BY ERIC STURDZA
The second quarter of 2015 carried a few interrogations. Whether regarding the US domestic economic impact of the most recent market disruptions (commodities prices, US dollar strength), the underlying causes behind a negative GDP growth in the first quarter, the Federal Reserve’s ability to raise interest rates for the first time in almost ten years, the impact on international markets of said monetary policy decision, the consequences of increasingly evident dysfunction amongst EU member countries, or a difficult boom-bust-like transition for the Chinese stock market, many US investors found themselves reflective, oversupplied with questions but shortchanged on answers.
With corporate results steady but not overwhelming and valuations on aggregate, considered reasonable, the S&P 500 followed suit and closed the second quarter at 2,063.1, just 0.2% above its 31 December 2014 mark. The Fund outperformed the market again in Q2 and thus generated +5.7% in the first half of the year.
Clearly, while the Q1 slowdown had signs of being an aberration, some important indicators of activity showed a gentle upturn rather than the expected bounce. In April, a first estimation of GDP growth coming out at 0.2%, much below most expectations, showed the US economy hurt by trade and the drop in the energy capex, with little compensation from the supposedly enriched consumer. But core CPI, bucking the deflationary trend of energy and strong US dollar, rose more than expected, helped by the housing market and sparking hope that this critical piece of the economy could be gaining strength, a hope eventually supported by data for the remainder of the quarter. Steady employment numbers and comfortable financial conditions also lent credence to the outlier nature of Q1 and to the ongoing belief that the economy, while not a firm as many would hope, remains on track.
The US equity market remained generally well-behaved, and traded in one of the narrowest ranges of its history, even with the Greek bailout negotiations and the Chinese stock market rout spoiling the party towards the end of June. At present, while the Greek situation has come to an ephemeral stabilisation, questions around the impact of the crash on China’s real economy remains a topic of discussion, especially given the extraordinary (in the western world’s view) steps the government has taken to curb it. Needless to say, the diagnostic and prescribed treatment varies widely from one observer to the other, most clearly depending on whether he/she sits in New York or Hong Kong. The number of people affected by the isolation of the domestic market from the rest of the financial world and the types of median amounts lost would suggest not just the absence of systemic risk but also a rather benign effect on the real economy. Some anecdotal evidence of decreased spending on luxury items –although difficult to untangle from a general slowdown and the ongoing anti-graft campaign – would suggest some hit or delay or discretionary spending. The strength of the response by the government further breeds distrust and paranoia around the true state of the economy and/or moral hazard begetting eventual imbalances. Whether these fears materialise will without a doubt be the topic of discussion for the coming months.
The “three pillars” which lie at the heart of our global perspective continue to be more central than ever, with global growth being revised down, validating continuous central bank activism, itself suppressing yields on assets globally starting from those with the lowest risks and leading to a dearth of investment alternatives. In these uncharted waters, the net result remains unconvincing risk/reward propositions, most severely in fixed-income (with the obvious extreme example of negative rates on some sovereign bonds). In this general state of affairs the US equity market still appears the cleanest of dirty shirts. But more importantly, it is critical to consider the “US equity market” for what it is: an amalgamation of vastly different companies, each facing specific sets of challenges, opportunities and uncertainties and responding with varying sets of competencies, assets and ultimately degrees of success. When markets trend strongly, common factors are the dominant force behind it and often with good reasons. Conversely, when no single macroeconomic development seems potent enough to lift markets, investors eventually return to paying more close attention to the specifics. That the market as a whole lacked direction in the first half of 2015 should not belittle the many impressive achievements of individual companies, many of whom are innovating, selling and expanding profitability at the highest rates of their histories, all the while demonstrating a mixture of discipline, strategy and operationa
l excellence. When focusing on businesses with a stellar track record of persistent growth but then opting out of those already “priced for perfection”, such times of indecision can yield compelling opportunities overlooked by investors focusing on heterogeneous averages. The old adage that “one can drown in a river on average two foot deep” should indeed also note that one can comfortably play racket-ball in a river that is on average, 100 foot deep. The point as always is to determine which is the right bank. It is the Investment Adviser believes that the current portfolio remains highly attractive, populated by leading companies with multi-year growth runways making their valuations – often similar to the market averages – suggest very attractive rewards compared to their inherent risks.
OVERVIEW OF SPECIFIC COMPANIES
Comcast experienced a tumultuous second quarter as increased pushback from the Federal Communications Commission (FCC) and rumors of further hurdles and delays being planned by the authorities, eventually got the better of Comcast’s management, who decided to walk away from the purchase of Time Warner Cable (TWC). Clearly, the combination would have been a major coup for Comcast, and its abandonment was both surprising and disappointing for the wide majority of investors and analysts, (many of whom had long considered it a done deal). The Fund has been a shareholder in the company for years and as mentioned in our Q4 2014 commentary, considered the TWC acquisition, (given Comcast’s stand-alone valuation,) a cherry on one of our favourite cakes; it did not however, consider it as a sine qua non for the investment’s attractiveness. Had it been the case, the investment would have become speculation, which would have made it antithetic to the Fund’s philosophy. In fact, as far as early 2014, by following the process, the Fund even briefly divested its stake in Comcast after the news of the intended merger was announced and the stock climbed substantially, discounting too much of an uncertain benefit too soon. The position was then bought back once the stock had found pre-announcement levels and valuations. Since, the investment thesis has always remained predicated on the firm’s standalone attractiveness and its share price performance legitimised by nothing more than its own earnings trajectory. Accordingly, the Investment Adviser was pleased to note that the market quickly agreed and reversed the temporary and rather shallow slump following the cancellation of the deal, to finish the quarter at +6.5% and H1 2015 at +3.7%. Without a doubt, the firm’s robust earnings published in May played a role in affirming investors’ belief in the stand-alone stor, and so did their ability to now deploy even larger share buybacks (4.5% of market capitalisation for 2015). With virtually all business units surprising positively and most notably NBC Universal continuing its impressive turnaround, the Fund also remains upbeat. Further, with a dominant offering, additional sector consolidation and management’s track record of strategic acumen, all at a valuation discount compared to its peers, Comcast remains a position in the Fund’s portfolio.
In Q2 the Fund returned to a previously held position, Universal Health Services (UHS), a hospital network with operations mainly in acute care and behavioral health. Having benefited from: (i) the wider penetration of health insurance following the Affordable Care Act and consequently greater access to acute care hospitals for the masses; (ii) a strong rebound in the southern states where it is most active- including Nevada; (iii) ongoing trends of aging populations and obesity which contribute to exponential use of hospital services and (iv) continuous growth in behavioral (psychiatric) needs compared to the relative scarcity of the offering, the company showed consistently strong numbers in the past quarters, and great promise for the coming years. By operating in mainly two different end markets, the company tends to suffer from a mild case of conglomerate discount, with the total entity valued below the likely sum of its parts, providing an enjoyable valuation cushion especially interesting in a company with a strong capital allocation track record including share buybacks. A further valuation cushion was on display in Q2 as the ruling by the Supreme Court regarding the legality of the federal exchange was approaching given the (mostly temporary) setback in insurance availability it could create in certain states, should the Court deem it unlawful. Much more relevant to the large acute care hospitals and geographically localised in its impact, this uncertainty was limited economic concern for UHS, yet Hospitals as a group were held back in their valuations awaiting the ruling. In the last days of the quarter, the Court reaffirmed the validity of the clause, providing a leg up for the sector. While this catalyst was welcomed as it contributed to the Fund’s performance, the investment thesis again was and remains predicated on the company’s own dynamics: With an EPS growth track record above 16% for the past ten years, a defensive business in a consolidating industry, a strong cash generation combined with a history of adroit capital allocation, further tailwinds for revenue growth complemented with high incremental margins, the Investment Adviser continues to consider UHS common stock as an opportunity at a trailing PE of 22 and trailing EV/EBITDA of 11.
Actavis, now known under the name Allergan, remains a top position for the Fund at the end of the quarter, with changes to the Investment Adviser’s thesis discussed in Q4 2014. After multiple transformational mergers in a few short years, the company took the quarter to focus on integrating the legacy Allergan businesses and fine-tune its new organisation now officially in business under the name Allergan and ticker AGN. The company reported earnings above expectations, provided strong medium term views now including the consolidated entities and an aspirational $25 per share EPS goal for 2017. Further in the quarter, the company announced its newest tuck-in acquisition, Kythera, in a $2.1bn deal which will further strengthen its aesthetics business. At the time of publication, the company just confirmed its intention to sell its lower-growth generics business to Teva for $40.5bn, implying around 6x Sales and 17x EBITDA, i.e. a higher valuation than the rest of its fast growing business. Impressively opportunistic on many facets, the deal notably does not include the promising biosimilars department. The market now will focus on the uses of this additional dry-powder and given management’s track-record, it would be remiss not to grant them the benefit of the doubt. While further large transactions are certainly on the table, share buybacks could potentially also serve to meet the aspirational EPS goals of 2017, a testimony to the multiple options now available to management. With a defensive business, a robust platform of existing products and the ability to integrate smaller tuck-in acquisitions, visible growth in the coming years, a world-class management team with multiple capital allocation options and a valuation below its lesser-growing peers, the Fund currently remains an investor in Allergan and expects further upside on the medium to long-term horizon.
Commentary provided by Sturdza Private Banking Group in their capacity as Investment Advisers to the Fund as of 11/08/15.