October proved to be challenging for financial markets

By Eric Sturdza

Fund Commentary
19 Nov 2014

By Eric Sturdza

Following a correction of -9.8% peak to trough, from 19th September’s highs to 15th October’s lows, the S&P 500 Index flared up to set new record highs a mere twelve trading days later, eventually posting its third strongest month in 2014 (+2.32%). 

This “flash correction”, rather benign with the benefit of hindsight, shook markets in ways not experienced since before QE3: the VIX Index, (a popular measure of market volatility) a proxy for hedging demand, reached highs reminiscent of 2011, while treasury markets experienced a level of volatility associated with disruptive events such as 1998’s Russia/LTCM crisis.

Unsurprisingly, forces behind this bona fide correction were an interaction of macro and micro factors; the former were mostly related to global GDP growth concerns with particular emphasis on Europe and were exacerbated by both an underwhelming ECB response and, chiefly, the imminent termination of the Federal Reserve’s Quantitative Easing. A continuing decline in crude oil prices and other commodities (even net of U.S. Dollar strength) provided further worries of falling global demand, correlating with weak German and Chinese industrial productions and reinforced fears already mirrored in the beaten-down forward inflation expectations.

Naturally, the deteriorating news flow relating to the Ebola outbreak accentuated risk sensitivities. On the micro side again, the context was an already fragile one with generally below average liquidity and an important source of equity demand as corporate buybacks slowed as companies entered their pre-earnings blackout periods. Against this backdrop, the record IPO of Alibaba Group (incidentally marking the top of the market in September) coupled with important unwinds by leveraged funds, further pressured liquidity increased risk-aversion. With risk-aversion begetting risk-aversion, the edginess and tight stop-losses of some investors was on display in many forms during the month, including the -7.5% intraday drop of the semiconductors index (now fully recovered) on negative guidance from unrepresentative Microchip Technology Inc.

The Fund performed well during this volatile period, outperforming the S&P 500 Index both during its down leg (ca. +2.1% relative performance) and upside (ca. +0.7% relative performance).

Catalysts for the market’s quick bounce included an initially soothing commentary from the FED (the President and CEO Mr. Bullard’s call for a pause in tapering, which did not materialise), somewhat comforting European Banking Stress Test results and later, a surprise increase in the Bank of Japan’s own QE on the last day of the month. Most importantly, the perception surrounding many of the above-mentioned issues evolved positively. This, together with the oil price fall being seen as a potential consumption tailwind, which when combined with recent constructive US economic and earnings data, appears to be cementing a mild, yet positive growth environment.

The Fund performed well during this volatile period, outperforming the S&P 500 Index both during its down leg (ca. +2.1% relative performance) and upside (ca. +0.7% relative performance). The source of this outperformance was primarily stock selection, with investee company’s high quality profiles generally protecting from large draw-downs and then appearing as bargains when optimism returned.

Further, the Fund’s already decent cash position at the end of September grew in the first week of October, as a result of what was viewed as a somewhat underwhelming opportunity set and often challenging and deteriorating, Momentum/Value tradeoffs. The Manager initially disposed of Resmed and Align Technologies and later in the month, T. Rowe Price Group on soft earnings, and DaVita HealthCare Partners on valuation. The excess cash allowed for additional downside protection and importantly, opportunistic buying in the second half of the month; as such the Investment Adviser was able to initiate positions in highly attractive companies, long on its radar, at discounted valuations such as: Teledyne Technologies, The Walt Disney Company, Polaris Industries, Anheuser-Busch InBev, Constellation Brands and two high quality semiconductors, Skyworks Solutions and Avago Technologies. MasterCard was also added at the end of the month following strong earnings.

As previously mentioned, October also saw the majority of US companies reporting their third quarter earnings. Almost all of the companies held by the Fund published strong numbers which were met positively by the market. Standouts included O’Reilly Automotive, who beat expectations and raised guidance after a stellar quarter on virtually all fronts. Other significant positions releasing earnings such as Apple, Blackrock and Comcast beat consensus estimations and furthered their growth trajectories. Precision Castparts was slightly below consensus, largely due to higher than expected maintenance costs, whilst key numbers remained strong and the additional details provided by management were welcomed by the investment community. The Investment Adviser reduced the position to an equal weight given the lack of momentum, and will look to add to the position as production rates and capital allocation plans confirm their expected hike in 2015. The earning season continues on its strong trend for companies held by the Fund and provides a noteworthy boost to some smaller sized companies, reversing soft price momentum in midcaps during the third quarter (e.g. Credit Acceptance Corp., ITC Holdings and others).
To summarise, October finished as a continuation of the three pillars of:
(i) underwhelming top line global GDP
(ii) central bank activism 
(iii) lack of investing alternatives (as described in the latest quarterly commentary)
The markets corrected on perceived complications in the first two pillars, global growth concerns and fears of the Fed’s QE withdrawal. Besides micro tailwinds, the market rushed back to records on the realisation that non-inflationary growth, now further cemented by the drop in crude, is a comfortable situation thus enabling the Fed to remain accommodative for longer and in that environment, the third pillar makes very few asset classes currently seem to offer a real alternative to US stocks. Despite this, the Investment Adviser remains more convinced than ever of the importance of a bottom-up, risk-averse stock selection process focusing on holding the highest quality businesses, when they are offered at compelling valuations. In this light, the Investment Adviser sees significant potential within the current portfolio and remains on the lookout for new opportunities as they arise.  
Commentary provided by Banque Eric Sturdza in their capacity as Investment Advisers to the Fund as of 11 November 2014