Healthly labour backdrop reiterated

The month kicked off with a positive Q2 GDP report, indicating +4.1% QoQ growth. Consumer data was surprisingly strong, with the report suggesting a more resilient consumer profile than some may have expected.

Fund Commentary
25 Sep 2018

The month kicked off with a positive Q2 GDP report, indicating +4.1% QoQ growth. Consumer data was surprisingly strong, with the report suggesting a more resilient consumer profile than some may have expected.

The personal savings rate saw a strong upward revision, potentially representing additional obstacles in terms of overall household cash flow, but more importantly highlighting that consumers are not under as much pressure as this indicator may have suggested. Nonfarm payrolls came in slightly under consensus estimates (157k vs an expected 190k), which is not a concern for the team as the difference can be explained by the upward revisions during pevious months alongside the Toys R Us bankruptcy (stores were closed in the last week of June). So for now, the labour backdrop still looks very healthy and supportive in the Investment Adviser’s opinion.

In August, the Fund posted an absolute return of +2.07%*. The largest monthly contributor was Apple (+0.47%) followed by Centene (+0.29%) and Mastercard (+0.28). On the other hand, Dollar Tree was the largest detractor (-0.40%) followed by Alibaba (-0.18%) and Booking Holdings (-0.13%).

Apple has had a significant run (approx. +30% YTD at the time of writing). The strong performance came as a slight surprise for the team after the Company had previously reported its FQ2 results, which were good but according to the Investment Adviser do not warrant such an upside. In the team’s opinion, the near-term outlook is constructive as the Company could continue to be buoyed by substantial buybacks, an increase in Berkshire Hathaway stakes (indicating positive price momentum), and an upside to FY19 estimates given the view that consensus estimates for iPhone ASPs (average selling price) may be slightly low. Over a longer timeframe however the team is doubtful that ASPs will continuously increase alongside margins and that iPhone replacement cycles will contract rather than elongate. As such, the Fund’s exposure to the Company has been gradually decreased over the course of 2018.

Centene reported its Q2 earnings around the end of July with a modest beat, with management slightly raising its 2018 adjusted EPS guidance. This said, the stock price declined following the announcement, partially due to concerns around risk adjustments and the quality of earnings. According to the Investment Adviser, the Company is in a leading position as a risk payer (paying into the program, not receiving from it), with risk perceived to be more on the upside than downside if the program was to be altered. Furthermore, the team believe that the concern over a lower earnings quality is exaggerated as the Company reported a $79m pre-tax benefit related to a 2017 risk adjustment, consistent with certain prior year adjustments ($48m last year and $70m the year before). The Fidelis acquisition was completed on 1st July, with management stating that this will drive low to mid-teens accretion in the 2nd year (following approx. 10% in the 1st year). The Investment Adviser is supportive of the deal as it complements the business’s strategy. Further, the team believes that Centene’s growth outlook in Medicaid remains unchanged and compelling. As such, the position size has been maintained and will gradually be increased going forward.

Mastercard posted its best results in 5 years in 2Q18 (strongest in terms of earnings and purchase volume growth). This said, the stock lost approx. 3%, most probably due to very high consensus expectations. EPS grew 52% year-on-year against the backdrop of a 15.5% (constant currency) growth in purchase volume. According to the team, the 40% tax-reform adjusted EPS growth is the fastest in approx. 5 years. Volume metrics (the key driver behind the long term earnings outlook) were excellent. Further, purchase volume growth accelerated again to 15.5% (constant currency), compared to the compounded average growth rate of 12%. US volumes (for 1H18) were the strongest since 2011, with cross-border volumes however modestly decelerating from 21.5% (constant currency) during the previous quarter to 19.4% (constant currency), however still remaining above the 5-year compounded average growth rate of approx. 15%. Going forward, the Investment Adviser believes that one key question about the Company will be whether valuations will hold against the backdrop of decelerating revenue and EPS growth. While it is difficult to see any meaningful catalysts that could warrant further expansion in the context of decelerating EPS growth, the Investment Adviser expects continued long-term stock upside from compounding high teens EPS growth.

According to the team, Mastercard (alongside Visa) is with all things considered still perceived as the best investment in the secularly growing payments market, with the duopoly being the cleanest beneficiary of the payments market, enjoying very attractive business models (large competitive moats, operating leverage and low capital intensity) and having sustainable midteens earnings growth. While there are many risks emerging (internet giants, government intervention, competition in emerging markets) none of them appear imminent, with the risks (for now at least) largely outweighed by the longterm optionality in these businesses from expansion in the addressable market, increase in yields (e.g. via an uptick in processing penetration or charging for value added services) and new income streams (e.g. via data based services). The stock has hardly ever been “cheap”, yet the team think that its valuation is far from exaggerated at currently approx. 39x for a mid to high teens EPS quality compounder. Going forward, volume performance and traction of other emerging market players will be of focus for t he team.

Dollar Tree reported its 2nd quarter earnings with great results for the Dollar Tree banner. This said, it fell short again in its Family Dollar stores, with the stock price subject to a downward revision to reflect these concerns. Dollar Tree posted total revenues of $5.53b (up 4.6% year-on-year) during the quarter, slightly below consensus expectations. A large portion of the gain in sales came from the Dollar Tree segment, which delivered 3.7% same-store sales growth, while Family Dollar remained unable to grow, with traffic down. Since the beginning of 2018 the Family Dollar banner has increasingly weighed on overall results – a trend which seems poised to continue as it will be difficult for Dollar Tree to keep offsetting gross margin pressures going forward due to the multi-year “turnaround” plan continuing to disappoint. Pressure will only increase for management to find an alternative route or dispose of the Family Dollar banner entirely. Nonetheless, reservations about selling a business such as Family Dollar before a potential downturn/recession (which can drive more traffic as people become more price sensitive) would not be surprising. The Investment Adviser continues to strongly believe in the potential upside for the Dollar Tree banner, especially if management shifts gear and focuses on diversifying the offering at Dollar Tree stores (by raising prices to include above $1 items). The Fund’s exposure will be maintained, at lower levels, whilst the Company continues to deal with the Family Dollar banner issue.

The views and statements contained herein are those of the Eric Sturdza Banking Group in their capacity as Investment Advisers to the Fund as of 21/09/18 and are based on internal research and modelling.