May update

BY ERIC STURDZA

Monthly Fund Commentary
23 Jun 2017

BY ERIC STURDZA

Economic data releases in May haven’t altered the main direction depicted in last month’s report. Nonetheless, some small changes in (1) the employment situation and (2) the Federal Reserve are worth mentioning before focusing on (3) the Fund’s developments during that same period.

(1) The last employment report came out substantially below market expectations at 138k, but was in line with the longer term payroll growth trend some Fed members are expecting. For example, Fed member John Williams said, “Over the next decade the labor force in the U.S. is projected to grow at only 0.5 percent per year, and this represents a considerable drop from the pace we’ve experienced over the past 40 years.” In other words, they expect a much lower number than 138k going forwards. Additionally, aggregate wage gains remain solid and should support the consumer whilst the expected 3.4% topline GDP growth for the second quarter keeps supporting the argument that sluggish first quarter data remains transitory.

(2) The Fed minutes for the May meeting confirmed the strong likelihood of a rate hike in June as expected and shed more light on how it plans to normalize its balance sheet. The main point is that most members favor a cap approach. In other words, the Fed would set a dollar amount ceiling to allow maturing securities to run-off the balance sheet on a monthly basis and leaves the door open to raise that cap every three months. Additionally, it was also hinted that their will most probably be a separate cap for Treasuries and Mortgage Backed Securities (MBS). The Investment Adviser believes that the Fed’s super transparent approach is to avoid any unnecessary turmoil such as the potential for a so-called “tantrum” based on the roll out of the balance sheet run-off which at the same time also makes it easier for the Fed to implement more hikes if they decide it is appropriate.

(3) The Fund underperformed its benchmark in May mainly because of specific stock effects. Biogen started the year well but the stock price has been suffering since the end of April due to a lack of near term catalysts combined with the fear of competition threatening Biogen’s established drug lines. An example of this is Roche’s newly launching Ocrevus on Biogen’s multiple sclerosis franchise. The Investment Adviser is still convinced by this company’s long term narrative despite the recent turmoil. Even though Ocrevus will likely compete most directly with Biogen’s Tysabri, the Investment Adviser also believes that this scenario is now priced in but that not enough credit is given to Biogen’s commercial execution capabilities, its currently attractive valuation, and its pipeline potential.

Another company that weighed on the Fund’s performance was Allergan. Since the recent underwhelming reports the stock price has been under pressure. The main reasons behind this are largely based on near term issues. The near term momentum is negative as there are no catalysts until the end of the year. Additionally, cash flow has been weaker (still at 19% of revenue due to deals they have done) when it should be around 30%. Also there have been questions about what is their free cash flow guidance for the end of the year to which management answered $1.5bn even though they didn’t specify that that was in fact the quarterly number. Nonetheless, the Investment Adviser agrees that there are a lack of near term catalysts but does see this as a buying opportunity for the following reasons. Firstly, the stock is owned more by hedge funds (approx. 8%) vs. 1.4% average hedge fund ownership for large cap US names which makes the stock price move faster when short term sentiment changes. Secondly, the lack of short term catalysts does not alter the longer term thesis on this company and has, on the contrary, created an interesting buying point for a company that is fundamentally very interesting just on the sustainable business alone (Botox, aesthetics and OTC Eyecare). Thirdly, catalysts will be present starting at the end of 2017.

The largest detractor in May was Autozone. Following two quarters of sluggish results, management announced that the largest factors behind the weak comps were the ongoing impact from tax refund delays and weather conditions. The Investment Adviser is cognizant that decelerating growth in miles driven and stable gas prices over the past 9 months result in diminishing tailwinds to industry growth and that the Do-it-Yourself segment which represents approximately 80% of Autozone’s sales could be under pressure if Amazon proves to be a material factor in the Auto Parts space over time. Nonetheless, until this materializes Autozone is still an industry leader which is now trading at very low valuations (compared to its history) whilst enjoying the best gross and profit margins the company has ever delivered. Therefore, if the environment remains fairly constant or fears are slightly overdone the stock should continue to deliver above market average earnings per share growth rate.

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 16/06/2017 and are based on internal research and modelling.