The last quarter of the year wound to a close accompanied by a sense of wonder at how distinct 2014 had proven to be. With a US economy finally registering above-trend GDP growth, a 2.1% yield on the ten-year Treasury, a departure from quantitative easing (QE) in the US, a barrel of oil worth around USD 50 and the EUR/USD exchange rate below 1.20, investors will likely look back in awe at what 2014 has engendered.
Contrary to the theme that has dominated the market thus far, there was greater alignment between macro developments and the direction of the equity market this quarter, with the dependency on the Federal Reserve’s (FED) QE replaced by more interest in legitimate economic strength. While the market still appreciates a nod from the FED, investors seem to have turned the corner on the “good news is bad news” period. Indeed, extending the trend seen in the US since the second quarter, economic data was generally positive, accelerating towards the end of the year. However, inflation, wages and the quality of the employment gains, still leave much to be desired.
The quarter witnessed the continuation of markets being dominated by the three interrelated pillars of (i) underwhelming “top line” global GDP growth, (ii) central bank activism and (iii) lack of investment alternatives. Whilst some aspects have evolved, these very much remain the keys to the current environment – with the rest of the world unequivocally under-delivering on economic growth, the US seems the best of the bunch. While the US has ended its program of quantitative easing, Japan announced an increase of its own program the next day, and Europe seems on the verge of joining the club. With more than half of all global government bonds yielding less than 1%, few assets seem to offer any enticing prospects for wealth creation. With the combination of these three pillars creating a difficult environment for stock picking at times, the fourth quarter was more conducive, with risk aversion favoring a reversal of the earlier style rotation with increased focus on individual fundamentals. The year will however remain a painful memory for most mutual fund managers, with more than 80% achieving a below benchmark return.
Looking more closely at the Fund’s development, the quarter started on shaky grounds for the US equity market, finding itself in the midst of a -9.8% peak to trough correction that reached its lows on the 15th of October. However, while the S&P 500 Index subsequently flared up to set new record highs a mere twelve trading days later, eventually posting its third strongest month in 2014 (+2.32%), the correction shook markets in ways unseen in years. The event was triggered by a perfect storm of both macro and micro factors: global GDP growth concerns (especially in Europe and China), an underwhelming response by the European Central Bank, the imminent termination of the FED’s QE, a continuing decline in crude oil prices (at the time attributed to falling global demand), deteriorating news flow relating to the Ebola outbreak, low liquidity, seasonally low buyback activity, and important unwinds by leveraged funds following bad risk arbitrage bets. Important forces behind the market’s quick bounce included soothing commentary from the FED and later a surprise increase in the Bank of Japan’s own QE, nicely replacing the FED’s retreat. But importantly, the strong earnings season and constructive US economic data reassured investors of the positive nature of the environment for US stocks.
The Fund performed well during this volatile month, outperforming the S&P 500 Index both during its down leg (circa +2.1% relative performance) and also on the upside (circa +0.7% relative performance). The source of this outperformance was primarily stock selection with the high quality profiles generally protecting from large draw-downs and then appearing as bargains when optimism returned. Further, the Fund’s already decent cash position at the end of September grew in the first week of October, as a result of what the Investment Adviser viewed as a somewhat underwhelming opportunity set and often challenging and deteriorating, momentum/value tradeoffs. The excess cash allowed for additional downside protection and importantly, opportunistic buying in the second half of the month. As such the Investment Adviser was able to initiate positions in highly attractive companies at discounted valuations such as Teledyne Technologies, The Walt Disney Company, Polaris Industries, Constellation Brands and two high quality semiconductors, Skyworks Solutions and Avago Technologies. MasterCard was also added at the end of the month following strong earnings. On the other side of the ledger, the Fund disposed of some positions, both on valuation considerations (O’Reilly, DaVita, Credit Acceptance) and on growth considerations (Resmed, Align Technologies, T. Rowe Price).
This “flash correction” – certainly the dominant event of the quarter – was followed by further gains being seen in US markets, in which the Fund continued to perform well in both absolute and relative terms, closing the quarter at +9.8% versus the S&P 500 Index return of +4.4%. The absence of energy stocks in the portfolio, the result of the Fund’s investment process focusing on long term earning stability, provided an important tailwind to this outperformance after OPEC further reiterated their resolve. The positive economic news flow in December, including above consensus data in the employment report, job openings, retail sales and the upward revision of Q3 GDP growth (to 5%), helped the market rebound from a few days of weakness. As usual, the cooperative tone from the FED also helped; by explicitly characterising their current views as consistent with prior guidance and underscoring the committee’s ability to be patient, Mrs. Yellen effectively ruled out an accelerated hike schedule and gave the market further confidence in a positive outlook for equities over the next few quarters.
The current level of non-inflationary growth now further cemented by the drop in crude, is a situation that will likely incite the FED to if in doubt, err on the side of accommodation, especially in light of continued frustration in labour market dynamics. Whilst volatility has picked up in the beginning of January on the back of more normalised (read less stellar) economic data and with the global stage remaining littered with potholes, earnings publications at the end of the month are expected to act as a further differentiator and will provide investors precious information around the first effects of the energy correction. The Investment Adviser believes that this environment continues to make few asset classes look as attractive as US stocks and sees significant potential within the current portfolio and remains on the lookout for new opportunities as they arise. With the strong performance of the Fund in the quarter just ended being the result of their disciplined risk-averse process, the Investment Adviser looks forward to applying it further in 2015, a year they envisage will require much focus on companies’ ability to grow in a turbulent world.
Overview of select investments:
Comcast’s earnings publication in October demonstrated another quarter of strength, beating profit expectations by 4% with a positive surprise from the NBC Universal division delivering better revenues and margins than expected. New broadband subscriptions continue to show momentum, likewise average revenue per user, a testimony to both the attractiveness of the small and medium enterprises niche and the superiority of their Xfinity set top box driving retention and improving profitability. Attendance at Theme Parks, an underestimated source of profits, was once again strong and is expected to continue to reap the benefits of both recent investments (e.g. new Harry Potter rides) and strengthening disposable income.On the capital allocation front, the significant returns of excess cash flow continue via share repurchases (750m USD in the October quarter) and are predicted to ramp to more than $1bn per quarter in the coming quarters. Uncertainty on the regulatory front emerged this quarter as a result of the public address by President Obama regarding Net Neutrality, the principle by which Internet Service Providers should treat all content creators equally for “access” to the internet. The issue revolved around the President’s desire to safeguard this principle by placing them more heavily under the FCC’s regulatory umbrella (reclassifying them as a Title II service). The prospect of a further regulatory burden and its impact on profitability displeased investors and increased the perception of risks to the completion of the Comcast-TWC merger. The address caused much ink to flow, not least given how uncharacteristic it is for a sitting President to weigh in publicly in an independent agency’s dealings. However, extensive discussions with specialists instil confidence that both a measured regulatory solution remains very much the base case scenario, that cable company’s economics will remain unaltered and that the case for the merger remains strong. More central to the investment thesis, Comcast on a stand-alone basis continues to execute above expectations, delivering above 20% earnings per share growth and enjoying a unique position in its industry. At around 20x trailing earnings and importantly, trading around the same price as a year ago before the announcement of the TWC offer, current valuations are decidedly not discounting much of the potential benefits of the TWC merger, a situation where risk/reward favours patient investors. With the stock slightly outperforming the market in the end of the quarter, Comcast contributed positively to the Fund’s performance.
Actavis, in its first full quarter following the acquisition of Forest Laboratories, reported third quarter earnings above expectations and raised its profit guidance for the year. Importantly, results showed evidence of an accelerated realisation of planned synergies, a positive sign given the importance of execution in such a large deal. Shortly after the release, Actavis made public their suspected interest in acquiring Allergan and eventually proved victorious by outbidding rival Valeant. This set the organisation for a third transformational acquisition/merger in less than two years. Whilst both the pace and the magnitude of Actavis’ acquisition strategy could be reasonable causes for worry, the Investment Adviser continues to find this company attractive for the following reasons:
• The acquisition track record of both the company and the current management team are second to none, as the preliminary results of the Forest deal continues to confirm. The CEO Brett Saunders’ reputation lies foremost in operational proficiency and cost control and this bodes well for achieving the necessary synergies.
• Large acquisitions are the consequence of a specific environment in Pharma (Pharmaceutical industry) where interest rates, valuations, product pipelines and tax efficiencies provide tailwinds for the right organisations to acquire highly cash generative and defensive businesses with long term visibility. By diversifying in strong franchises and further leveraging its platform, Actavis is effectively growing while diminishing its risk profile.
• Once these tailwinds abate, the company remains a first class organic growth story. Indeed, a central point of the investment case remains the company’s heavy focus on organic growth and their January 2015 pre-announcement (EPS to be 10-15% above the previously raised consensus) further demonstrates not only the strength but the upside potential of Actavis’ existing businesses. As such, while remaining vigilant the Investment Adviser does not believe the company’s sustainability is of concern today.
With a slight outperformance in Q4 and an important weighting for the Fund, Actavis was a positive contributor to performance.
The 4th quarter was particularly favourable to the Fund’s auto parts retailers, i.e. Autozone, O’Reilly Automotive and Advance Auto Parts. This was predominantly due to a strong earnings season in which all three beat expectations and gave evidence of robust trends in customer demand hence further differentiating them from the broad retail industry. The sharp decrease in oil prices provided a tailwind as average miles driven positively impact sales. While unusual for the Fund to hold multiple organisations drinking from the same profit pool, the Investment Adviser believes the industry and this group in particular, exhibit characteristics that make them highly desirable investments. The result of a powerful (and ongoing) consolidation, these three dominant players are broadly following the same operating models, heavily focused towards scale, network/logistics, capital efficiency and aggressive redistribution of excess cash to shareholders. Autozone, the pioneer in these best practices, controls 15% of the US retail market with almost 5,000 domestic stores. Its disciplined expansion strategy coupled with a focus on logistics have made its distribution network greatly superior to online competitors in terms of product availability (a key criteria for buyers, especially in the B2B/commercial segment where O’Reilly dominates). Exploiting the low brand sensitivity of customers, these organisations all carry their own private labels and gain a dominant position with suppliers to such an extent as to achieve highly defendable price point and impressive inventory concessions (Autozone has negative working capital). These companies are enthusiastic distributors of free cash flow to investors via share repurchases, a logical consequence of their unique setup: (i) an addressable market providing organic growth opportunities (some of it now outside the U.S.) with very low cyclicality and volatility, (ii) modest growth-adjusted valuations (iii) an understanding that capital efficiency can create economic value. While the three companies broadly follow these tenets, O’Reilly the fastest growing highest valued and most aggressive cash distributor, has a greater focus on the commercial market while Autozone, the dominant player in the retail market (“Do-It-Yourself”) with the longest track record of excellence, sports slightly inferior growth rates but unrivalled operating metrics and a slightly more conservative approach to balance sheet management. Advance Auto Parts, historically the laggard of the group in terms of operations, has started enjoying the first fruits of a turnaround following their acquisition of competitor General Parts International, making it the largest network of the group. With a strong existing business on the commercial side and now a dominant network with ample opportunities to increase profitability by further improving operations, the market has rewarded the stock with a more appropriate multiple.
While clearly benefiting from shared competitive advantages and exposed to common risk factors such as car fleet age, weather severity, oil price (miles driven), market saturation and outside competition (mostly online, although not a threat to this day), the Investment Adviser views the companies as being differentiated in terms of end markets (retail versus commercial), growth and valuations (premium vs average), business quality (proven excellence versus improving) and source of earnings surprise (industry factors versus company-specific, operational). While the Fund has been an investor in both Autozone and O’Reilly, at varying degrees for the better part of its life, Advance Auto is a more recent and modest investment.
After handily beating expectations for the quarter and a rally of 20%+ in the stock price, the valuation of O’Reilly reached levels not seen in the life of the Fund, both on an absolute and relative basis. While its quality and growth profile can be legitimate reasons for a re-rating, the Investment Adviser believes this limits return potential in the mid-term while increasing the risk of disappointment. By following their process and risk/reward discipline, the Investment Adviser has deemed it an opportune time to exit this investment and redeploy cash in more compelling opportunities. Following Autozone’s strong showing, while still an investment for the Fund, the weighting of this habitual top five position was somewhat reduced. The Investment Adviser continues to see the potential for both Autozone and Advance Auto to deliver mid-teens EPS growth in the coming years but with lower current multiples providing decent opportunity for compelling price appreciation. When combined with a defensive, non-cyclical business, the Investment Adviser continues to find these investments attractive. Unsurprisingly, the group’s strong Q4 performance (above 20%) coupled with its significant weighting in the portfolio contributed positively to the Fund’s performance.
Cognizant, the IT consulting and Business Process Outsourcing firm, confirmed through its stellar results that the prior quarter’s softness was as expected, more of a “bump in the road” than evidence of a change in their environment. The company beat expectations and more importantly raised back the guidance it had lowered in August. The positive surprise mostly arose from higher revenues, adding to investors’ confidence in management prior explanations. The outlook for 2015 remains positive, with a solid pipeline and a pricing environment described as stable, which should enable the company to continue achieving mid-teens EPS on low teens revenue growth. During the quarter, Cognizant also closed the previously announced USD 2.7bn acquisition of TriZetto, a leading administrative solutions provider for the healthcare industry. With more data now available, the Investment Adviser believes the transaction remains a legitimate and accretive move by Cognizant to cement their lead in the most promising healthcare end market. By using USD 1.7bn of cash previously earning ca. 1% and borrowing USD 1bn at 3month LIBOR + 1%, Cognizant acquires a leader in a highly profitable growth niche with expected 10% revenue growth in 2015 and most importantly, key assets both in terms of product (especially their Facets software) and relationships (they serve 350 healthcare payers and 250’000 health providers) where cross-selling opportunities should flourish. Clearly the price tag of ~3.8x revenues already reflects a number of these synergies, however significant upside could be achieved from the increasingly unique ability by Cognizant to win large, integrated mega-projects (such as the recent HealthNet contract) in a growing and consolidating end market. Other than the general level of corporate IT spending, specific focus by investors should now be on (i) the integration and quality maintenance of the TriZetto products and operations, (ii) the quick capture of the lower-hanging synergies and (iii) the smooth ramp of the HealthNet contract which should enable them to attract attention and win other such large deals. The Fund, with Cognizant being a top 10 holding, will be looking at these developments closely. The position performed very well in Q4 with most of it being a reversal of the August underperformance. While the multiple has risen back to a more customary level, it remains at or below those carried by inferior peers. The Investment Adviser considers that the earnings growth alone should provide a strong source of returns in the coming years and consequently the Fund retains its overweight exposure to Cognizant.
Commentary provided by Banque Eric Sturdza in their capacity as Investment Advisers to the Fund as of 21/01/15.