Market sell-off seemingly unrelated to change in fundamental economic backdrop

BY ERIC STURDZA

23 Mar 2018

BY ERIC STURDZA

In February, the U.S. equity markets were subject to a correction after a long run, which had been marked by particularly low volatility, urging questions such as: (1) if the sell-off had been caused by rising rates? and (2) if this correction would alter the Fed’s path?

In the Investment Adviser’s opinion, the correction was purely technical as the general exposure to the US market was probably long for the majority of investors, with volatility at historically low levels and the market looking overbought on a momentum basis.

According to the team, there is no apparent reason for the Fed to alter its stance on the appropriate path for monetary policy, as the recent correction and sell-off was seemingly unrelated to any particular change in the fundamental economic backdrop. Furthermore, attributing the correction to a rise in yields appears at best dubious to the team, as yields are still at very comfortable levels on a real (inflation adjusted) basis, with the real yield for 10-year Treasuries at approximately 0.7% – a relatively stable level over the last 5 years, which remains well below the levels which trigger policy tightening (at about 3% real), as experienced in 2006-2007. As such, the correction was treated as a buying opportunity for both new positions and those already held.

In February, the Fund returned -3.38% against -3.73% on the part of the benchmark. In terms of sector allocation, not being exposed to Energy, Telecommunication Services, and Real Estate acted as tailwinds, whilst the overweight in Healthcare acted as a headwind.

In terms of stock selection, Envision Healthcare (+7.0% ) was the largest contributor, followed by Booking Holding (+6.4%) and Cognizant Technologies (5.4%). All three companies reported solid earnings during the month and saw their fundamental thesis reinforced.

On the other hand, Shire Plc and Becton Dickinson Co (BDX) (both loosing -8.6%) were among the largest detractors in February, despite having published solid results for the last quarter. Therefore, the reason behind both declines appears to be based on future expectations. BDX reported better-than-expected results, with the guidance issued by management largely in line with expectations. However, the Investment Adviser urges not to forget that BDX has been and continues to be keen on abandoning its moniker as a “predictable company”. After surprising investors with its first major acquisition in its operating history a couple of years ago, the Company doubled its CareFusion deal size in 2017 with the acquisition of C.R. Bard. While the purchase and improvement may not seem particularly impressive, it is nonetheless a sizeable jump for a company that competes in product areas that have historically grown less than the broader medical sector.

Nowadays, BDX has a product pipeline with the potential to expand the overall size of the market and at the same time position the Company as a full-suite product and services vendor. As such, stock performance is expected to mainly be dependant on management’s ability to execute cost/revenue synergies associated with its most recent purchase.

Shire also reported strong Q4 results mainly driven by excellent performance in immunology. However, the Company’s 2018 EPS guidance was below consensus estimates, mainly attributable to the potential generics entry of Pentasa and management’s intention to allocate capital towards manufacturing capacity. Despite investors’ concerns about the updated guidance, the acquisition of Baxalta and potential competition (from generic entries) that have altogether kept the share price under pressure, the Investment Adviser still sees Shire as undervalued. Therefore, the position will be maintained as the Company’s strategy to focus on the rare-disease space is attractive and could yield significant upside over time, whilst the Company’s impressive free cash flow generation seems to be durable.

The views and statements contained herein are those of the Eric Sturdza Banking Group in their capacity as Investment Advisers to the Fund as of 13/03/18 and are based on internal research and modelling.