BY ERIC STURDZA
The month of February was challenging for equities around the world. The MSCI US Index finished down -30bps, yet was down -6% around the middle of the month. The Fund underperformed its benchmark by 1.4%, mostly due to its portfolio of IT companies, some of which are discussed below.
At its worst, the market was pricing- in a steep deterioration of the economy which, as in January, was not supported by current available data. GDP was revised slightly higher and while most industrial and consumer data continued to be uninspiring, with some signs of stabilization towards the end of the month (e.g. core durable goods orders), employment continued once again to be rather solid and inflation showed signs of life. More S&P 500 companies reported earnings, generally without fanfare, but once again this does not explain the volatility experienced in February.
REFLECTIONS ON THE CURRENT ENVIRONMENT
The current regime emerged in late summer 2015, and the second half of the year proved to be the polar opposite of the low-volatility, steady positive appreciation of the first half. The pandora’s box of an un-omnipotent Federal Reserve was de facto open with further evidence that inflation, whether core or non-core, was continuously lagging alongside measures of real economic activity, particularly in the so-called “old-economy” where manufacturing and industrial companies reported continuous deterioration. While strength in the job market continued to be welcome, it was increasingly lonely in exhibiting steady improvement rather than a diminishing rate of change. The Federal Reserve’s decision to proceed with the first Fed Funds rate increase in nine years thus came at somewhat of an awkward time. In stark contrast to the hiccup of autumn 2014, the Fed wasn’t alone in its move to a marginally less dovish stance. Both the European Central Bank and the Bank of Japan, expected to significantly up the ante in terms of accommodation, came-in slightly more measured, thereby inflicting significant levels of volatility in the currency markets and a dose of uncertainty for European stocks. Further devaluation of the Renminbi, coupled with more evidence of weakness in Chinese economic activity, added fuel for global growth pessimism. While historically considered growth friendly, further record oil production by OPEC did not this time enthuse the financial world, as behind this increasing consumer surplus lies a more fractious and unstable geopolitical reality, further deflationary expectations formation, and mounting financial difficulties for energy companies worldwide – and their industrial suppliers. As mentioned in the past, an important key to further benign and positive US equity markets resided with the American consumer, and so far, he/she has not responded to this increase in purchasing power as strongly as hoped/expected.
So far in 2016, a number of Central Banks have done their utmost to backpedal and renew pledges of unbuffered support, but the diminishing returns to quantitative easing as well as the skepticism facing the implementation of negative rates has tempered the markets’ optimism in the face of once again indecisive macroeconomic indicators. At the time of writing, Mr Draghi’s willingness to maintain his credibility has just been reconfirmed, with extraordinary measures put in place to facilitate credit flows in the European Union, and while the message is certainly welcome by markets (and corporate bond traders), few investors are dialing down their questioning of “what next?”.
During the transition described above, the Fund, while holding on to its relative outperformance in the third quarter, significantly underperformed in the last quarter of 2015 and this trend has not yet turned in 2016. This underperformance is, no doubt, disheartening. Its causes are diverse, and style certainly was to blame, but in the end it reflects a stock selection that fell short of the challenges posed by this transition of regimes. Indeed, the universe of stocks as defined by the process underperformed the market as a whole, but cannot explain the entire variance. While some of the Fund’s positions encountered unfavorable developments which undoubtedly warrant revisions (e.g. McKesson, Express Scripts), a significant number of companies experienced a detrimental de-rating which was, in its intensity, at odds with the Investment Adviser’s expectations. Apple’s de-rating to one of the lowest valuations for a mature tech company would be just one example of this phenomenon. And certainly, a price was paid for holding some exposure to midcap companies and for generally being involved in companies overweighted among the mutual fund world, as the pickup in redemptions reverberated across many popular stocks, especially in healthcare. The absence of a few strong outperformers in that period also failed to provide respite to the Fund’s relative performance, as positive catalysts found subdued market responses compared to the recent past (e.g. Jarden acquisition by Newell-Rubbermaid, Allergan’s planned acquisition by Pfizer, etc). Despite de-ratings, virtually all of the Fund’s main positions have not been challenged in their original investment theses and are thus still held under the same underlying assumptions as discussed in previous communications (e.g. Apple, Amerco, Avago, Cognizant, MasterCard, Signature Bank, Skyworks, Universal Health Services, Visa, etc.).
The earnings growth rate of the companies held in the Fund continues to be significantly superior to that of the market, and consensus earnings per share growth for the portfolio stands in the mid teens for both 2016 and 2017. In an earnings season generally recognized as having been on the weaker side, Q415 and Q116 earnings surprises for the portfolio’s companies were not as stellar as in the past, yet growth remains in impressive territory, and it is the Investment Adviser’s belief that these companies remain in position to deliver strong returns based on their current specific dynamics. As always, the Fund will be managed in-line with its bottom-up process and the efforts will be focused on isolating the best growth companies trading at reasonable valuations and capturing over time the earnings growth they deliver to their shareholders. While the nature of the Fund will place it at a disadvantage should cyclical rebounds materialize, opportunities are forming in secular growth segments where valuations have compressed in spite of positive fundamental developments, setting the stage for investors such as the Fund to deploy cash in compelling risk/reward situations.
OVERVIEW OF SELECT COMPANIES
Alphabet, the parent company of Google, reported expectations-beating numbers, one of the few companies in the S&P 500 to show not only strong but accelerating revenue growth in the last quarter of 2015. The search engine business, increasingly used on mobile devices, continues to generate immense profitability, and while already large and ubiquitous, remains on a 20%+ p.a. revenue growth trajectory and 80-85% incremental margins. By demonstrating its ability to control capital expenditures and grow revenues, the company has impressed upon the world the attractiveness of its established businesses’ economics and earned a higher level of tolerance from shareholders for their higher risk development portfolio aptly called “other bets”. In so doing, the company was also able to re-rate to higher multiples in-line with sturdier assumptions of durability. Besides resilient profitability and better than expected capital efficiency, a critical aspect of durable growth is the still strongly expanding addressable market, as dollars spent on online advertising (and online video in particular) are still a fragment of total spend, and still very much disconnected from the changing consumer habits (increasingly favoring computer & mobile screens over traditional television and print). Alphabet should be one of the winners in this ongoing, multi-year migration. With close to 20% EPS growth expected in the coming years from firm positioning in secular growth trends, more than 10% of the company’s market capitalization in net cash and a strong innovation culture, the Investment Adviser continues to deem Alphabet’s valuation (PE ~26) reasonable and a compelling risk/reward, and expects the shares to outperform again after an unexciting performance so far in 2016. Alphabet is a top 5 position for the Fund.
Avago, now officially called Broadcom following the latter’s acquisition by the former, announced strong results and a steadier guidance than expected. Given the deal’s official close in February, the new combined entity is just emerging, with a positive surprise mainly due to strong cost controls outplaying the soft revenues linked partially to Apple’s iPhone deceleration and a generally soft macro environment. Clearly, the medium-term playbook for “New Broadcom” revolves in large around further cost controls while at the same time maintaining their leading position in their end-markets (some of them still experiencing double digit multi-year growth). Despite management’s cost cutting track record, the multiple has contracted in 2H 2015 on fears of end-market softness, most commonly associated with China’s economic slowdown and the slowing replacement cycle of smartphones globally. Although destocking and a slowdown in telecom infrastructure spending did affect the industry, important drivers of medium term top-line growth (e.g. for RF, chip complexity derived from increasing data consumption) remain intact, while the industry’s consolidation (e.g. for RF, only 3-4 major players worldwide) protects profitability, as New Broadcom’s 40% operating margin target attests. Further, New Broadcom’s product portfolio will now be vastly more diversified than in the past, diluting the volatile smartphone product cycles: next quarter’s guidance testifies to this, with now 70% of sales outside of mobile devices driving the company’s growth in a period where competitors linked to Apple are still seeing inventory adjustments. Going forward, execution of the synergies plan will be key, especially if the macro environment dampens emerging market consumption. The Investment Adviser believes the secular tailwinds for this company remain in place, and that the New Broadcom’s technical excellence, diversification, competitive position and focus on efficiency should help their multiple (currently around 14x consensus 2016 EPS) at least stabilize. While having been reduced in size in H2 2015 to reflect the volatility of the stock and its correlation to other portfolio companies, New Broadcom remains a holding for the Fund.
Citrix Systems is a new addition to the Fund. The company, known especially for its popular desktop virtualization services, is in the midst of a significant transformation aimed at regaining focus on core products and simplifying operational structures to cut costs and climb back to typical profit margins seen in the sector. Having enjoyed regular low teens EPS and sales growth for many years, revenue deceleration since 2013 pressured the company into rethinking its model, culminating in last year’s new strategic vision and change of CEO. Since then, the company has started showing notable progress on profitability and announced plans to spin-off non-core assets. In Q1 2016, it announced the third quarter in a row of remarkable margin expansion, and stabilizing revenue growth. Given the further growth of the addressable market, a strong suite of existing products with leadership position and a newly refocused management team, the company’s multiple of ~16x consensus 2016 earnings does not reflect much anticipation of further durable margin expansion or return to high single digit revenue growth, which the Investment Adviser believes creates a compelling risk/reward proposition. This year’s stockmarket volatility gave the Fund the opportunity to enter Citrix after their expectations-beating earnings report had added more evidence to the viability of this new trajectory, at prices compressed by general negativity towards IT companies. Given these “fortuitous” conditions, Citrix, while remaining an
average weighting, is a top contributor to performance so far in 2016.
Comcast, a significant position for the Fund for many years, continued to report strong operational numbers in Q1 2016. While the cable industry is in the midst of regulatory changes, continued consolidation and emerging competition from alternative video delivery systems, Comcast reported increasing video subscribers due to the popularity of their X1 set-top box, strong growth in high speed data subscribers, and continued strong performance all across their NBC Universal business. The performance gives credence to the thesis that while competition is fierce, a) leading products in terms of technology, convenience and content breadth can still attract/retain video subscribers, b) enterprise clients as well as private customers willing to limit themselves to alternative video delivery still need high speed, reliable internet access (which carries much higher incremental margins for Comcast), c) NBC Universal continues to develop into a highly profitable unit which provides a natural hedge in a world where content costs continue to rise for cable providers, a significant differentiator relative to Charter, Time Warner Cable etc. Further, the theme parks business continues to deliver impressive profitability. The decision to buy a majority stake in Universal Japan, mirroring Disney’s theme parks expansion in China, demonstrates the ongoing shift towards Asia for the entertainment industry and the many growth opportunities remaining on that side of the income statement. The stock’s attractive risk/reward seems currently more a function of its strong strategic and financial position than its imminent potential upward surprises. Consensus expects around 10% EPS growth for 2016, and given the likelihood of a Charter-TWC merger, chances for meaningful external growth contribution are low at this time. This places Comcast on the lower end of our preferred spectrum for growth, yet its discount to peers, its ongoing strong free cash flow generation, its cheap sum-of-the-parts value and its historical track record keeps the Fund invested. Given its defensive characteristics, its ongoing operational performance and the significant weighting in the Fund, Comcast is a top contributor to performance so far in 2016.
Alliance Data Systems’ (ADS) quarterly results came-in above expectations, but with the surprise resulting from non-operating factors, in this case a more favorable tax rate. Overall, while some softness in the private label cards business and pressures from Canadian Dollar revenues were evident in the fourth quarter, 2015 on the whole was a strong year for the company, with earnings-per-share growing close to 20% and further important steps continuing to be taken in promising growth avenues. Nevertheless, the company’s guidance for 2016 sparked an important price correction. Revenue growth of 12% (constant currency) was left unchanged as management pointed out that the abnormally low charge-off rates would need to head back towards historical norms, something most investors expected but were hoping would still be a few quarters away. Following the 20%+ drop, the company announced an increase of the buyback authority to a total of $1bn and, a few days later, a new contract win with Shire. ADS, since its origins as JC Penney’s card processing unit in the late 90s, has become a marketing powerhouse with key assets covering multiple aspects of the business-to-consumer relationship, spanning from loyalty programs to private label credit cards to online advertising. The company’s focus on acquiring and developing seemingly distinct yet complementary capabilities and working towards integrating them remains a powerful long-term vision as complexity increases and retail margins erode. The strong in-roads made with top retailers, and the early signs that specialized knowledge and cross-selling opportunities are increasingly leveraged within the organization remain key positives for the company’s long-term prospects. And in this regard, an important milestone was reached this quarter by showing that Conversant, a significant acquisition closed in 2014 (online marketing company) was finally back to growth and winning contracts with existing ADS clients. In all likelihood, using management’s expectations for trends in charge-offs, continued on-plan performance for other divisions, and the impact of some of the recently increased buy-back authority, the company could well increase earnings per share by 15% in 2016, which at a PE ratio in the low double digits last seen in 2008-2010 should be considered attractive. Long-term prospects are central, and in this regard the Investment Adviser feels enthusiastic about ADS’s relevance, durability and ability to grow profitably in the future given its leading expertise and strong integrated model and inevitable migration of advertising spend towards more complex, targeted, multi-channel solutions. As a top detractor in 2016, Alliance Data Systems remains an average weight position in the portfolio.
The views and statements contained herein are those of Sturdza Private Banking Group in their capacity as Investment Advisers to the Fund as of 18/03/16 and are based on internal research and modelling.