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deFund Performance: In 2022, the Strategic Global Quality Fund outperformed the benchmark by 4.41% with a return of -13.73% compared to -18.14% for the MSCI World Total Return. Overall this is a respectable result in the fact that the performance is substantially better than the index, although disappointing that it is down in absolute terms.
Market Overview
The year 2022 will be remembered by most people as the year Russia started the war with Ukraine, invading the country on 24th February. This had a severe impact on the energy markets, financial markets and the people of Ukraine; together with its neighbouring countries. Europe had not seen such a large-scale war and disruptions since WWII.
From an investor’s point of view, the year will be one to forget, given the down trade in the equity markets combined with a sharp increase of interest rates; meaning the 60 / 40 balanced model also fell sharply as this strategy then lost value in absolute terms. This was driven by interest rate increases from the various central banks – not least the Federal Reserve of the United States – as inflation was no longer seen to be transitionary. The US Dollar strengthened during the year as is normal during times of political uncertainty and US Dollar liquidity was reduced.
Portfolio Strategy
The Fund employs a bottom-up stock selection strategy with a strong preference for high-quality business models, as evidenced by high margins at the operating level and / or return of capital employed, ideally combined with visible revenue streams. The aim is to buy these types of companies at a discount to their intrinsic value. Accordingly, the sector allocation is a consequence of the investment process rather than a driver of it.
Typically, the portfolio will have a structural bias towards sectors such as Consumer Staples, Healthcare, Consumer Discretionary, IT, Media and Support Services, while normally avoiding the Commercial Banks, Insurance Companies and Commodity sectors.
At the sector level, the main contributor to performance was the underweight exposure to the Technology sector (13.8% for the Fund versus 21.6% for the benchmark) combined with good stock selection, giving a total alpha of 2.9%.
Similarly, the relative underweight exposure to the Consumer Discretionary sector, combined with good stock selection, contributed 2.6%.
Thirdly, the structurally overweight exposure to the Consumer Staples sector contributed 2.0%; and finally, the overweight exposure, combined with stock selection in the Energy sector, contributed 1.6%.
Stock selection in the Healthcare sector was not so good at -1.8%, while the structural underweight to Financials contributed -1.3%, given the background of rising interest rates. The three top stocks during the year were McDonald’s (+0.92% attribution), Visa (+0.71%) and Schlumberger (0.70%).
McDonald’s is executing well on its strategy of staying relevant to the consumer (simplification of the menu as well as quality improvements), with additional lessons learnt during the COVID period. Importantly, McDonald’s is a beneficiary of recessionary trends as people trade down when eating out and thus is normally very stable during difficult economic times.
Visa remains well-positioned to benefit from the long-term structural switch from cash to card, as well as from physical to online shopping. Moreover, a large part of its business is related to travel (and cross border) and thus has benefitted from re-opening, post the COVID shutdowns. Lastly, its revenue streams are a function of the prices paid and has thus benefitted from inflation.
Schlumberger contributed 0.70% during the period. The period of underinvestment in the fossil fuel space due to governmental pressure to focus on renewables means that the world is facing a dramatically tightening situation in its traditional sources of oil and gas. The politicians seem to have forgotten that, without energy, the transition to renewables will not happen, even if one can overcome the intermittency of renewables (which we have not done yet).
Accordingly, the end markets of Schlumberger are undergoing a resurgence, and as the world’s leading player in the oil service industry, Schlumberger is well-positioned to benefit from this. During recent years, the company has positioned itself more towards engineering / software solutions with the exit from US drilling activities.
The focus on offshore oil is good for Schlumberger, especially while the Middle East is undergoing a huge investment programme. The company expects to grow its top line by double digits for some years.
On the negative side, it is worth mentioning three names: Meta (-0.73% attribution); Siemens Healthineers (-0.72%); and IFF (-0.65%). Meta derated sharply during the period due to a combination of an expected slowdown in revenue growth, increased competition from Tik-Tok and high levels of investment in the Meta space.
In particular, the market did not like the approach by Mark Zuckerberg to continue investing heavily in the Meta space while the top line was under pressure, resulting in a sharp drop in profits. The position was sold at a loss while we wait for the top line to improve and / or for the priorities of the management to change.
Siemens Healthineers was impacted by several factors: the large selling of European equities by investors based outside Europe; the ongoing chip shortage affected its production of various products with implications for operating margins and rising interest rates impacted highly valued stocks. We like the structural positioning of the company and will be following developments closely.
IFF, a world-leading ingredients company, continues to struggle to deliver, which resulted in a CEO change during the year. The integration of the Dupont business should lead to a better company overall and the trend towards consolidation in the sector was confirmed by the subsequent merger of Firmenich and DSM.
The stock struggled during the year given the sharp strengthening of the US Dollar, as 75% of its operations are outside the United States. In addition, the fact that they are still somewhat highly geared meant that the rising interest rate background also impacted the valuation the market is prepared to put on it. We take the view that with time these issues will be overcome and that the company should deliver the expected compounding returns.
During the year, we carefully considered how to better incorporate ESG principles as required under the Article 8 categorisation of the Fund. Using input from Sustainalytics, the Fund has reduced its investments in companies where ratings showed underlying issues – specifically, we do not really believe in the “transition investment cases”.
Most significant was the disposal of holdings in the major oil companies which are unlikely to come back. Together, with some other fine-tuning, this has led the Fund to gain an additional globe from Morningstar, to end the year with a four-globe rating.
Outlook
The markets have seen a rally from the October lows, and the news from the Federal Reserve that the next rate increases will be at a slower pace has put fire into the financial markets. That said, we caution strongly against getting caught up in the news of the day.
The war in Ukraine shows no sign of ending, with expectations of increased Russian activity in the coming weeks. At the end of the day, Russia (Putin) has no qualms about losing hundreds of thousands of soldiers and it may just become a war of attrition – which country is prepared to lose more people?
History shows that recessions are nearly always induced by the Federal Reserve as it raises interest rates too far and it is not clear why this time should be any different. The lagging effects of the sharpest interest rate increases, combined with QT, are yet to be seen given they normally take 18 / 24 months to materialise. It remains our view that the United States and Europe will likely be in a recession during 2023, and thus, continued caution remains warranted.
As always, we invite investors and prospects to contact us should they wish to receive any additional information.
Adam Turberville
Director
+44 1481 742380
a.turberville@ericsturdza.com
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The views and statements contained herein are those of Lofoten Asset Management in their capacity as Investment Adviser to the fund as of 06/02/2023 and are based on internal research and modelling. Please click on Disclaimer Page to view full disclaimers.