Fund Manager Quarterly Commentaries
Read the latest fund manager commentaries for the quarter ending 30 September 2017.
Global equities rose in the third quarter, as better corporate performance in the energy and materials sectors outweighed geopolitical tensions and volatility in politics.
At the stock level, snack food maker Calbee detracted from performance after it reported weaker-than-expected earnings. Nonetheless, it could benefit from a domestic recovery, given its established market share in Japan.
Bicycle component maker Shimano also hurt portfolio returns, as its share price dropped after it lowered its full-year forecast amid rising raw material prices. Nevertheless, Shimano retains a strong market share and is the de facto industry standard for bicycle gears. Tenaris also cost the portfolio, as its management’s anticipation of a weaker second-half performance raised concerns.
Conversely, Banco Bradesco advanced as investors began to price in the bank’s further interest rate cuts and potentially better growth outlook. Aveva Group rose amid plans for a merger with Schneider Electric’s software business. Daito Trust Construction made a positive contribution to performance as the builder of rental homes saw good orders.
In portfolio activity, we introduced Ritchie Bros, a US-focused auction business with large market share and good cash generation. Separately, we added to EOG Resources, M&T Bank, Schlumberger and apparels retailer TJX on attractive valuations, while we pared City Developments and Banco Bradesco on recent share-price strength. Finally, we exited Wood Group, in view of its increased leverage, following a recent acquisition.
Global equity markets continue to be buoyed by accommodative central bank policy. However, this momentum could be stymied by geopolitical tensions, costly natural disasters and government policy missteps. Equity markets are monitoring both the impact of the Federal Reserve’s balance sheet normalisation, and the outcome of US President Trump’s proposed tax reforms. In addition, EU solidarity and companies’ operations may be tested by rising populism, the secessionist referendum in Spain, and the ongoing Brexit talks with the UK.
These developments aside, volatility is at historical lows and global equity valuations have generally risen for a protracted period. To navigate these markets, we continue to manage the portfolio by investing in good quality companies at attractive valuations: diligently monitoring our holdings’ business and financial performance, while maintaining a long-term perspective of their potential.
US equities delivered strong, broad-based gains during the third quarter. Stocks continued their ascent toward all-time highs despite increasing geopolitical tensions, divisive rhetoric in Washington and three major hurricanes that caused devastation across several states. Investors, however, seemed focused on better-than-expected economic news and generally positive corporate earnings announcements.
The portfolio performed well in the quarter, outperforming wider US equity markets. The portfolio’s outperformance was almost entirely the result of stock selection. Stock selection was strongest in information technology, industrials and health care. By contrast, exposure to materials, consumer staples and an underweight exposure to energy subtracted value.
A main contributor to performance was industrials company Oshkosh. During the quarter, Oshkosh reported strong revenue in all segments. Access equipment saw higher volumes and benefited from a more favourable product mix. The company’s defence segment ramped up sales as the US government took an interest in their Joint Light Tactical Vehicle. Oshkosh’s Fire & Emergency segment benefited from improved pricing and higher sales volume, and its Commercial segment saw higher sales of refuse collection vehicle units.
A primary detractor from relative performance was medical device maker Medtronic. Shares of Medtronic declined after the company announced lower revenue in its Diabetes business, mainly the result of short-term supply constraints on sensors for its blood glucose monitors. Such short-term concerns do not influence our long-term thesis for this company, which includes what we believe to be an outstanding management team driving product innovation, operational efficiencies and margin improvements.
At Aristotle Capital, we focus on individual companies and take a long-term view, attempting to minimize the distractions of what may be on others’ minds. We will persist in our quest to add value through in-depth company research, focusing on what we perceive to be high-quality businesses with attractive valuation and catalysts we believe will materialize in a three- to five-year time horizon.
UK & International Income
Market leadership fluctuated according to the latest Brexit runes although towards the end of the period the Bank of England indicated that an interest rate rise was all but certain and this supported sterling. For our money, we doubt that any rate rise would mark the beginning of a succession of increases but perhaps it is at least another indication that the days of nearly free money are behind us.
Over the period, the portfolio was a little ahead of the benchmark, the net result of the interaction of what we didn’t own rather than the efforts of our deployment of capital. In the case of the latter, negative contributions from Melrose and Inmarsat were notable whilst Segro enjoyed another strong period. These price actions changed nothing in term of our position size or longer-term view.
Purchases were confined to a slight addition to the oil weighting where the recent strength of the oil price is increasing the likelihood is that dividends will be able to be maintained. On its own this would not have been enough to prompt a purchase but it is clear that the oil companies are able to do more to reduce costs than would have seemed possible 12-18 months ago.
We added to Card Factory on the weakness precipitated by ‘disappointing’ results as the company resisted from passing on cost increases through higher prices. Given that we feel that Card Factory enjoys a material and sustainable competitive advantage, we viewed this more positively than the market.
It is not surprising that given Brexit increasingly looks like an idea without a plan, Jeremy Corbyn has a plan that the market doesn’t much like. Were any of these factors to be better, then we suspect that it would be like embers on brushwood as international investors scrambled to increase their low UK exposure.
Global and Worldwide Opportunities
Global markets continued their solid year with another positive quarter. As they have for the year, emerging markets led most broad indices in the third quarter, with foreign developed markets and the US trailing. Headlines were dominated by geopolitics, natural disasters and monetary policy – though markets shrugged off most headlines as economic fundamentals and corporate earnings remain sound overall.
Among our top contributors were ASML Holding, Visa and Keyence. ASML, a leading developer of machines used to produce integrated circuits and chips, is effectively capitalising on rapidly growing demand for extreme ultraviolet lithography (EUV) machines for high-volume chip manufacturing via accelerating sales.
Visa is driving accelerating organic growth against a backdrop of rapidly increasing digital transactions thanks to several secular trends. Japan-based Keyence is benefiting from the powerful secular trend toward automation in manufacturing –which has been partly tied to massive demand from smartphone producers but has also picked up steam as labor costs have risen globally.
The largest detractors were DexCom and Regeneron. As the quarter concluded, DexCom received news the FDA approved Abbott’s continuous glucose-monitoring (CGM) system—which represents a disruptive, low-price competitor to DexCom’s CGM. While DexCom remains a strong franchise, competitors are closing the gap faster than we thought likely—as a result, we pared our exposure while we evaluate the profit-cycle potential from here. Regeneron’s Dupixent for atopic dermatitis is off to a solid launch, and the company reported strong results for the drug in its second indication, asthma. However, the drug’s efficacy looked stronger in more severe patients than in those with more moderate disease –an outcome that weighed on shares.
We purchased the logistic systems producer Daifuku, global travel industry IT services provider Amadeus IT Group and European life sciences company Lonza Group. We sold ASOS and Helmerich & Payne in favor of more attractive opportunities.
The synchronised global economic recovery stayed the course. Regional industrial forward indicators continued to point toward expansion while consumer spending held up. This positive albeit modest economic growth combined with signs of a timid rebound in inflation led central banks in mature economies to signal near term credit tightening.
Sterling rose strongly as UK interest rate rises came into view. The reporting season was solid with many companies beating expectations. Political risk remains an overhang globally with the Conservative Party staging a civil war, Kim Jung-Un causing provocation, Trump struggling to implement his legislative agenda, unrest in Spain and Angela Merkel trying to cobble together a centrist coalition.
Global equities delivered positive performance in the third quarter. The global index rose around 1% in sterling terms. Emerging markets and Europe excluding the UK were the strongest regions. Sector-wise, the strongest performers were oil and gas (as oil prices rebounded strongly) and materials. The weakest sector was the more defensive consumer staples.
In the UK, RPC performed strongly after reporting a solid trading update and announcing a share buyback. Worldpay rose sharply after confirming takeover bids. Sentiment over Johnson Matthey improved after the company talked up its battery technology in-house expertise.
We made no significant changes to asset allocation. The UK equity exposure was trimmed throughout the quarter reflecting both UK market underperformance and new monies being allocated to other regions. We remain underweight in bonds as we believe the sector is richly valued. We believe the recent break down in stocks and sectors correlations should foster a market environment favourable to active stock picking.
The UK market made modest progress despite a lack of significant progress on the Brexit negotiations. This strength was led by good rises by the oil and gas and materials sectors. Both sectors benefitted from rising prices, which is bolstering companies balance sheets. In the case of BP and Royal Dutch Shell this should enable them to fully cover their dividends from cash generated in the near future. The repair of the balance sheets of some of the miners is enabling the resumption of dividend payments.
The portfolio is underweight in both oil and gas and materials. Despite this headwind the portfolio performed well with continued strength in IQE being the main riser as investors become excited by their exposure to the new Apple I-phone. Other strong performers included Conviviality and FDM Group. The main detractor was Safestyle on the back of a profits warning. A lack of holdings in Reckitt Benckiser and WPP helped performance.
During the quarter the holdings of BP, Hollywood Bowl and Intermediate Capital were increased. The shares in IQE have more than quadrupled over the past year and advantage was taken of this rise to significantly reduce the holding. The holding of Safestyle was reduced and further profits were also taken in Conviviality, Hilton Foods, New River Retail and Sirius Real Estate. The holding of Epwin was sold.
The ongoing Brexit negotiations will continue to dominate sentiment. Sterling will be sensitive to these negotiations with weaker sterling helping overseas earners. The current problems of the Conservative Party combined with a resurgent Labour Party could cause some volatility. Interest rates rises in the UK have been well signalled and Europe is likely to begin to reduce quantitative easing. Any rises are likely to be modest meaning that the yield available in the stock market should continue to attract investors.
UK Absolute Return
A backdrop of positive growth and low inflation has remained supportive for equity markets. Currency moves and geopolitics, with Trump now challenged both at home and abroad with an escalating North Korea crisis, did little to alter the volatility profile which remains subdued. Euro strength, rather than US dollar weakness, has also become a focus for investors and a greater concern for the European Central Bank.
Industrial positioning fared well through the third quarter, though this was offset by retail consumer-exposed shares seeing weakness. A broadly equal balance of stock-specific success and disappointment was also seen. Organic growth ahead of expectations, especially in the largest division consumer products, alongside margin expansion took Intertek higher. Rentokil also continued to perform well as structural drivers enhance the turnaround story at the hygiene and pest control specialist.
News from the Food and Drug Administration in the US around plans to reduce nicotine levels took tobacco giant British American Tobacco lower. Dixons Carphone was another negative contributor as revenue weakness lowered earnings expectations.
We remain positioned in between the pessimism displayed by the bond market and the optimism offered by the climb higher in equities. While fears of deflation have dissipated, any expected improvement in the level of inflation has failed to materialise. Some of the inflation fade this year can be explained by the unwind in Trump-related euphoria yet the outlook remains lacklustre. With further US Fed decision-making ahead, we continue to assess the implications that higher rates and balance sheet normalisation may bring to equity markets.
Markets picked-up steam in July with positive performance across previously challenged broad asset classes, such as commodities and emerging sovereign debt. Themes such as dollar depreciation, soft inflation data, and low equity market volatility persisted, while commodities prices improved and many US and Japanese earnings results exceeded expectations.
Emerging market equities were a standout performer and continue to dominate asset class returns on a year-to-date and twelve-month basis, supported by a weaker dollar and a cautious Federal Reserve approach toward tightening.
Moving into August, markets modestly slowed with strong performance from less risky assets such as inflation-linked and sovereign debt, and other traditional safe havens such as gold and the yen. Cautious investor sentiment was driven by bubbling tensions between the US and North Korea, and Hurricane Harvey hitting the Texas coast. However strong economic data confirmed sustained economic strength: Japan’s GDP demonstrated an exceptionally strong second quarter, due to surging household consumption and business investment, while retail sales in the US rebounded and Eurozone GDP beat expectations.
Global equities again hit new highs in July as China’s growth print beat expectations and commodities from iron ore to crude oil rallied, which supported commodity-exporters. However, this reversed in August as North Korea-related geopolitical concerns and a looming US budget shutdown drove losses in commodities. The immediate effects of Hurricane Harvey drove crude oil prices down on expectations of refinery shutdowns and an excess in supplies.
Emerging sovereign debt rose through August after a flat start to the quarter, outperforming its developed market counterparts and positively contributing to performance. Credit continued its positive streak in July, with outperformance from high yield credit. These sold-off alongside equities at the start of August, then rallied as geopolitical tensions eased toward the end of August.
The annual Jackson Hole central bank meeting shed no light on the path of monetary tightening, buoying returns. On a hedged basis, UK linkers were the standout performer in August, while all other markets delivered more muted positive returns.
Through the quarter to the end of August all asset classes posted positive returns, with Emerging Market Infrastructure Clean Energy and Timber contributing the most to returns.
Index Linked Gilts
Gilt yields rose over the period with the 10-year up 0.89% and the 30-year rising 0.37%, as rhetoric from the Bank of England (BoE) turned hawkish. An unexpected surge in retail sales in August provided further impetus for the bank to raise interest rates for the first time in a decade at its next meeting.
Brexit negotiations kicked off in Brussels on July 18. The third round of talks has been postponed until the end of September. The EU’s chief negotiator, Michael Barnier cited concern that no decisive progress had been made on the principal subjects. Two rounds of talks remain before October, when EU leaders meet to decide whether sufficient progress has been made for talks to switch to trade negotiations. As the UK is approximately four times more exposed to the European economy than vice versa, the EU is operating from a position of relative strength.
Inflation reached a joint five-year high in August with consumer price inflation increasing from to 2.9% from 2.6% in July driven mainly by clothing, household goods and motor fuel. The low exchange rate and clement weather helped propel clothing and footwear prices up by a record breaking 4.6% in August.
Unemployment fell to 4.33% in the three months to July, the lowest since 1975. Despite this, wage growth continues to lag inflation, remaining at 2.1%, excluding bonuses, during the same three-month period. The public sector pay cap of 1%, which has been in place in England and Wales since 2013, has been lifted. Police officers will receive a 1% rise plus a 1% bonus and prison officers a 1.7% rise with ministers given flexibility to raise other industry sectors.
Retail sales rebounded in August, growing 1% in volume terms. This leaves the total value of retail sales growing close to 6% year-on-year split evenly between higher prices and higher volumes. It leaves the consumer looking a little stronger in the face of higher prices, or at least a little more able to withstand those higher prices.
Despite rising inflation and sterling’s fall, the Bank of England left all policy unchanged. However, at its final meeting of the quarter on September 14, the rhetoric turned hawkish with the bank noting that if inflationary pressures continue to build then “some withdrawal of monetary stimulus is likely to be appropriate over the coming months.”
In July, the political uncertainty continued, with May facing leadership challenge in the UK, Donald Trump’s administration experiencing numerous setbacks such as failing to repeal the Obamacare and dealing with intensifying investigations, and North Korea successfully launching a missile test.
A day before members of the G20 economic forum met in Germany, the European Union and Japan reached a broad agreement to lower tariffs on most products traded between them. This announcement was significant since earlier the International Monetary Fund warned that protectionism put the global growth recovery at risk. While most central banks kept their interest rates steady during the month, Canada’s buoyant economy led to the first-rate rise since 2010.
The global equities continued their upward trajectory with emerging market equities outperforming developed markets. August was characterized by a reversal in risk tolerance. As geopolitical events such as an escalation in North Korean tensions and a terrorist attack in Spain became more prominent, investors turned to safe haven assets – particularly gold – that ended moving higher during the month.
The global equity performance was restrained with emerging markets outperforming for the month. Inflation data – disappointing in the US and surprising to the upside in Europe – increased expectations that the European Central Bank would start to downsize its accommodative programmes and the Fed would hold rates steady for the rest of the year. The transition from August to September was marked by hurricane Harvey that caused extensive damage on the Texas Gulf Coast and led to US government increasing the debt limit and agreeing financing until mid-December.
UK & General Progressive
The UK stock market has continued to move higher in recent months supported by global economic growth and positive corporate earnings. Currencies moves have impacted share performance as President Trump’s lack of progress in enacting his pro-business agenda and expectation of a very gradual increase in US interest rates contributed to US dollar weakness.
Although we see more muted returns from equities going forward we continue to see ample opportunities to invest in companies that are global industry leaders, companies with dominant market positions or those with the power to forge new markets and disrupt incumbents.
Companies impacted by the weakness in the US dollar include RELX, Compass, Melrose, Ferguson and Shire, all of which we believe provide excellent growth opportunities and should drive these shares longer term. From a stock specific perspective, we have been reassured by these companies’ recent results.
One of our holdings, Reckitt Benckiser, reported slower revenue growth as it digests the Mead Johnson acquisition has been impacted by a cyber-attack affecting its operations in the short term. We expect the company’s operational performance to improve over the coming quarters.
Our large team allows us to meet all the companies we invest in. Through these meetings, over time we aim to from a deep understanding of a business and of management’s strategy. In the case of Next, the group has experienced a challenging environment, some of it self-inflicted however, after meeting management to understand the issues we retained the holding. The shares have reacted positively to the company’s recent modest upgrades to guidance, potentially indicating the start of a re-rating.
Risk assets continued their strong run of performance during the third quarter, picking up where they left off during the second quarter. Emerging market high yield corporate debt was no exception and continued to deliver stellar returns with the JPM CEMBI Diversified High Yield index returning +2.83% for the quarter, bringing the year-to-date total return up to 9.27% to end September. Central to this strong absolute performance was generally better growth and inflation data, stable EM currencies as well as a rebound in commodities, with oil prices particularly strong, ending the quarter at US$57.50 a barrel.
News flow was broadly speaking quite positive in some of our key markets as we saw progressive political developments in Argentina with the expectation now for a more market-friendly, pro-reformist, outcome in the upcoming elections. While in Brazil there has been something of a lull in the negative corruption headlines, which caused underperformance during the second quarter. Even in the Middle East and the Korean peninsulas, despite ongoing geopolitical tensions, thus far the price action has been somewhat muted.
From a bottom-up corporate perspective, we continue to see positive fundamental developments play out for the most part which has translated into a big year-on-year decline in default rates. For context, the year-to-date EM high yield corporate default rate is now 1.4%, which is on track to come in significantly lower than the 5.1% for 2016.
Central to this positive performance has been our decision to run the Portfolio with risk-on tilt, with more exposure to higher-beta sectors (for example the commodity complex) and individual idiosyncratic credits further down the credit-quality spectrum, which have been among the best performers this year. Looking forward, we retain our constructive stance on the asset class. We feel that the positive trends that have been in place for much of this year will continue into Q4, albeit with bouts of volatility along the way which we will look to take advantage of.
High yield bonds performed well during the third quarter of 2017, despite posting minor losses in August. Lower quality bonds outperformed higher rated credits overall during the quarter. High yield bond yields and spreads decreased towards the end of the quarter.
A position in chemicals manufacturing company, TPC Group LLC, was a top contributor during the quarter, due to its positive correlation with higher oil prices. A convertible bond position in Liberty Interactive LLC added to performance.
Liberty Interactive’s capital structure continued to trade well post the company's decision in April to convert QVC into an asset based subsidiary, which substantially simplifies the company's capital structure. Most recently, the company announced its buy in of HSN stock, which was not previously owned and will help de-lever the company. Finally, a position in oil and natural gas company, Halcon Resources Corp. added to performance after announcing the sale of its Williston Basin operated assets in North Dakota to a private company for $1.4 billion.
The largest detractor during the quarter was a position in New Albertsons, due to the volatility in the grocery space created by the recent acquisition of Whole Foods by Amazon. In addition, New Albertsons has postponed its plans to IPO around the pressure in the grocery space. Hedges via Iboxx High Yield total return swaps took away as high yield was up during the quarter.
Lastly, a position in Puerto Rico General Obligation (“GO”) bonds detracted 18bps. The Puerto Rico complex trading down altogether as a result of the government fighting the control board over furloughs and other measures to cut cost. Furthermore, the GO bonds were down since Hurricane Maria on concerns that the cost to rebuild the infrastructure damage from the storm coupled with the blow to the economy will reduce the availability of money to pay creditors. We believe the recoveries in Puerto Rico will be determined by long term debt service capabilities and should not be dramatically impacted by this event.
Greater European Progressive
Our strongest stock returns were from Bureau Veritas, Unilever PLC and Sage. We reduced our over‐sized weights in SAP and Heineken after they contributed among the highest returns to our portfolio over the last couple of years, and their discounts to our estimates of intrinsic value declined.
Our companies with the weakest stock returns were British American Tobacco, Publicis and Brenntag, yet we think their long‐term investment theses are undiminished. BAT and Publicis are already large weights, and we took the opportunity this quarter to increase our weight in Brenntag. We also added to our positions in Colruyt and UBM on share price weakness.
The European index return appears to have been a cyclical bet with the top 5 returning sectors in the MSCI Pan Euro index on a one‐year basis as follows: Financials +39.6%, Industrials +26.3%, materials, Consumer Discretionary +21.7%, and Energy +19.3%. One of the weakest returning but highest quality and least cyclical sectors in our opinion was Consumer Staples, where Burgundy has significant investments.
We own companies that remain profitable, cash generative, liquid, solvent and flexible in difficult times, which usually arrive unpredictably, and that do better than most over entire business cycles. This approach can lag during periods of optimism when weaker and more economically sensitive and financially levered stocks can do well.
It has been 9 years since that last significant recession (i.e. the Global Financial Crisis), interest rates remain near all‐time lows and central bank stimulus remains near all‐time highs, and risk seeking behaviour and valuation multiples appear high. Burgundy continues to be cautious by ensuring our companies are high quality and that our valuations remain sensible.
Burgundy had a weaker quarter with slightly negative returns. Our companies with the weakest stock returns this quarter were Publicis, Nestle and United Technologies. We think the long‐term investment theses of each of these companies remain valid, although we let United Technologies management know that we are not pleased with their planned acquisition of Rockwell Collins. We think Publicis’ share price declined largely due to disappointing results from its competitor, WPP. Our conviction in Publicis increased during the quarter.
Our strongest stock return was from Cenovus, partially recovering from an overly depressed valuation after being our worst performer. Our next strongest returns were from Keyence and Union Pacific.
We substantially trimmed our weight in Philip Morris International after it contributed among the highest returns to our portfolio over the last couple of years and reached a P/E ratio of approximately 24 times – an expensive measure of a company’s value. We continued increasing our portfolio weight in Cielo, at an attractive P/E ratio of 15 times, taking advantage of continued share price weakness.
We own companies that remain profitable, cash generative, liquid, solvent and flexible in difficult times, which usually arrive unpredictably, and that do better than most over entire business cycles. This approach can lag during periods of optimism when weaker and more economically sensitive and financially levered stocks can do well.
It has been 9 years since the Global Financial Crisis, interest rates remain near all‐time lows and central bank stimulus remains near all‐time highs, and risk seeking behaviour and valuation multiples appear high. Burgundy continues to be cautious by ensuring our companies are high quality and that our valuations remain sensible.
International Corporate Bond
The strong return and low volatility witnessed in the first two quarters of the year continued in the third quarter based on a strong return in July and more moderate returns in August and September. The stable and positive returns came despite intensifying geopolitical tensions on the Korean Peninsula due to the war of words between North Korea and US.
The portfolio had robust positive returns across all sectors. Stock selection proved positive during the quarter driven by positive security selection within Healthcare and Retail. Within retail there were two main drivers. Firstly, Dutch retail company Hema reported strong financial numbers during the quarter. Hema is a relatively new portfolio company which the portfolio invested in for the first time in July.
Secondly, the portfolio’s underweight in US upscale grocery retailer, The Fresh Market, contributed positively to security selection as the company continue to experience difficulties and reported disappointing numbers.
On the other hand, the portfolio also witnessed performance drag from allocation in particular due to the underweight in Energy which was the strongest performing sector during the quarter due to a rebound in oil prices and subsequent rally in commodity-related credits which are predominantly within the US dollar part of the market.
The double BB-rated segment accounted for less of the new issuance compared to the two previous quarters but roughly 50% of the new issuance was senior secured. During the quarter, the portfolio participated in 9 new issues. One of the new names was Dutch general merchandise retailer Hema. Another new name was Stada, a large German generic drug producer.
Our short to medium-term outlook remains positive with healthy fundamentals and expected low default rates going forward. Nevertheless, we continue to focus on downside protection with a defensive portfolio, which we would expect it to outperform in case of upcoming weakness.
The MSCI All Countries World index scaled new peaks in September and notched its eleventh consecutive monthly gain. In local-currency terms, the index rose 2.4%. Renewed optimism over President Trump’s ability to stimulate growth helped global equities overcome jitters over North Korea’s nuclear ambitions.
Major US indices hit record highs in September. While Senate Republicans once again failed in their goal to repeal Obamacare, the president’s tax-reform proposals revived some of the earlier cheer about “Trumponomics”. The Federal Reserve announced it would start unwinding its balance sheet from October, but surprised investors by maintaining projections for another rate hike this year and a further three in 2018; this increased expectations of a December rate hike. Optimism about the US economy’s health prevailed although there were some fears that recent hurricanes could dent growth in the near term.
The UK’s FTSE 100 lost ground in September as sterling appreciated despite Brexit-related uncertainties and a sovereign downgrade from Moody’s. The currency got a boost from August’s consensus-beating inflation print and the prospect of a more hawkish Bank of England. However, sterling fell at month-end after the annual rate of GDP growth in quarter two was revised down.
Europe ex UK equities performed well in September as the euro weakened and the region’s economic markers remained resilient. However, Spanish stocks lagged due to concerns over Catalonia’s bid for independence. The weaker-than-expected showing of Chancellor Merkel’s party in the German election triggered some short-lived market angst at month-end. Japanese equities also had a buoyant month as a weaker yen bolstered sentiment towards the country’s export-dominated stock market. The prospect, then reality, of Prime Minister Shinzo Abe calling a snap general election provided additional impetus to the equities rally.
Asset allocation aided relative performance, due mainly to our zero-weighting in mining. Stock selection contributed strongly: sustainable technology company Johnson Matthey led performance, with other top contributors including our high-conviction positions in J D Wetherspoon, Marks and Spencer, AstraZeneca and ITV.
Sector allocation was marginally positive, chiefly due to our overweight position in energy. Regionally, gains were driven by our picks in the North American market. Top positions included our overweight in General Motors, L Brands and PacWest Bancorp
Consumer staples led contributors, with Shiseido being the strongest of the two portfolio companies in the sector.
Industrial Generac’s strong performance can be partially attributed to reactions to hurricanes in the Caribbean. Team, Inc.’s sale can be attributed to a change in our thesis about the viability of the business and therefore as an investment.
No one likes being wrong, but the only thing worse than an error is not acknowledging it. One of those missteps was Team, Inc., a long-time Portfolio holding. Team provides maintenance and installation services for pressurized piping systems and process inspections of industrial plants. We first added the company in 2009 with the idea that they provided an essential service and clients couldn’t delay upkeep for too long.
During the holding period, several events such as a CEO change in 2014, more acquisitions than the balance sheet could support and more deferrals than expected resulted in a great business effectively ruined. We exited our position in August 2017 because we didn’t believe that the potential reward matched the risk of permanent loss of capital involved with remaining invested.
In September 2017, Team’s board acknowledged their own oversight by replacing the CEO and beginning the search for a replacement. Returns can compound, but unfortunately so can mistakes. Our Investment team constantly reviews our holdings to ensure they're the best use of capital at the time and don’t hesitate to leave a position when they no longer believe in the thesis.
The Chinese economy increased on the back of rising property prices and strong performance in the materials sector, while Thailand’s economic outlook was helped by improved macro data. On the negative side, Taiwanese equities retreated as investors took profits from the tech sector, while Indonesia continued to suffer from net foreign outflows.
LG Chemical saw its share price re-rate significantly and continues to rise. Although more than 90% of earnings is still from petrochemicals, the company is thinking long-term, investing in new technology and, for now, is leading in battery production.
Meanwhile, China Mengniu Dairy continued to benefit from improvements to its product mix. Margins have shown a healthy expansion, while operating cash flow has soared due to better inventory management.
On the negative side, Dr Reddy’s Laboratories underperformed, as a series of inspections from the US Food and Drug Administration led to concerns around quality control issues, while delays to a number of its product launches caused lacklustre sales growth and compressed margins. Ramsay Health Care weakened on concerns around its slowing UK and European business.
We initiated a position in Bank Central Asia, a high-quality Indonesian bank. The industry is still vastly underpenetrated and we believe BCA’s strong deposit and retail franchise should benefit from the uptick.
We purchased Shanghai International Airport, the hub airport for the Yangtze Delta region. Air travel in China at present is still very low but has decent growth potential, supported by an increasing number of outbound tourists and surplus capacity.
We sold Infosys Technologies on concerns around the political in-fighting at the company which led to the resignation of the CEO and Dr Reddy’s Laboratories after the company reported weak earnings due to regulatory challenges and price erosion in the US market.
We remain cautiously positioned across Asia as equity markets continue to be buffeted by geopolitical events. The status quo in Western democracies has, unsurprisingly, been challenged due to rising levels of global income inequality and public discontent. Although there have been positive signs of a revival in world trade growth in general and Asian exports , we maintain our concerns around populism and the backlash against globalisation. Meanwhile, softer inflationary concerns coupled with an overly tightening bias from central banks has the potential to stamp out what little recovery there is.
However, as bottom-up investors, our focus remains on finding high-quality management teams and businesses that have, over time, delivered predictable and sustainable returns comfortably in excess of the cost of capital, despite the prevailing headwinds. We believe that finding and investing in these companies and holding for the long-term is the most important foundation for compounding financial value over time.
Global Emerging Markets
Emerging market equities rose in sterling terms in the quarter, helped by broad based strength throughout the region. The portfolio produced a return of 2.6%. The markets of Brazil, Russia and Chile were among the strongest while Taiwan, Turkey and Indonesia were the weakest.
The underperformance during this recent period has been related in part to our lack of exposure to the IT sector including the Chinese internet names such as Alibaba and Tencent. We continue to add value and generate positive returns in other sectors and geographical regions.
We continue to find attractive, high quality businesses at attractive valuations in areas of the universe that have borne the brunt of commodity declines and weak economic conditions. Indicative of this is our recent purchase of Steinhoff Africa Retail Limited (STAR). It is South Africa’s largest non-food retailer by sales and is the leading player in the non-grocery market in sub-Saharan Africa. It has also finalised a strategic economic investment in Shoprite and will aim to use the enhanced bargaining power to improve returns for the combined entity. We have long admired the strong business model and franchise of Shoprite, and believe that the simplification of the relationship with Steinhoff through the listing of the STAR assets may be a positive for minority shareholders.
Portfolio positioning has not changed dramatically since last quarter and continues to have a bias towards companies listed in markets that bore the brunt of commodity price declines, such as Brazil, Chile and South Africa. The resulting economic shock resulted in weaker currencies, more attractive valuations and the tantalising possibility of improving national governance.
Enthusiasm for the emerging markets equity opportunity continues to increase resulting in strong flows into the asset class. Whilst positive in the near-term this does increase our level of overall caution. With a long-term perspective, however, we are positive about the prospects that emerging markets offer equity investors. This is due to the opportunity to gain exposure to the structural trend of rising living standards in some parts of the developing world.
The portfolio achieved a positive return in what was a mixed quarter for bond markets. Overall, corporate bonds outperformed their underlying government bond market.
Expectations about future central bank policy and geo-political concerns over the Korean peninsula were two of the main influences on market returns over the three months. At the start of July, market expectations were high that the Bank of England and the European Central Bank would soon both start reducing the amount of economic stimulus. However, weaker inflation over the summer helped to temper these expectations.
By September, expectations that monetary policy would be tightened were raised again. This followed statements from both the BoE and ECB, which were interpreted to mean that both central banks were looking to reduce the amount of monetary stimulus in the months ahead.
Against this backdrop, the portfolio benefitted from positive performance across a broad range of sectors. The highest contribution came from subordinated financials, with high yield bonds and corporate hybrids also making a notable impact on returns. The contribution from duration was broadly flat with a small negative return from our exposure to sterling offset by positive contributions from US dollar and euro denominated duration.
The broad shape of the portfolio was unchanged over the quarter. The core of the portfolio is held in non-financial high yield bonds. This exposure is focused on higher quality companies that we consider have a lower risk of default. We also have significant holdings in non-traditional parts of the high yield bond market. This includes bonds within the financial sector and junior non-financial bonds with equity-like characteristics known as corporate hybrids. Around 18% of the portfolio is held in US corporate bonds, which due in part to the divergence of US and European monetary policy can pay a higher level of income.
Looking ahead, given the low level of yields we are more cautious. The key challenge facing bond markets over the latter part of the year is likely to the potential impact of a reduction in quantitative easing from the ECB and a potential rise in UK interest rates. Given the low level of inflation, our central scenario is that any change will be gradual and unlikely to result in substantially higher yields. That said, we continue to find selective investment opportunities and position to capture them.
Portfolio performance was negative. Broadly, this was down to negatively performing ideas outnumbering positive ones. There were no single ideas that dominated performance, however, our currency ideas struggled. US dollar weakness negatively impacted our ideas pairing the US dollar against both the euro and the Canadian dollar. The implementation of these currency ideas through options provided some protection, cushioning the portfolio from the full market move in those currency pairs. These ideas have been in the portfolio for some time and we still believe that the US dollar will rise over the next few years.
The interest rate hike and increased expectations of further hikes in Canada led to an appreciation of the Canadian dollar, which also had an adverse impact on our idea preferring the Russian rouble to the Canadian dollar. We latterly changed the implementation of this idea to pair the long view of the Russian rouble with the US dollar and this worked well in the final stages of the quarter.
Our idea preferring the Indian rupee to the Chinese yuan was also negative as the Chinese currency had a particularly strong quarter (in a quarter that favoured emerging market currencies). Yuan strength was driven in part by enhanced confidence that the fears of a hard landing for the Chinese economy were disappearing.
A currency idea was also our biggest positive contributor with our preference for Chilean and Mexican pesos over Australian and New Zealand dollars performing well. This was driven by a surge in the copper price over the month and an improved growth outlook in Chile (which is a major copper exporter). An increase in volatility levels in Asian markets relative to US equity markets boosted our idea pairing a long Asian equity volatility position with a short view on US market volatility. At the same time, despite losing ground towards quarter end, our selective Asian equity idea also made a positive contribution.
Following the recent depreciation of the US dollar, we changed the implementation of our two long dollar ideas, versus the euro and the Canadian dollar. We also added a long Canadian duration position in our US dollar vs Canadian dollar idea, where we believe the market has priced in too many interest rate increases. Changes also included removing the Italian leg of our European Divergence equity ideas where our relative value trade now pairs a positive view of French equities exclusively with a less positive view on German equities.
The third quarter was a positive one for global markets, with commodities and emerging market equities posting the largest gains. Investors continued to favour the more economically-sensitive areas of the market, such as the energy, materials and financials sectors. This led to the more defensive, quality stocks, which have historically provided attractive, resilient long-term returns, underperforming.
The portfolio delivered a negative absolute return with the consumer staples sector being a key driver of the underperformance. Tobacco stocks, which have been long-term quality outperformers, endured a testing quarter. The US Federal Drug Adminstration announced at the end of July that it was considering reducing nicotine levels in cigarettes in the US to non-addictive levels, which unsettled the market. Our holdings in Altria Group, Imperial Brands, British American Tobacco were all affected. We believe this sell off is overdone as the announcement marks the start of what is likely to be a very long and drawn-out process that could take many years to conclude.
Furthermore, the authorities are ramping up the regulation of non-tobacco products (e-cigarettes, vaping etc.), which may ultimately play into the hands of the larger traditional tobacco companies which we hold. While the investment landscape for the tobacco industry is undergoing change, we feel the current valuations of these tobacco stocks remain compelling.
More positively, our position in alcoholic beverage company Diageo was the leading contributor to relative returns as it enjoyed a strong run post its quarterly results update in July. Management shared targets which included: margin expansion of 1.75% over three years; £700 million worth of savings, up from £500; and buying back up to £1.5 billion of stock in 2018. Our position in global payment provider Visa also enjoyed a strong quarter, sparked by pleasing quarterly results in June.
More generally Visa is continuing to benefit from the very strong tailwind driven by more transactions conducted by card rather than cash. We estimate that roughly three quarters of global consumer transactions are still settled with cash. We believe there is still a long-term growth story to unfold and remain optimistic on our Visa holding. Since then the stock has enjoyed a good run, on the back of positive sentiment towards the IT sector in general.
The portfolio underperformed during the quarter, which was characterised by falling volatility and rising equity markets. Leading sectors were technology and resources. The latter was a tailwind for us, as our five oil and mining stocks all performed strongly; whilst the former was a relative drag, as was the cash balance.
In addition, two stocks were particularly weak. Capita gave back some of its relative outperformance year-to-date as a well-flagged accounting change and half year results were taken badly by the market. We had anticipated some volatility and reduced the position over the summer, but for us the events of September confirmed our thoughts that the cash flows have reached a solid base and the balance sheet is in a much stronger position now than it was six months ago. The journey back to high-single-digit cash flow growth may be slow but the valuation remains compelling and we have been buying back what we sold over summer.
The other weak stock was Uniti, a telecommunications real estate investment trust (REIT) in the US which was spun out of Windstream in 2015. Windstream remains Uniti’s major tenant and two events over summer caused concerns about the ability of Windstream to continue paying the network lease: first Windstream cut its dividend, and second a claim has emerged that the spin out of Uniti constituted a technical default on Windstream’s senior debt. Uniti stock has reacted to this very negatively, but we see tremendous value here now, based on ownership of a strategically valuable and growing fibre network in the US, with particular strength in underserved rural areas.
This work gives us strong confidence in the intrinsic value of the company, although as with Capita, we are braced for further volatility.
UK General and Progressive
Performance in the third quarter was aided by good performance from British American Tobacco, whilst BP, Diageo and Page Group also contributed positively. Centrica and National Grid were both individual laggards as Prime Minister May revived her pledge to cap energy bills for consumers on variable tariffs during the Conservative party conference.
The cyclical nature of markets and the behavioural pattern of its participants mean that stock market crashes are inevitable. Whilst there is much to be learned from previous crashes, the housing bubble and credit crisis in 2007, the dotcom crash of 2001, the Asian crisis in 1997, it seems many investors prefer to bury their heads in the sand. In their book, ‘The Ostrich Paradox’, Howard Kunreuther and Robert Meyer explain the cognitive bias which means we continually underprepare for disasters. It is not that we forget the events, just that we forget the emotion and pain associated with them.
Take Hurricane Earle as an example. As it approached North Carolina in 2010, only 55% of residents who owned storm shutters put them up. Years of false alarms combined with the inconvenience of putting them up, only to then take them down with no hurricane actually coming, led to complacency. We would attribute the same cognitive bias to investor complacency in equity markets; the longer a bull market continues the less likely investors are to protect for a correction.
We, on the other hand, stand by our long-standing absolute valuation discipline. Equity valuations have been artificially inflated through years of quantitative easing and ultra-low interest rates, so for us, with capital preservation at the heart of our process, rolling the dice is not an option. That means holding cash if we cannot find attractively priced compound growth stocks underpinned by strong balance sheets and repeatable cash flows.
Investment Grade Corporate Bond
Corporate credit spreads generally tightened in the quarter, despite a brief episode of widening in August due to heightened geopolitical tensions in North Korea, rumoured merger activity in the media space and a pick-up in bond issuance. Corporate credit still outperformed duration-matched global treasuries given improving earnings and credit profiles, accommodative central banks and demand from Asian and European investors.
Overweight risk adjusted stance to select credit sectors and issuers were the main contributors to excess returns versus the benchmark during the quarter. From a sector allocation perspective, the portfolio’s risk adjusted overweight position to the best performing energy and Insurance sectors proved key as did a long-standing overweight to the banking sector. Within the banking sector subordinated holdings led the outperformance driven by their attractive yield pickup and improving fundamentals.
Off-benchmark allocation to high yield credit proved beneficial as the asset class benefited from a robust global synchronized growth dynamic as well as for the search for yield. Specifically, positioning within the high yield segment of the energy sector was quite positive.
Security specific selections were another source of positive excess returns. Issuers held within banking (RBS and CommerzBank), communications (TeleCom Italia and Ziggo Bond Finance) added notable value. Bond selections within the insurance sector weighed on returns slightly.
Risk appetite has remained strong this year, and we expect the trend to continue into 2018. The macroeconomic backdrop of stable growth and inflation is expected to persist in the absence of a geopolitical shock.
Despite seeing improving growth, developed economy inflation remains below central banks’ targets; therefore, we believe monetary policymakers will shift gears slowly. The Federal Reserve is expected to raise interest rates in December 2017 with two additional hikes by the end of 2018. We do not anticipate an European Central Bank rate hike within the next twelve months and expect them to maintain ultra-accommodative policies even if at a lower 'dosage.' Japan’s struggle to increase inflation should keep the Bank of Japan in accommodative mode for the foreseeable future
Global stocks set record highs, rising for a sixth straight quarter after US companies posted better-than-expected earnings for April to June. Reports showed the world’s major economies growing in unison for the first time in a decade, while the Federal Reserve reconfirmed that monetary policy would only be tightened gradually and Angela Merkel won a fourth term as chancellor of Germany.
The portfolio recorded a positive return in the quarter. At a stock level, the best performers included PayPal, Visa and Facebook. PayPal gained on better-than-expected earnings, which delivered 26% growth in total payments volumes, including 50% in mobile transactions. Visa rose after its earnings topped analyst expectations for the third straight quarter, aided by outperformance of Visa Europe relative to the expectations held at the time of the acquisition. Facebook rose after the social-platform operator posted second-quarter earnings that beat expectations. Engagement on the platform has surpassed two billion people and the monetisation of this engagement was shown by the 49% growth in ad spending, while the company highlighted the opportunity to extract revenue from its chat platforms, Messenger and WhatsApp.
Stocks that lagged included Kraft Heinz, Starbucks and HCA Holdings. Kraft Heinz slid after second-quarter revenue fell more than expected, although cost-cutting boosted profit beyond analyst estimates. Starbucks fell amid market caution over the outlook for growth in retail traffic and store footprint. The company slightly reduced its annual profit forecast. HCA fell amid uncertainty as to whether the health repeal bill would be passed, given the September expiration of the budget reconciliation.
Over the quarter, we initiated positions in Kraft Heinz and Crown Castle, two high-quality defensive securities, and sold CVS Health amid heightened risks around US healthcare policy.
Abnormally loose monetary policies have created distortions in asset markets, particularly in what we would call bond-proxy equities, which are sensitive to movements in longer-term interest rates. We are cautious about the outlook for these stocks.
UK Growth and UK & General Progressive
The portfolio achieved positive returns over the third quarter.
Negative sentiment towards the tobacco sector boosted the portfolios’ performance, since they are both underweight the sector. Tobacco stocks weakened on news of moves by the US Food and Drug Administration to reduce nicotine levels in cigarettes. The mining sector was strong and holdings in both KAZ Minerals and Anglo American performed well. This followed a strong rebound in metal prices, helped by a weaker dollar and robust demand from China. Elsewhere, Tesco’s progress continued, with positive sales data released during the quarter.
On the negative side, Carillion issued a profit warning, suspended the dividend and saw the departure of its CEO. The stock’s position in the portfolios was already small and we took prompt action to sell the remainder. Centrica continued to experience negative sentiment on the risk of political interference in the sector. However, we remain very satisfied with the 6%+ dividend yield that the company offers.
Portfolio turnover was low during the quarter. We met with the management of GlaxoSmithKline, and also concluded that the dividend may have reduced wriggle room due to less favourable exchange rates – we therefore reduced the holding. We also reduced holdings in Anglo American and BHP Billiton in light of unsustainably high iron ore and coal prices. In terms of purchases, we increased the holding in BP, which has been helped by the oil price moving up – operationally, the business is also moving into a good position. We added to Associated British Foods, whose businesses have performed well. Furthermore, we bought SSE, a fully integrated utility company.
In summary, we have been adding to the portfolios’ domestic exposure for stocks where we see low valuations and where companies are already some way into making structural changes. In the background, there is the possibility of sterling trending upwards, which would lessen the disposable income squeeze. A second theme running through the portfolios is energy. There is a rebalancing under way in the oil market; the majors are learning to live with lower oil prices and yet still pay decent dividends in the forecastable future. Finally, our portfolios are positioned to take advantage of disruption, whether it be in consumer staples, tobacco or indeed in the food retail and home and personal care space. Amid all this, we have a strong undercurrent of Darwinian winners eating away at their competition.
The UK Income Portfolio returned 1.8% during the third quarter.
On the upside, a number of the fund’s energy holdings, supported by a rally in the oil price, attracted positive sentiment, especially as their dividends started to look covered. In addition, Genel Energy reached a resolution with the Kurdistan Regional Government on oil payments. Further positive contributions came from the mining sector, particularly from Kenmare Resources and South32. Not owning some of last year’s more popular stocks, such as British American Tobacco and Reckitt Benckiser, was helpful, as the market started to question the high multiples on stocks which offer little growth and are burdened by newly increased levels of debt.
Turning to performance detractors for the quarter, Pearson sold its stake in Penguin Random House and, as we’d anticipated, cut its dividend by more than consensus expectation. We are holding onto the company due to its depressed valuation and the continued programme of restructuring and cost cutting. Elsewhere, Piraeus Bank’s share price suffered when the International Monetary Portfolio said the sector needs to raise more capital. We are maintaining our holding as operational progress through the Greek recession has been solid, the balance sheet remains strong and a sell-off of the loan portfolio should alleviate capital concerns. Centrica continued to experience negative sentiment on fears of political interference in the sector. However, we remain very satisfied with the 6%+ plus dividend yield.
We are content with the fund’s positioning and made no significant changes during the quarter. We sold Marks & Spencer, particularly on concerns of the security of the dividend. We also sold our position in Admiral, which had served the fund well and has now rerated. We recycled the proceeds into Lloyds and Direct Line.
The portfolio is balanced in terms of outlook. Financials are the largest sectoral holding in the portfolio – it should benefit from slowly-rising rates and from the post-crisis reforms the company has made.. We are cognisant of the risks on the horizon, however, and have added to our holdings in gold companies and in some defensive stocks.
Global Equity Income
Global equity markets advanced over the quarter as a result of steady corporate earnings growth and low inflation. As expected, the US Federal Reserve Board left interest rates unchanged at its September meeting and announced it would begin to reduce its balance sheet in October.
Emerging markets were the strongest-performing region, as the US dollar remained weak for most of the quarter. Energy was the best-performing sector, as a result of the declining US dollar and increased global demand for oil. The materials sector also posted strong gains based on higher commodity prices. The IT sector benefited as investors favoured growth stocks over value stocks. Investors continued to rotate out of more defensive sectors – healthcare and consumer staples were among the worst-performing sectors.
Stock selections in the healthcare and telecoms sectors contributed to positive performance. Individual contributors included Koninklijke Philips NV, Verizon Communications and Affiliated Managers Group.
An overweight position and stock selection in the Consumer Staples sector detracted from performance, as did stock selections in the IT, materials and industrial sectors. Individual detractors included British American Tobacco, Japan Tobacco and Nestlé.
During the quarter, we added Cisco Systems, JPMorgan Chase and Samsung Electronics to the strategy. We exited Philip Morris International and Samsonite International, as their share prices approached fair market value.
Global markets continued to fare well, with most key indices rising. The US continued to struggle on a relative basis, with markets questioning the US administration’s ability to implement its economic agenda.
Although the Fed appears committed to interest rate increases, we believe its commitment to data dependency is questionable. US political uncertainty contrasts with that of the eurozone, where France’s initiation of structural reforms has added to political stability. Meanwhile, a sense of unease remains over North Korea’s nuclear situation. In addition, with central banks generally signaling the end of unconventional monetary policy, we are concerned that the transition, if not executed well, could have a negative impact on financial markets.
High yield bond markets performed well in the third quarter, finishing up 2.04%. Notable performers included energy, utilities and steel, while telecommunications, retail and consumer products were the main laggards. This portfolio suffered somewhat due to over-exposure to the energy and retail sectors, although this was offset by positive stock selection. Performance across the top ten gainers was fairly balanced, but APX Group, an energy exchange operator, was the strongest performer in the quarter. On the losing side, the largest detractor was Albertsons.
We initiated several new positions during the third quarter, while also reducing exposure to a number of positions that we believed no longer offered attractive yields. Some of the larger positions that we initiated included CEVA and Sable International Finance. CEVA is a transportation logistics company that completed a restructuring in 2013. Performance has stabilized and the bonds offered the opportunity to invest in an event-driven situation that is further supported by increased mergers and acquisitions activity in the industry. With respect to Sable, a triple-play telecommunications provider, we believed the bond yield presented a good opportunity to invest in a company with strong technicals and stable fundamentals. The bonds were issued in mid-August at the height of geopolitical tensions with North Korea, which caused the price to drop. The bonds have since rallied and are now trading higher than when they were issued.
Looking ahead, there is the potential for increased volatility towards year-end, given the forthcoming meetings of the Federal Reserve and European Central Bank, the likelihood of additional rate hikes, and movement (whether positive or negative) on tax reform. We continue to monitor each situation closely. In this environment, our focus remains on finding positions that offer an attractive combination of yield and total return potential. We remain poised to trade opportunely into positions that we believe offer the potential for attractive returns should volatility increase.
International Corporate Bond
After shining in the first half, stocks continued to surge in the third quarter. Bolstered by the growing US economy and investor optimism over the Trump administration’s pro-growth tax plan, the S&P 500 gained 4.5%. In contrast, the 10-year Treasury note earned just 0.3%, as the prospect of the Fed tightening monetary policy pummelled bond prices at the end of the quarter. Taking their lead from equities, high yield bonds extended their rally, trouncing investment grade bonds by a wide margin.
Although the high yield bond market slumped in August, the third quarter was a relatively tranquil period. The energy sector rallied on higher oil prices and high yield bonds finished the quarter on a strong note, gaining in value over the full period. Within the various industry groups, the oil equipment providers and the oil and gas producers were the standout performers. The weakest performers were the food and drug retailers, a sector which weakened on markets following Amazon’s purchase of Whole Foods.
The portfolio benefited from its allocation to the strongly performing metals & mining sector, as well as from credit selection in restaurants, retail, food & drug sectors. However, our defensively positioned portfolio was out of kilter with today’s risk-on environment.
As investors brace for the Fed to gradually raise interest rates, it’s fair to ask how high yield bonds would fare in such an environment. Thanks to their higher yield and typically shorter maturities, the sensitivity of high yield bonds to interest rate changes is relatively moderate. As a result, high yield bonds should be well positioned to outperform investment grade bonds as rates rise. In addition, rising interest rates usually imply a growing economy, and a growing economy usually means improving creditworthiness and fewer defaults.
Credit conditions in the high yield bond market were sound during the third quarter. We expect the 2017 market default rate to be about half of the long-term average. Recent trading trends support our hypothesis.
The investment markets are having to contend with a constant stream of unsettling messages, particularly around progress with Brexit negotiations (or lack thereof) and the associated political rhetoric. It is not just the UK that is experiencing political upheaval – some other recent election results across the globe have contributed to a wider sense of uncertainty. It is interesting to note, therefore, that UK commercial property values have risen over the year thus far, and that the independent IPF consensus forecast for the 2017 full-year returns are more bullish than they were at the start of the year.
Whilst economic growth may not be as strong in the UK as in many other developed economies, we are experiencing near-record employment, which has a generally positive impact on demand for commercial property. Even the prospect of the Bank of England raising rates sooner rather than later has not dampened investor demand for good-quality stock, and investment volumes have been on a par with the same period for 2016. Perhaps this is due in part to the fact that, compared to the 10-year gilt rate, property yields remain higher than longer term averages.
Occupational demand remains strong across the St. James’s Place property portfolio, with occupancy levels in excess of 95%, which is higher than in the period leading up to the Brexit referendum. The demand for good-quality space is leading to some rental growth – during the quarter we settled a number of upward rent reviews at levels ahead of expectations. The industrial sector continues to be a particularly strong performer, with new lettings across the country in Leeds, Frimley, Poyle, Hayes, Chelmsford and Sittingbourne.
The St. James’s Place property portfolio is invested in over 100 quality assets with more than 900 tenants. Notwithstanding the political and economic uncertainties that lie ahead, the portfolio is well placed to deliver sustainable income with scope for growth. The income-dominated style of return from commercial property continues to make the sector a valid component of a diversified multi-asset portfolio.
Global Smaller Companies
Global small caps continued their upward march in the third quarter, returning 6.2% in dollar terms and 3.1% in sterling terms. All major geographies contributed to the broad-based rally. We outperformed thanks to strong results among our UK, Brazil, and India holdings. This more than offset relative underperformance in the US, where our holdings performed well but our underweight positioning proved costly.
Sentiment toward US stocks improved throughout the quarter, despite a mostly dismal news cycle. Hurricanes battered the US and the Caribbean, causing devastation in Houston, Puerto Rico, and elsewhere. One silver lining was that these disasters helped to ease bulging auto inventories. Attention has also returned to the promise of US tax reform. The European recovery continued to have legs, and concerns about the Chinese economy subsided dramatically.
Top contributors for the quarter included Estacio Participacoes (Brazil), Equiniti Group (UK), and ON Semiconductor (US). Professional services firm Equiniti surged on the back of an entry into the US share registration business. We recently hosted management and were encouraged by the enthusiasm they expressed for the quality of the asset being acquired. Shares in Brazilian education firm Estacio promptly doubled after its proposed acquisition by market leader Kroton was blocked by antitrust regulators. After this bewilderingly sharp rally, Estacio now trades more in line with peers, but we see a credible case for the firm narrowing the margin gap that attracted us to Estacio in the first place. ON Semiconductor’s performance was representative of the strength we witnessed in auto-exposed names.
Detractors for the quarter included Pioneer Foods (South Africa), Eastman Kodak (US), and Sotheby’s (US). Staple foods player Pioneer has traded weakly due to higher input prices and poor hedging. We believe these transitory pressures should abate towards the end of the year. Print and imaging player Kodak remains out of favour as a long-awaited growth inflection remains stubbornly out of reach. Auction house Sotheby’s sank following an earnings miss that was largely driven by items that deferred earnings into the future. That said, investor disappointment in the firm’s lack of demonstrated operating leverage at this point in the cycle is understandable
Diversified Bond and Multi Asset
The third quarter of the year was marked on the one hand by resilient economic data, and on the other by rising geopolitical risks across the globe. Tailwinds in both employment and growth helped to offset the volatility caused by tensions surrounding North Korea and the hurricane season. Notably, on the global front, the unemployment rate in the UK declined to 4.4% during the quarter, the lowest level since 1975. The annual Central Bank Jackson Hole Summit came – Janet Yellen’s speech stuck to conventional topics, with no formal mention of rate hikes or inflation concerns. Conversely, the European Central Bank indicated its intention to curtail asset purchases based on better economic prospects, which boosted the euro against most global currencies, and particularly against a weaker US dollar. All in all, it was a constructive period for risk assets, as global yields ended the quarter unchanged, commodity prices recovered, and global equity prices increased.
The portfolio increased its exposure to interest rate changes during the quarter in order to dampen the potential impact of volatility, given the heightened global macroeconomic risks. The top contributor to performance was once again the non-agency mortgage-backed security sector. It was followed by the emerging markets sector, which remained supported by a combination of a rally in commodity prices, further price rises and a generally benign environment for interest rates. The new corporate credit market (or ‘primary market’) was abnormally busy during the first part of the quarter, providing attractive concessions and a cost-efficient way to optimise security selection. As a result, the allocation to investment grade credit also benefitted performance.
Currency positioning modestly detracted from performance. The tactical positions in the credit markets contributed positively. Trades aimed at capturing the mispricing at the short end of the yield curve also added to performance.
The UK market continued to make steady progress during the quarter despite the potentially destabilising effect of the Brexit negotiations and a hung parliament. Around 50% of UK plc’s profits are derived from overseas and consequently a renewed pick up in global economic growth has been helpful for the profitability of many UK-listed companies.
Within the portfolio, Royal Dutch Shell, BP and RBS were all contributors to returns whilst GlaxoSmithKline and Sky were both detractors. We are very encouraged by the developments at the big integrated oil companies, which are now managing their cost bases and capital budgets extremely tightly in the lower oil price environment. Both BP and Shell are targeting $50 oil as the price at which they can cover their generous dividends with internally-generated cash flows. We added to the Portfolio’s holdings in both companies during the three months. RBS has recently agreed with regulators the remedies that it needs to adopt as part of the deal to retain control of Williams & Glyn. The company therefore continues to make good progress on tackling its legacy issues and demonstrating the value that we think exists within its underlying business. On the negative tack, Glaxo updated the market as to its strategy under its new CEO. Some investors were disappointed that the review was not more radical and the shares fell as a result. The Fox purchase of Sky now sits with the Competition and Markets Authority for review and we expect a result sometime in the next six months. We expect that the deal will go through at a 15% premium to today’s share price although, in the meantime, the political uncertainty surrounding the deal has weighed on the share price.
Following a long period of rising share prices, stock market valuations are at elevated levels and many shares therefore offer the prospect of relatively meagre returns. We believe that, in such an environment, investors need to be selective in what they hold, focussing only on those companies where the bar of expectation is reasonably set.
The portfolio outperformed the market over the quarter. It benefited from strong price performance in STM, Dassault Aviation and Commerzbank. On the negative side, Vallourec, Maersk and Barclays performed poorly.
The outlook for European equities remains very positive. Eurozone GDP grew by a healthy 2.3% in the second quarter whilst the European manufacturing PMI yet again rose, this time from 57.4 in August to 58.2 in September. On the political front, furthermore, President Macron has been able to pass his controversial labour market reforms. These ‘revolutionary’ changes include, most notably, the decentralisation of collective wage bargaining. This will especially benefit businesses with fewer than 50 employees (95% of all French businesses) by allowing management to negotiate directly with employees rather than through a union body. Other changes include a cap on severance pay and easier redundancy rules for the French employees of international companies.
European markets are also good value compared to the US, trading at an unusually large 36% discount to the US (according to the Shiller P/E ratio) – many domestically-orientated companies trade at even heftier 50%+ discounts. Coupled with tangible evidence of accelerating economic recovery and the perception that the political backdrop has become more stable, interest should return to the region.
The overall shape of the portfolio remains broadly unchanged.
Some 53% of the portfolio is made up of companies with an above-average sensitivity to the business cycle. Within this group, almost two thirds are those traditionally labelled cyclicals, such as the Spanish homebuilder Neinor and the French industrial conglomerate Saint-Gobain.
The remaining 47% of the portfolio comprises our growth company investments. We have invested in a broad range of businesses, ranging from the German media group Axel Springer to the food and drug tester Eurofins. We have focused on companies with strong secular growth drivers, generally avoiding businesses whose future prospects are predicated on continuing economic growth in the emerging world. We have been especially wary of bubble-priced ‘no-growth growth stocks’ such as the consumer staples.
Greater European Progressive
The portfolio outperformed market over the quarter. It benefited from strong performance in STM Dassault Aviation and Commerzbank. On the negative side, Vallourec,
Maersk and Barclays performed poorly.
The outlook for European equities remains very positive.
Eurozone GDP grew by a healthy 2.3% in the second quarter whilst, yet again, the European manufacturing PMI rose from 57.4 in August to 58.2 in September. On the political front, furthermore, President Macron has been able to pass his controversial labour market reforms. These ‘revolutionary’ changes include, most notably, the decentralisation of collective wage bargaining. This will especially benefit businesses with fewer than 50 employees (95% of all French firms) by allowing management to negotiate directly with employees rather than through a union body. Other changes include, a cap on severance pay and easier redundancy rules for the French employees of international companies.
The outlook for the British economy, however, appears less certain. Whilst the economy appears to be slowing down somewhat, we will only begin to have some idea of the real impact of the Brexit vote once the negotiations start to make some real progress. The outline of a possible deal with Europe may well only really emerge in 2018, and perhaps even later.
European markets are also good value compared to the US, trading at an unusually large discount – many domestically-orientated companies trade at hefty 50%+ discounts. Coupled with tangible evidence of accelerating economic recovery and the perception that the political backdrop has become more stable, interest should return to the region.
The overall shape of the portfolio remains broadly unchanged. Some 56% of the portfolio is made up of companies with an above-average sensitivity to the business cycle. Within this group, almost half of our investments are comprised of more traditionally labelled cyclicals, such as the airline group IAG.
The remaining 44% of the portfolio is built up of our growth company investments. We have invested in a broad range of businesses, from the German media group Axel Springer to the food and drug tester Eurofins.
The Global Equity portfolio returned 3.9% in sterling terms over the quarter, far ahead of the pace of global stocks. The information technology and consumer staples sectors were the top contributors to relative investment results, while consumer discretionary and healthcare were the top relative detractors. On a regional basis, Emerging Asia and Western Europe contributed most to relative results, while the US/Canada and Latin America were the top relative detractors.
On a relative basis, the top individual contributors to investment results were Baidu, Alibaba, ASML Holding, Shopify, and Facebook. The top relative detractors from investment results were Chipotle Mexican Grill, Regeneron Pharmaceuticals, Nike, Edwards Lifesciences, and Incyte.
During the quarter, we purchased PeptiDream, and sold Under Armour and Whole Foods Market.
The information technology sector continued to post strong returns in the third quarter, underpinned by solid economic data and improving business fundamentals. The US posted its strongest quarterly GDP growth in over two years, with support from consumer spending and business activity. IT spending by both small/mid-sized businesses and large enterprises remained healthy, and semiconductor demand remained high. This spending environment — combined with the secular trend of increased mobile and internet usage for commerce, content and communication — will likely support continued strong growth rates from the information technology sector.
The outsized contribution from technology companies this year demonstrates the importance of a patient and criteria-based approach, in our view. We do not attempt to predict the leading or lagging sectors and countries on a quarterly basis. Rather, we continue to believe that investing in leading franchises capable of generating above-average earnings growth across economic cycles is the most prudent way to add value over time. Instead of investing with cyclical factors, we try to identify the durable secular trends that can underpin the growth of leading businesses. We remain steadfast in our approach, and in our belief, that selectively buying the right businesses will be the primary driver of long-term value.
The portfolio continued to deliver on its income objective through a combination of dividends from the global equity portfolio and the sale of uncertain equity upside potential.
Global equities made further gains over the quarter, with all major regions moving higher supported by a combination of stable expansion and benign inflation, reinforced by positive earnings releases. Higher-yielding stocks underperformed the wider market as central bank rhetoric started to tend towards the hawkish end of the spectrum and investors adjusted their portfolios in anticipation of interest rate rises.
The net dividend yield realised over the last twelve months for the global income basket stood at 4.3% at the end of September, exceeding the target. The global income basket returned slightly less in local terms over the quarter. The policy of hedging foreign currency exposure had a positive impact on returns. The total hedged equity exposure returned 3.7%.
There were positive contributions from all regions and from most sectors. Only consumer staples and IT stocks detracted from performance. The former of these fared worst by some margin, as defensive sectors underperformed.
The recent rise in bond yields has created an environment in which higher-yielding stocks have underperformed. September saw the Federal Reserve announce that it would begin normalising its balance sheet while signalling a potential rate hike in December, while the Bank of England gave its firmest indication yet that it is ready to raise rates. However, holding higher-quality companies, with more robust dividend profiles, should preserve the yield and returns in relation to the market.
It was a positive quarter for the portfolio, which delivered strong returns through accessing global equity market returns with embedded risk controls to reduce the likelihood of material loss. The portfolio benefited from solid gains in global equity markets against a backdrop of continued low volatility.
The main drivers of the market’s strength were broadly unaltered during the quarter. Economic growth stayed in something of a “Goldilocks” zone overall – stable expansion and benign inflation was backed by positive earnings releases. The supportive environment allowed investors to overlook a comparatively turbulent geopolitical backdrop.
The S&P 500 rose in dollar terms over the quarter, supported by a number of factors, including supportive macroeconomic data, a robust quarterly reporting season and further weakness in the dollar.
Eurozone equities gained – the Euro Stoxx 50 index returned 4.8% in euro terms. Eurozone economic data remained largely robust. The possibility that the European Central Bank (ECB) could soon reduce its stimulus measures continued to be a focus for the market, pushing the euro higher.
The UK’s FTSE All-Share index also rose. More cyclical areas of the market performed well, led by the resources sectors, as both industrial metal and crude oil prices recovered.
In Japan, stocks also advanced in local terms over the quarter.
Volatility fell over the quarter and global equity markets advanced in the low-risk environment. The portfolio’s exposure to global equity markets resulting from the volatility target mechanism remained at or close to its maximum level. The high equity exposure proved beneficial and the volatility-targeted exposure delivered strong gains.
As a result of these gains, the put option overlay became less valuable as it provided protection over a period that turned out to deliver positive performance. Overall the two risk management techniques in place reduced downside risk and enhanced returns versus global equity markets.
Global equities posted solid gains in the third quarter. The main drivers of the market’s strength were broadly unaltered. Economic growth stayed in something of a “Goldilocks” zone overall; with stable expansion and benign inflation, backed by positive earnings releases. The supportive environment allowed investors to overlook a comparatively turbulent geopolitical backdrop. The US equity market rose over the quarter, helped by supportive macroeconomic data, a robust quarterly reporting season and further weakness in the US dollar. UK equities also rose. More cyclical areas of the market performed well, led by the resources sectors, as both industrial metal and crude oil prices recovered. Defensive areas of the market performed poorly, in line with higher long-term government bond yields, as expectations rose for monetary tightening.
Among the portfolios’ UK equity holdings, Anglo American and South32 performed well, as industrial metal prices recovered against the backdrop of generally positive sentiment towards the Chinese economy and strong results. Tesco rallied after industry data from Nielsen revealed it had enjoyed the highest sales growth (by a good margin) among the big four supermarkets over the latest 12-week recording period (which ended in mid-August). Marks & Spencer and Debenhams recovered in line with the wider general retail sector, which had been negatively impacted by weakness in sterling prior to the period under review, due to its significant US dollar cost base. This negativity unwound, when sterling recovered sharply at the period end, after the Bank of England indicated it plans to normalise base rates. Less favourably, education business Pearson performed poorly, as the market highlighted the negatives in its first-half results.
2017 continues to progress as we had hoped and anticipated. Markets are strong, but, unlike prior rallies, this one is justified by a tangible improvement in political and economic fundamentals (despite some exceptions, such as in the UK). Our list of approved businesses continues to compound equity value per share at highly attractive rates. Eurozone political risk has receded dramatically, while UK political/Brexit risk (on which we’ve always been focused but the market has been complacent) is now starting to become more widely appreciated. Economic momentum remains positive almost everywhere outside the UK, though the political impasse in the US has postponed any benefit from deregulation, tax cuts or infrastructure spending. With signs of a strengthening recovery now well under way, the key test facing the global economy over the next 12 months is whether it is strong enough to stand on its own feet without the benefit of further stimulus and whether present valuations will require an acceleration of growth.
The largest contributors in the quarter included a provider of payment processing services in the UK, which appreciated on the announcement that a US-listed industry peer made a firm offer to acquire the Company; an internet search engine in China; and a manufacturer of acute healthcare consumables. The largest detractors in the quarter were a media agency group in Japan; a manufacturer of dental products; and a global manufacturer of branded athletic footwear and apparel. Cash ended the quarter at 12.2%, an increase from 9.5% at the end of June.
The macroeconomic and political shocks of the last year (and the equally surprising and counterintuitive market responses) have demonstrated the folly of attempting to anticipate macro developments and have rewarded disciplined, bottom-up investors who allocate capital based on discounts to intrinsic value. Although our approved list has risen significantly in price over the last five years, we believe it continues to offer stronger growth and less risk than overall markets
Conditions for the third quarter were broadly similar to what we experienced in the first half of 2017, as central bank policies continued to be supportive.
Risk assets performed well in the early part of the quarter and volatility only increased when tensions between North Korea and the US began to escalate, although dips in assets prices were relatively shallow.
However, rates products did experience some sharp moves, mainly driven by comments from central bankers. In Europe, hawkish comments by ECB President Mario Draghi caused yields on German Bunds to rise sharply while, in the UK, higher-than-expected inflation and comments from the BoE governor Mark Carney, caused commentators to price in one rate hike by year-end.
In the US, tensions with North Korea and a destructive early hurricane season saw Treasury yields reach 2017 lows; however, as the quarter ended a return of risk-on sentiment and hawkish comments from Fed chair, Janet Yellen, resulted in yields rising sharply.
Overall, conditions were well suited to the strategic positioning of the portfolio, which returned 1.84% for the quarter. Every sector made a positive contribution to performance, with allocations to insurance, subordinated banks and collateralised loan obligations continuing to outperform, although it was emerging markets that delivered the strongest returns. In addition, the decision to keep interest rate duration relatively short protected the portfolio during the period of rates volatility.
Looking forward to the rest of the year, attention in Europe is focused on the ECB which is expected to announce changes to its QE program. Political tensions have also resurfaced, particularly in Catalonia.
We are also expecting rate rises in the US, while the BoE is likely to reverse its emergency rate cut after the Brexit election result.
The portfolio managers continue to view credit risk as being attractive, and it will probably take a shock to the system to change the current drivers. However, with valuations more stretched, the portfolio managers are maintaining a slightly more defensive positioning.
Conditions for the 3rd quarter were broadly similar to what we experienced in the first half of 2017; central bank policies continued to be supportive and high cash balances created strong market support for risk assets.
Risk assets performed well in the early part of the quarter and volatility only increased when US-North Korea tensions began to escalate, although dips in assets prices were relatively shallow.
However, rates products did experience some sharp moves, mainly driven by comment from central bankers. In Europe, hawkish comments from ECB President Mario Draghi caused yields on German Bunds to rise sharply, while in the UK higher-than-expected inflation and comments from the BoE governor Mark Carney caused commentators to price in one rate hike by year-end.
In the US, tensions with North Korea and a destructive early hurricane season saw Treasury yields reach 2017 lows; however, as the quarter ended, a return of risk-on sentiment and hawkish comments from Fed chair, Janet Yellen, resulted in yields rising sharply.
Overall, conditions were well suited to the strategic positioning of the portfolio, which returned 2.35% for the quarter. Every sector made a positive contribution to performance, although the Insurance and Emerging Markets sectors that delivered by far the strongest returns. The decision to keep interest rate duration relatively short also protected the portfolio during a period of rates volatility.
Looking forward to the rest of the year, in Europe attention is focused on the ECB, which is expected to announce changes to its quantitative easing programme.
We are also expecting rate rises in the US, and anticipate that the BoE is likely to reverse the emergency rate cut it introduced after the Brexit election result.
The portfolio managers continue to view credit risk as attractive, and it will probably take a shock to the system to change the current drivers. However, with valuations more stretched, the portfolio managers are maintaining a slightly more defensive positioning.
Emerging Markets Equity
Emerging-market equities pared earlier gains during the final weeks of the third quarter, as the pound and dollar rose against other currencies. Signs that the Bank of England may soon raise interest rates boosted the pound, cutting sterling-equivalent prices of the portfolio’s assets. The dollar gained strength after the US Federal Reserve said it would begin winding down its quantitative-easing program in October. Because quantitative easing is considered responsible for fuelling much of the post-crisis recovery in global equities, the announcement raised investor concerns about the possible impact on emerging markets.
India was the single-largest among several sources of portfolio underperformance. In response to the weaker-than-expected GDP growth posted in the second quarter, the Indian government said it was considering measures to stimulate the economy. The announcement added to worries about rising fiscal deficits, spooking international investors and sending India’s currency and stock market lower. The portfolio also underperformed in Korea, China, Mexico and Brazil.
The greatest detractor from portfolio performance was Medytox, a Korean manufacturer of injectable neurotoxins for cosmetic applications. Although China’s clampdown on tourism to Korea weighed on shares of Medytox during the quarter, we view medical tourism as incidental to the company’s long-term growth trajectory.
The strongest contributor to performance for the quarter was Bajaj Finance, an Indian non-bank financial company offering a broad spectrum of lending services. Driven by robust demand for loans, annualised profit after tax at Bajaj surged 42% in the company’s most recent quarterly results.
Much has been written about the likely implications for emerging markets as central banks in developed countries prepare to unwind their quantitative easing programs. For our part, we expect any negative effects to be limited and short-lived. Current circumstances are very different from 2013, when the prospect of US monetary tightening chased investors out of higher-yielding emerging-market currencies. Today, fiscal and current account balances in most countries are stronger, foreign-exchange reserves are generally higher and investor sentiment is better.
Global fixed income markets generated positive returns in the third quarter. Escalating geopolitical tensions between the US and North Korea and serial disappointments in inflation data helped to contain the increase in sovereign yields prompted by central bank policy normalisation. Sovereign yields increased across most developed markets amid shifts to a more normalised monetary policy, with the biggest moves in Canada, Australia, and the UK. US treasury yields also increased, but the yield curve flattened as longer-term yields increased only marginally due to stubbornly low inflation. Japanese government bond yields, anchored by the Bank of Japan’s (BOJ’s) yield-targeting policy, were little changed.
The past nine years have been characterised by expanding central bank balance sheets, stagnant productivity and inflation. These themes have dominated financial markets, squashed volatility and suppressed bond yields. Looking ahead, it feels like we are entering a new phase where the above factors are beginning to shift. Global central bank balance sheets are slowly coming off the peak, the Fed and the Bank of Canada (BoC) have started lifting policy rates, the Trump administration is pushing to reduce the regulatory burden, capex intentions are lifting, fiscal policy plans suggest a number of countries are looking to stimulate, and there are signs that companies may be looking to deepen their capital stock, which should boost productivity over time.
The UK economy is growing around 1.5%, which supports a November rate hike. However the UK cycle is underperforming most other European countries, which means that the Bank of England rate hiking cycle cannot diverge significantly from the ECB and other European central banks. The UK economy has a fragile setup –a lack of political leadership heading into complex negotiations, bad structural backdrop (weak productivity, high debt), and slowing consumer spending. Political risk is rising – if Theresa May’s leadership takes a tumble, it opens up the risk of election and the rise of socialist candidate Jeremy Corbyn. Lastly, recent data revisions have indicated a bigger structural vulnerability: a higher current account deficit financed through liquid (portfolio) inflows rather than stable, long-term (FDI) flows.
UK High Income
This has been a challenging period for performance, with a combination of stock news and a general mood of market antipathy towards much of the rest of the portfolio weighing on returns. As the summer progressed, global equity markets became increasingly narrowly focused, returning to the themes that drove behaviour in the second half of 2016. Markets have appeared singularly fixated on stocks that are seen as proxies for Chinese credit growth – in the UK, that basically means mining companies, Asia-exposed banks and some consumer staple businesses – with the rest of the market languishing behind.
That statement is not intended to distract from the stock specific issues that have impacted performance in recent weeks – they have also clearly been unhelpful. Most notably, Provident Financial has suffered significant operational disruption in its household consumer credit division. This has been very disappointing for the company and its investors, but we believe that the market has substantially over-reacted to the news. We have maintained our exposure to the business, believing that Provident Financial will recover from these temporary problems, although we acknowledge that it may take some time to do so.
As long-term investors, sometimes what we are trying to do will not chime with the mood of the market. While in the short-term this can be painful to endure, our response to it is to continuously retest our investment hypothesis. In doing so, we have repeatedly returned to the same conclusion – our long-term strategy is very appropriate for the current investment context. We do not believe that the rate of credit growth that we have recently seen in the Chinese economy is healthy or sustainable – neither, therefore, is the market’s response. It has taken the valuation stretch in markets to dangerous levels, and we believe that the portfolio is well placed to benefit when conditions begin to normalise.
Past performance refers to the past and is not a reliable indicator of future results. The value of an investment with St. James’s Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. You may get back less than you invested.
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