-term value. This is an area where P&G has created a major problem for itself.
Expensive acquisitions from the past, under different regimes, are now weighing on P&G’s value creation – as determined by the ratio called Return on Invested Capital (ROIC). With all hands being turned to stripping out cost, less and less investment is being made to build value. And this has attracted the unwanted attention of activist investor Nelson Peltz.
Nelson Peltz wants seat on P&G’s Board.
In a recent filing, Trian Fund Management disclosed a $3.3 billion stake in the $240 billion company. Mr Peltz, Trian’s founder and CEO, is bewildered by P&G’s lack of growth, value creation and acquisitiveness – the latter of which, Peltz claims, has allowed start-ups to eat into their lunch, eventually ending up in the hands of their competitors. He believes P&G’s challenges stem from its organizational structure and a culture highly resistant to change. At the core of his solution is a plan to re-organize the business into three autonomous units to improve decision making – an unusual (and refreshing) departure from the usual tonic of leverage and buy-backs. A seat on the board, he argues, would allow him to act as a management consultant and to oversee the structural reforms that he believes will reinvigorate P&G’s lagging growth and ROIC.
P&G has pushed back, claiming many of the proposed initiatives are already underway. The two are now engaged in a proxy battle, giving P&G the dubious honour of being the largest company ever to fight one. Size, it seems, is no longer a defence from activism. Whilst proxy fights can be distracting, we welcome Mr Peltz’s attention. For too long, corporate America (in particular) has squandered money on expensive buy-backs that only benefit executives. Perhaps a refocusing of attention onto value creation, as opposed to earnings growth, will keep the attention of future unwanted activists at bay.
P&G shares have largely traded sideways over the last two years. Now, on the brink of hitting new highs, we have trimmed our position as we watch with eager anticipation the outcome of the pending proxy battle on October 10th.
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