BY ERIC STURDZA
On the cusp of the New Year, we looked back in awe at 2014 and at how distinct it had been, citing a barrel of oil cut in half, further appreciation in bond prices and a sub 1.2 EUR/USD exchange rate. Clearly, the financial world had some more in store: unbending production pressured oil further, global demand for yield pushed the US 10-year bond further down, all the while the divergence in monetary policy between the US and the rest of the world led the US Dollar higher against virtually all other currencies (with a brief exception being of course, the Swiss Franc).
The “three pillars” which lie at the heart of our global perspective have become even more prominent in the Q1 of 2015, with:
Underwhelming global growth, on aggregate, extending its disappointing track record,
Central bank activism continuing with a dovish Federal Reserve and an unleashed European Central Bank, and
A lack of investment alternatives, as most strikingly observed in Europe with negative bond yields on many sovereigns and some corporates, and a flaring up of the equity market.
A closer look at some of the important dynamics of the first quarter has to encompass both the evolution of economic data and that of currencies, both of which require global considerations. Clearly, growth in economic activity weakened from above trend at the end of 2014 to below in Q1 2015. The first signs materialised early in the year and did not revert to “normal” levels as of yet. While it is always difficult to meaningfully dissect contemporaneous, unrevised data, it is impossible to escape the fact that once again economic activity has been underwhelming and has not maintained its comforting momentum. Retail sales started to disappoint early in the quarter with the first signs of weakness in the December data published in January. Employment numbers came in mixed, with a strong positive surprise in the January data but followed by volatile numbers in the months thereafter and most notably disappointed for the month of March, initially sending equity futures down heavily over the Easter weekend. Inflation, even stripping out the most volatile components of energy and food, also lingered far below the Fed’s desired level in the first quarter. Retail sales, theoretically a clear beneficiary of falling petrol prices, continued to disappoint throughout the quarter. Realisation that anticipating a fed hike had strengthened the USD and that in turn, corporate profits were being penalised by it, then adding up a dose of uncertainty behind the strength of the economy and the potential bright spots of this very transition (consumer purchasing power though FX, oil, jobs and an inflexion in salaries), the markets ended-up slightly disoriented; and once again shifted their focus on the Fed, to ensure they would insert themselves in this complicated equation in the most helpful/least disruptive manner. From that standpoint, the march FOMC meeting was once more a central event, where a delicate exercise in word selection needed to convey a balance between confidence, flexibility and control. By skillfully directing the markets towards a threshold of “reasonable confidence” with inflation reaching 2% in the midterm to begin any increase, Mrs. Yellen maintained enough room to manoeuver and provided further credenceto her willingness and ability to be data-dependent. Coherently, the interest rate projections by FOMC members were shifted downwards and by enough to possibly suggest a bias towards a September liftoff, ceteris paribus. When doubting the Fed’s resolve, one should bear in mind that low global inflation expectations are an enemy which has been extremely difficult to defeat and, given the theoretical inclinations of most central bankers, will be seenas even more difficult to overcome next time around if policy errs on the side of the hawks, as it will create additional precedent. In a central banker’s eyes, this certainly must carry a significant weight, and resurging debates on their poor historical record in this area (tightening too early coming out of deleveraging recessions/depressions) should influence the Fed to err on the side of inflation. The Fed has time and again fought for the world to trust the prominence of data above their own forecasts in their decision-making process, and one can legitimately doubt their willingness to relax their standards at such a critical juncture.
In the end, it is worth reiterating that while critical to a global understanding of the world and markets, the analysis of the Central Bank’s actions only has limited bearing on the Fund’s positioning, other than isolating sources of potential macro risks and opportunities. As one famous fund manager likes to say, “If you don’t do macro, macro will do you”.
Returning to the question of the data weakness, one would be remiss not to ask what broke the promising momentum experienced in Q4 2014. A decisive variable in this equation is the weather impact which, for a second year in a row, has been unseasonably rough. A number of weak statistics (especially retail sales and housing starts) and, more importantly, a number of divergences (e.g. housing starts vs. building permits, payrolls vs. job openings vs. consumer confidence) and surprising volatility (jobless claims, payrolls) could potentially be explained by weather disruptions. While not definitive, this explanation and its parallels with 2014 could well set-up an environment where much of the improvements awaited in the first quarter materialize in the coming months. Notably, high consumer confidence coupled with the yet-to-be-seen impact of lower gasoline and a strong USD could represent a strong combination for the U.S. consumer. Anecdotes from across the country as reported by the beige book would also tend to support this view.
The Fund handily outperformed the US market this quarter, returning 5.55% against -0.26% for the Dow Jones Industrial Average and 0.44% for the S&P 500. More than 80% of the outperformance was achieved due to stock selection, mostly the result of strong earnings publications and opportunistic, strategically sound and financially accretive company-specific developments. NXP semiconductor’s acquisition of Freescale is one of such events; Valeant’s acquisition of Salix would be another. While admittedly always difficult to fully assess beforehand and always a fresh source of operational challenges and surprises, we also appreciate that growth avenues are diverse and legitimately include acquisitions as well. In a world where growth is difficult to find and where many companies decide to return all profits to shareholders in order to effectively shrink their assets, M&A should not be a rejected priori. A focus on multi-year track records of outperformance provides an appreciation for the powerful impact of a consolidating industry. And in those industries marked by powerful customers and where intellectual property has played a crucial role in erecting barriers to entry, the few winners who temporarily extract a disproportionate part of the value added are understandably eager to reinvest some of their extra-ordinary earnings to further develop key competitive advantages. In this sense, it is interesting to note that none of the Fund’s holdings have been targets during the investment period but on the contrary, in the recent year a few have been acquirers.
To touch on market environment and positioning, we continue to note that correlations across equities in the US remain high, creating a rather challenging market for stock picking. While correlations do not tell the entire story and merely describe the tendency to move in the same direction contemporaneously, it does set a difficult background for differentiation. Similarly to beat the reference indices, active managers are pushed towards having to think about magnitudes rather than direction, in all likelihood gradually inciting a decent number to take excessive “beta” in the quest to outperform upwards trending markets. Clearly, these correlation issues are primarily due to Central Banks’ disproportionate impact and role in the market today but must also be assisted by the advent of exchange traded funds. While we understand this reality, we do believe that:
- While difficult, it is still possible to outperform the market over time by focusing on asymmetric risk/reward profiles (compelling upside, limited downside)
- With the US equity market now less undervalued as a whole and appearing less like “the only game in town” given Japan and Europe’s current monetary support, a harder look at fundamentals has and necessarily will continue to take place,
- While growth remains below historical rates in recoveries, the US does look able to achieve moderate positive growth and together with low rates should generally help legitimise current market levels.
Ability to grow earnings on a multi-year horizon in an idiosyncratic fashion, should however still receive a healthy premium to average market multiples given the scarcity of this characteristic. As usual the earnings season, starting in earnest in the second half of April, will provide key information on the ability for companies to respond to the current challenges. The conversation is expected to remain dominated by currency impacts and hints about the true state of the economy and the energy complex.
OVERVIEW OF SELECT INVESTMENTS
Canadian Pacific (CP) is one of the seven largest, or “Class I”, transcontinental railways operating in Canada and in the United States, covering close to 14’000 miles of network spanning major Canadian hubs, the U.S. Midwest and Northeast. Originally established in 1881, today’s CP is largely the result of an important turnaround led by railway legend Hunter Harrison in 2012. Through heavy focus on cost (e.g. moving headquarters to an operating yard), an adroit strategy to streamline the network (e.g. selling some non-core lines) and accretive financial restructuring (e.g. downsizing fixed assets, restructuring leases, share repurchases), margins were able to grow at a rapid clip, now approaching the industry’s best and on their way to lead in a few years. With important tailwinds around pricing (rails’ significant advantages over trucking), volumes (Canada-US commerce, intermodal) and further operational improvements (bottlenecks, efficiency) the company is expected to maintain its current mid-teens growth trend in the coming years. With substantial improvements in return on equity over the past few years fuelled by margins and capital structure, the increasing contribution of accelerating volumes growth in the single digit to low double digit levels (from virtually zero in the past year) will complement the decelerating cost initiatives and allow for additional shareholder returns. While the company is exposed to crude-by-rail shipments and fracking sand in the Bakken region, new terminals in Canada should still in the shorter term, help offset weaknesses. Agriculture, an important end-market for CP, will in all likelihood be a challenge and will be a source of scrutiny from investors. These interrogations have pressured CP’s relative valuation to the market to levels observed in 2011. During that time however, Mr. Harrison’s team has drastically increased the growth prospects and the quality of the company and the macroeconomic picture has improved to support volume growth. Further, the exposure to some commodities end-market becomes more valuable for CP as the USD strengthens against the CAD, with Canadian exporters (both internationally and to the US) becoming more competitive. All in all, we see CP as a compelling risk/reward profile given its mix of multi-year growth opportunities, limited fundamental risk and valuation. Initiated in small amounts in December 2014, CP has been increased steadily throughout the quarter and will likely remain a significant position for the Fund in the coming months.
Constellation Brands (STZ) is a leading producer and seller of alcoholic beverages, mainly present in the North American market. Constellations’ portfolio of brands covers imported beer, wine and distilled spirits, with major brands such as Corona, Modelo, Robert Mondavi, Clos du bois or Svedka Vodka (among many others). The Fund initiated a position during Q4 of 2014, after the first signs of the company’s success in integrating its new, highly profitable and growing beer operation. Indeed, STZ purchased the outstanding stake in the Crown Imports joint venture in 2013, thereby gaining complete control over Corona brands in the US and permanent brand rights for all Modelo brands. This propelled more than half of STZ’s earnings towards the American beer market, known for having great consumer “stickiness”, pricing power in the premium brands (esp. Corona) and substantial growth opportunities, especially within the Latin-American population. With large additional investments in glass manufacturing and brewery, the company is finding ways to use its cash for capex, setting a strong base for growth going forward. In January, STZ announced its earnings, showing a positive surprise on both EPS and sales, led by strong demand for Corona and Modelo beers. With further positive data on capex, growth trends, cash generation plans and integration milestones, the stock re-rated to multiples aligned with high quality, defensive staples. With EPS growth contribution from the acquisition now weakening, the company still expects to reach high single digit to low double digit EPS growth in the coming year before accelerating back to mid-teens growth on increased returns of the by then significant free cash flow. With a valuation now having increased substantially, the recognition of the decreasing attractiveness in the risk-reward profile has led the Fund to reduce the weight of STZ in the portfolio. However, we do still believe that the company can grow its share price in-line with its EPS in the near future and can do so with limited risk. Hence, we will continue to monitor its progress, notably in relation to other investment opportunities. With a strong price performance (18%) and an overweight position, STZ was a significant positive contributor to the Fund in Q1.
Thermo Fischer Scientific (TMO) is the world leader in serving life science’s needs. More specifically, it provides and manufactures analytical instruments, laboratory products and services, specialty diagnostics, and life sciences solutions for pharmaceuticals, biotech companies, universities, hospitals, clinics, research bodies and government agencies. The Fund initiated a position in TMO near the end of Q4 2014, based on a view of a sustainable EPS growth path, a compelling relative valuation versus its peers and the S&P 500 and its stance as industry leader with a portfolio that has a range, scale and reach unparalleled by any of its rivals. Once more, TMO is a consolidator in a low-risk, defensive business and has managed to continuously grow its profits through many different cycle stages.The Fund appreciates the addition of TMO as:
- The LIFE acquisition is not limited to instantaneous accretion but has the potential to be a source of sales and EPS growth over several years in several niche areas,
- End market improvements are likely as economic growth progresses and certain government clients see their budgets stabilise, and
- Further revenue and cost synergies drive competitiveness. With a robust, expectations-beating fourth quarter and full 2014 result, the company was able to show meaningful debt reduction taken on for the LIFE acquisition and restart capital return plans.
Obviously, foreign currency exposure and translation effects weighed on the USD-denominated result, obscuring the true, impressive operational results and guidance of the company, both showing strong double digit EPS growth trends. While the FX headwinds will persist for some time, we believe the valuation to be a reflection of it, especially compared to its inferior peers. With a stock price increasing only a few percentage points in Q1, we expect TMO to prove itself over time, as a steady positive contributor to the Fund’s performance.
Commentary provided by Sturdza Private Banking Group in their capacity as Investment Advisers to the Fund as of 29/04/15.