Uptick in market volatility and return dispersion anticipated


25 Apr 2018


The correction of US equities in February, which was more technical in nature than anything, spread to March as political drama came to the fore.

Fears over tariffs and the possibility of a trade war were further exasperated by the departure of Trump’s Head of the National Economic Council (Gary Cohn) – an individual largely perceived as a voice of reason within the Trump administration. Nonetheless, the probability that this ends in a broad trade war is low in the Investment Adviser’s opinion.

The team further thinks that a considerable escalation from this point is needed to justify the stock market’s previous reaction, as for now, it appears highly unlikely to shift the course of fundamentals in the economy. Indeed, the market is (at these levels) seemingly pricing in a worst case scenario, which – if correct – justifies current levels, that practically price out all positive consequences from the tax cut.

With the real 10-year yield still trading around 73 bps (thus monetary policy remaining far from restrictive) and the S&P 500 trading on much lower forward PE multiples, the Investment Adviser sees compelling upside from these levels given current available data.

In March, the Fund returned -0.99%, outperforming its benchmark by 1.49 percentage points. In terms of stock selection, Shire Plc. was the largest monthly contributor followed by Allergan and Constellation Brands (+0.71%, +0.31% and +0.16% selection effect respectively).

As mentioned in the previous commentary, the Investment Adviser has seen Shire as significantly undervalued in recent months. As such, it was not surprising for the team to hear that the Japanese pharma firm Takeda is officially considering making an offer for the diversified rare-disease-focused Company. Until a confirmation is published, the Investment Adviser will keep an eye on the Company, which on a standalone basis still offers a very compelling risk/reward profile- even after adjusting for the announcement.

In the Investment Adviser’s mind, the deal is most probably motivated by Shire’s extremely attractive valuation and the fact that both firms have a significant footprint in Massachusetts. What is interesting to observe here is how the Fund’s selection process (designed to select companies with track records of outperformance) yields a portfolio of companies that are earning compounders and have a strong tendency to operate in niche markets. As such, they build a moat around their business, resulting in an interesting valuation cushion. If this range or level is breached (as seen with Shire or NXP Semiconductors) it very quickly yields a compelling takeover situation. After all, who wouldn’t want to buy a market leader that has developed a moat around its business and is trading at a large discount to fair value?

Constellation Brands reported a year-end EPS of $1.90 (+28% YoY), ahead of consensus by approximately 8.9%. The firm’s beer business remained impressive, with sales having grown 12% in the quarter, driven by a 10% increase in shipment volume. Management also provided a first outlook for FY19 EPS of $9.4-$9.7, slightly more favourable than anticipated.

The stock currently trades around 28x their trailing 12 months EPS, which can appear expensive, but once compared to peers or the Company’s expected growth rate it does not. Nonetheless, the Investment Adviser does not see much more room for a further expansion of multiples but is expecting shares to appreciate behind high single digit top-line growth and double-digit EPS growth in FY19.

Additionally, the consumer packaged goods environment is very challenging at the moment, with the current quarter likely going to be difficult for staples as a whole. As such, it wouldn’t be surprising for the Investment Adviser to see some share appreciation over the next couple of weeks as investors re-appreciate the solid results compared with lower performing peers.

All in all, the Investment Adviser strongly believes in the compelling risk/reward profile the Fund offers on both, a relative and absolute basis. Additionally, with stock correlations at noticeably low levels (on a historical basis) and a macroeconomic environment marked by increasing uncertainty, the Investment Adviser believes that an uptick in market volatility and return dispersion is to be expected and should make 2018 more favourable for stock pickers.

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 13/04/18 and are based on internal research and modelling.