BY ERIC STURDZA
The month of October was very strong for the S&P 500, rebounding back to its former highs and recording one of the top 10 best monthly performances since 1928. The Fund significantly lagged the index on this rebound, partly held back by a handful of companies reporting below expectations and partly due to dramatic leadership shifts in the market in favour of groups outside of the Fund’s universe or preferences – cyclicals and bond proxies, to name a few. The Investment Adviser does not expect these unfavourable dynamics relative to the benchmarks to persist, and continues to follow its philosophy and process focused on quality secular growth companies at undemanding valuations.
The month of October saw markets, at first still shaken by the August-September volatility, spring back to life and reach pre-August 24th levels, recording the 8th best single monthly performance since 1928. The lead by Basic Materials (+13%) and Energy (+11%) surprised, especially given the backdrop of neutral to negative marginal commentary on global growth, the lack of support from the commodity price curves, and a weak set of numbers and tone from the industrial complex. In a now infamous quarterly call, the CEO of a major industrial company stated that “the industrial environment is in a recession […] I don’t care what anybody says because nobody knows that market better than we do […]”. While the Fund’s universe precludes investing in the majority of such names and often rotations in their favour sets a higher bar for outperformance, the Investment Adviser does not believe the current context to be supportive of such themes over the long-term, and thus expects these relative headwinds to abate. The same conclusion follows for the Fund’s preference for domestic companies selling in USD, and other themes proving, currently, to be relative headwinds. The Investment Adviser’s current circumspection towards most cyclicals should not however be extrapolated to the whole of the US economy, as many service and consumer-facing companies continue to show good numbers in Q3. This well-documented dichotomy finds its reflection in the divergence between ISM Manufacturing (neutral, below expectations) and the ISM Services level (indicating accelerating expansion).
The majority of the Fund’s companies reported earnings in October, with the bulk of them continuing to show impressive earnings momentum and delivering results above expectations, such as Google, Signature Bank, Apple or Express Scripts. Some companies reported below expectations, falling victim to underwhelming end-market demand (NXP Semiconductors) or increased costs. In both cases, while the market’s punishment was severe, it did not upend the Investment Adviser’s longer term thesis given the existing sources of growth, and as such triggered sizing adjustments but no outright exits. Valeant Pharmaceuticals also published earnings above expectations in October. As the scope of allegations against them and their distribution partners continued to widen and made the recovery more of a binary event, the Investment Adviser had to come to the conclusion to close the position. While recognising the potential for repercussions of the Valeant debacle on other players and providers, the decision was made to maintain the Fund’s position in Allergan while limiting a significant portion of the downside should the most recent catalyst, i.e. the politically sensitive discussion to merge with Pfizer, come to no mutually beneficial conclusion.
The Fund is retaining a defensive position given the unconvincing October rally exhibiting strikingly low breadth and the generally challenging environment for business in Q3. Many companies nevertheless continue to outperform operationally, but valuations, especially on the eve of a rate normalisation process are a factor which continues to pressure the universe of desirable investments on a risk-adjusted basis.
The views and statements contained herein are those of Sturdza Private Banking Group in their capacity as Investment Advisers to the Fund as of 18/11/15 and are based on internal research and modelling.