February update

BY ERIC STURDZA

Monthly Fund Commentary
21 Mar 2017

BY ERIC STURDZA

In February, the market was focused on (1) the Federal Reserve and the chances of them raising interest rates during their next meeting (March) and (2) the remaining publications for the ongoing earnings season.

(1) During the first half of February the market implied a 36% probability of the Federal Reserve implementing a rate hike in March. At the time, there were three main points to consider from the latest round of FOMC minutes: (a) a substantial amount of members saw a rate hike coming fairly soon, (b) members also saw the risk of inflation heating up as modest, and (c) the balance sheet debate (i.e. how to reduce it) will begin in coming months. All in all, the Investment Adviser interpreted this information as consistent with the Fed’s previous narrative i.e. to keep a March hike on the table. Therefore, it seemed the market’s low implied probability was based on the fear the Federal Reserve could hike rates too fast (twice within three months) creating a market tantrum, rather than on hard data. However, as mentioned in previous reports, the Investment Adviser believes that the market’s interpretation of interest rate hikes has shifted from negative to positive (as long as economic data remained supportive). This belief turned out to be correct. In the second half of February, the combination of hawkish statements from Fed officials and supportive economic data releases led markets to shift their implied probability to above 96%, with no negative impact on equity markets. Thus, a March rate hike is now fully priced in and expected.

(2) Overall, the S&P 500 4Q2016 earnings season was a strong quarter accompanied by a positive outlook as the percentage of reported companies that managed to beat or meet bottom line consensus forecasts stands above the historical average of 76%. Technology, Healthcare, and Financials were the three sectors that contributed the most in terms of upside surprises. Nonetheless, the average investor was yet again hard to impress as generally speaking only companies that published a double beat on both bottom and top lines were rewarded via a stock price appreciation (on average +1.2%). On the other hand, companies that missed on both estimates underperformed on average by -3% and those that beat on only one metric also underperformed on average by -0.75%. Therefore, the trend identified at the beginning of the earnings season, that investors have generally been more responsive to downside risk over upside gains, remained consistent.

During the month, 16 companies in the Fund published their results with an overall sales growth of 15.4% and earnings growth of 20.6% compared to the 276 S&P 500 companies that published their results with an average sales growth of 6.45% and earnings growth of 9.82%. The largest upside surprise came from Priceline Group which reported its top and bottom lines above consensus estimates by 1% and 9.5% respectively, thereby yielding a year-over-year EPS growth rate of +42%. Currently, the Investment Adviser still expects Priceline’s global online travel agency’s market leading position to expand over the medium and long term. The company’s superior position in China, ongoing leadership in Europe, and expanding presence in vacation rentals and restaurant reservations are trending well and are the main drivers behind the company’s potential to gain additional market share. Priceline has built a leading network of hotel properties and other services, which drive an increasing user base. As such, this network effect should continue to expand in both developed and emerging economies. To replicate Priceline’s network in developed markets has proven to be extremely costly for key competitors, because boutique hotels (a substantial portion of the region’s market) that are already in business with Priceline, face labour and expense constraints when trying to expand their offering over multiple distribution channels. On the emerging markets side, the company is growing its leadership in China with its Ctrip partnership and also in its own booking platforms (such as booking.com and agoda.com), which is key to the Investment Adviser’s thesis as developing regions represent over half of total industry online booking growth.

Another company that published above expectations was Allergan. The manufacturer of specialty pharmaceuticals beat top and bottom line consensus expectations by 2.4% and 4% respectively thereby yielding a year-over-year EPS growth of 14%. The company’s aesthetic business is growing at a solid pace of 14% year-over-year. Moreover, if one removes the use of Botox Therapeutics, the rapid growth of so-called fillers (28% year-overyear vs. Botox at 13% year-over-year) is progressively closing the gap between the two franchises which nicely reinforces the company’s “moat” around the franchise whilst weakening the ongoing bear argument that new low-cost toxins will take share from the franchise. On the international front, Allergan is also showing a strong presence with a 9% year-over-year growth rate, mainly driven by aesthetics (16% YoY growth) and eye care (7% YoY growth) – a trend that is perceived by the Investment Adviser as extremely positive due to Allergan’s lower international market share versus other drug companies. The improving international growth trend could both accelerate corporate growth and stabilize the business if international sales continue to show consistent growth and thereby warrant a higher multiple. On the pipeline side, the company’s main events are expected to arrive in 2018. For 2017, the only major readout is the high risk-reward phase II of Botox. In terms of risk, the Investment Adviser has concluded that a sudden halt to the aesthetic growth is unlikely but generic threats on Estrace and/or Restasis are present and priced in.

Autozone’s Q4 results missed consensus projections by 0.95% on EPS and by 1.9% on sales. While its 2.5% year-to-date revenue growth trails expectations, management did cite IRS delays in sending tax refunds as constraining the quarter’s sales growth. As such, the Investment Adviser still anticipates the shortfall to be reversed. Nonetheless, the stock price has been under pressure recently and it appears to be more driven by fears over Amazon’s renewed focus on auto parts rather than a missed quarter. That being said, the Investment Adviser sees this move as temporary because the sector seems to be more insulated than others especially given the immediacy of customers’ need for parts to be able to return their vehicles to the road, and the importance of in-store services (such as diagnostics and advice) to do-it-yourself motorists. Furthermore, the Investment Adviser also believes that Autozone’s leadership in the do-it-yourself segment has not only given the firm a comprehensive national store network which the firm can leverage, but also provides the company with an unmatched exposure to the American population as 80% of the population lives within 8 miles of one of its stores. Additionally, it is believed that price is secondary to differentiation on the basis of service across the industry, which limits competition despite high margins. As such, the price correction has been digested as a buying opportunity.

All in all, the Fund’s total return for the period was +4.53% compared to its benchmark which returned 3.86%. The Fund’s sector allocation was the primary driver behind the outperformance. The Fund’s natural tendency to overweight more growth oriented sectors such as healthcare and information technology whilst underweighting lower growth sectors such as energy and telecommunication services continues to yield results. On the stock selection front, Priceline, Citrix Systems and ePlus were amongst the top contributors whilst consumer staple stocks such as Kroger and Casey’s General Stores were amongst the largest detractors. Looking forward, the Investment Adviser is confident with the Fund’s strategy of strictly selecting the best growth compounders at reasonable valuations and the above average return this strategy can deliver to shareholders over time.

 

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The views and statements contained herein are those of the Eric Sturdza Banking Group in their capacity as Investment Advisers to the Fund as of 16/03/2017 and are based on internal research and modelling.