REBOUND AFTER WEAK 2018, GROWTH AND QUALITY REMAIN ATTRACTIVE
Year started very well as the growth was supported by favorable central bank positions across the world
Fig.1 2019 H1 Total return by regions and styles
(MSCI Regional (SPI used for Switzerland), Style, Size indices (Gross TR), USA
– in USD, EU – in EUR, CH – in CHF, World – in EUR, EM – in USD);
* – Hérens Quality Composite; Source: Herens Quality AM, Reuters, MSCI
** – Quality Global Composite, MSCI World – hedged performance
Since the beginning of the year, markets showed an astonishing performance returning on average 15-17%, while Switzerland did as much as 21% (wow!). There is a kind of dissonance between those figures and the news rhetoric, where where prevailing headlines were trade wars and signs of economic slowdown . The straight-forward reason for that was a rebound from December lows and centralized stimuli economies across the world have been receiving. Major beneficiaries -quality and growth investment styles- continued their winning streak over value, which is struggling for quite a prolonged period. 2019 kicked off very well as growth was supported by accommodating central banks’ policies across the world: ECB said rates would remain at current levels at least until the end of the year, dovish Fed comments provided hope for two rate cuts this year, Swiss National Bank stuck with its ultra-loose monetary policy. Also Chinese government joint these efforts, authorizing massive stimulus of US$1.22 trillion in 1Q2019 (vs. US$586 billion in 2008-2009). Additionally, we saw good performance both on macroeconomic level and business level in the developed markets. Quite different signals were coming from the emerging markets, which resulted in relatively weak EM performance: Sino-US trade tensions began affecting financial results of the companies and viable threat of significant outlook cuts appeared. Ever lasting dispute between the US and China alongside worsening global trade outlook weighted on the performance of developed markets in 2Q 2019, which was largely flat in April-June period. Realizing that in the given market conditions solid growth stories remain critical for the good performance, investors favored companies with decent strategies for further earnings growth and, therefore, fled to growth and quality, which has growth tilt and fundamental resistance to draw downs. As a result,value was left as an outsider in all regions yet again. On the sector level, performance trends were not that consistent: IT performed everywhere, while Financials did well in USA and EM and poor in Europe. Consumer Staples had excellent performance in Europe and Switzerland, but in US and EM it was Consumer Discretionary that did well.
PORTFOLIO INVESTMENT DECISIONS
Below we share few investment decisions we have taken with regard to Quality portfolios in the first half of 2019.
Barry Callebaut (BUY)
February 19th marked the day we added world largest cocoa grinder (by capacity) to our Swiss portfolio, thus increasing exposure towards defensive Consumer Staples sector, which proved to be a beneficial decision on all accounts. Every time equity market got hit by another wave of uncertainty and volatility, Barry, alongside with other food companies in the portfolio, stepped in and ‘saved the day’. As a pure B2B company that serves various customer segments (from global and local food manufacturers to artisan and professional users of chocolate), Barry Callebaut is an outsourcing partner of choice for big global names, among which are Nestle, Hershey’s, Mars and alike. As Barry’s chocolate is inside 25% of all consumer products around the world that contain chocolate or cocoa, you might be actually consuming one right now without even knowing it. Because grinder does not own any cocoa plantations, sustainability topic runs strong across Barry’s sourcing strategy through Forever Chocolate initiative. As of today, 44% of cocoa beans sourced by the company come from sustainable sources, whereas by 2025 Barry aims to bring this number to 100%. Ever growing share of sustainable sourced beans also bears very positive financial implications for the company – this is Barry’s way to address and keep premium customers that regard sustainability as key differentiator and, therefore, are prepared to finance it. Exposure to raw material fluctuations is, of course, an inherent weakness of Barry’s business model; however, most of company’s business is based on a COST-PLUS pricing system that passes on cocoa beans costs directly to the customers in order accommodate for price fluctuations and protect margins. Breadth of the portfolio, uncompromising focus on innovation, emerging markets push and customer proximity are just few factors that allow company to consistently outgrow
respective market and do so with ever expanding profitability. R&D focus is indeed imprinted in grinder’s DNA. In 2017, company came up with what market called ‘the biggest innovation in 80 years’ – fourth type of chocolate, called Ruby for its distinctive pinky color. Since in portfolio Barry yielded 15% and outperformed SPI by 6%, which might seem not that much, but we never invested in it in hopes to realize fast gains. Gradual yet consistent performance was the attribute we, as quality investors, were looking for and it seems like the family owning Barry’s business shares the same views.
PORTFOLIO INVESTMENT DECISIONS
Just recently, in mid-June, two years after making buy decision, we sold Halma, a niche player in global health and safety sensor technologies sector with presence in high growth markets, such as medical, environment and safety systems. Halma makes, and sells globally, a diverse range of equipment required to meet regulations in health, safety and the environment. This can encompass everything from hazard detectors to environmental protection kits and sensors. In addition to strong organic growth, Company has a successful M&A strategy with 10-year long track record of acquired growth of c.4% p.a. In June 2019, Halma, as expected, reported strong results – revenue grew in all major regions, but especially in the US and UK. Full year revenues added an impressive 13% to £1.2bn, while profits grew by 15% to £246mn- record figures for the group. Company’s robust earnings over the last years have driven the stock price to all-time highs and, after revisiting its valuation, we decided to sell. We closed our position with 83.7% gain in absolute terms and with 79.9% out-performance vs Stoxx 600 Index. Halma was also the best performing stock in European portfolio YTD, with 46% performance at the time of sale. We agree that premium multiple given such business quality, market positioning and growth rate is deserved, but even after publishing results Company’s absolute and relative valuation stood at its peak: PE ratio has increased to the extreme if compared to the historical levels – 40x vs 34x (3 year average), as well as premium to the sector has expanded greatly (Technology Hardware & Equipment sector traded at 24x PE). We believe that such valuation level is unsustainable and further increase in multiples in our view is unlikely. Also, because Halma’s business model partly relies on the ability to make acquisitions, as the group grows bigger, it becomes harder to find large enough acquisition target that would make a meaningful contribution to the top-line growth.
Ingersoll Rand (BUY)
In January 2019 Ingersoll-Rand (IR) appeared on our radars as a potential addition to the US portfolio after Industrials was among the sectors that corrected the most during 4Q last year. We like the companies that are exposed to strong secular trends – like energy efficiency in case of IR – as 90% of company’s products are falling into this category. Ingersoll is a diversified conglomerate that hosts multiple well known leading brands under its roof – Trane (world leader in Commercial Heat Ventilation and Air Conditioning (HVAC)), American Standard (Residential HVAC), Thermo King (Transport Refrigeration), Ingersoll Rand (Compression Technologies) and ARO (Fluid Handling). Business of the company is structured into Climate Segment (Trane, American Standard, Thermo King) responsible for 76% of sales and Industrial (ARO, Club Car) with 24% share. Company has also strong innovation culture with 85% of product portfolio refreshed since 2012. Fast forward to the end of April IR reported impressive results, specifically in Climate segment that posted organic growth of 10% with strong margin gains. Company also guided for the higher end of its annual outlook (EPS of $6.35 vs previous range of $6.15-$6.35) as it saw order momentum continuing for the full year. More importantly, Ingersoll Rand announced that it intends to combine own industrial assets with Gardner Denver, thus creating second-largest maker of pumps and compressors to compete with industry leader Atlas Copco. And market was surely convinced of the development, sending stock 7% higher that day. Since our Buy decision in mid January and until 1H 2019 the company made massive 38%, far ahead of 14% gain of Industrial sector in the US. The outlook remains bright and regulation is highly supportive both in Europe and the US. In 2014 European Council adopted climate and energy framework to reduce emissions by 40% and in April 2019 New York City passed what is described as “the most ambitious climate legislation for buildings enacted by any city in the world” – reduction of carbon emissions of 80% by 2050 (buildings represent 70% of emissions). That also makes the company a perfect fit for any ESG investor portfolio.
CORPORATE EXCELLENCE INSIGHTS PUBLISHED IN 1H 2019
Corporate Excellence Insights is our monthly publication that includes a brief update on markets and our thoughts about major trends that are impacting the investment management industry.
ZOMBIE COMPANIES: ECONOMIES ON THE EDGE OF THE ABYSS
The buzz around zombie or ‘walking dead’ companies got louder last year after a series of interest rate hikes in the US brought those operationally sick companies one step closer to their death rope. A number of studies signaled about the unprecedented quantity of zombie companies. Having interest coverage ratio below one over three consecutive years and being older than 10 years, zombie companies are not able to generate enough income to service their debt. However, there is always a risk that the ‘good’ companies heavily investing in business development or which experience temporary weakness could also fall into the unwelcome category.
SHARE BUYBACKS: AN ELEGANT SOLUTION TO YOUR EPS GROWTH PROBLEM
2018 was a year of the ultimate shopping spree for S&P 500 companies, which spent a mind-blowing $1 trillion plus in cash on share buybacks – the biggest amount yet over the course of the last decade. However, studies have also shown that managers often use repurchases of own capital as a tool to meet earnings forecasts (aka manage market expectations) or sell their own shares. They are also a great manifestation of shareholder primacy and short-term profits, as companies are neither putting this money into business through CAPEX or R&D, nor retaining it as a financial cushion for when economic downturn strikes.
BIASED ACCOUNTING FOR KNOWLEDGE-INTENSIVE COMPANIES
Fixed asset are largely becoming commoditized. Few decades ago, the equipment was often a source of uniqueness to the company as it was not available to every enterprise due to several reasons, limited funding being one of them. In the new millennium, assets such as buildings, cars or factory robots do not offer competitive advantage by themselves. Competitive advantage is being created by the company internally, when investing in the know-how, marketing and personnel, or is being obtained when engaging into mergers and/or acquisitions. However, the companies with substantial know-how investments are unjustifiably exhibiting lower earnings, lower asset base, and higher valuation multiples. Can something be done with regard to this problem?
HOW REALLY GOOD ARE THOSE CLAIMING THEY ARE GOOD?
Being really caring about the environment and human rights and, therefore, deciding on ESG investing, how confident you can be that your investments do not harm our planet? CFA Institute research revealed that the major investors’ concern around ESG topic is that its integration in the investment process might be just for marketing. We decided to question, whether ESG-focused funds follow their stated investment objectives and select environmentally-friendly and socially good companies with transparent and plausible corporate governance structure.
NEW HIGH CONVICTION PRODUCTS “TOP 8 TECHNOLOGY, TOP 15, TOP 25”
The launch of high conviction TOP 8 portfolio in 2014 turned out to be very successful with 11% annualized outperformance since inception. The initial concern about lack of diversification for the portfolio consiststing of only 8 stocks vanishes, when looking at beta of 0.9. The strategy proved that high quality stock selection can lead to the minimization of black swan effect. Additionally, the portfolio results empirically proved a theory of the diminishing effect of diversification after the quantity of stocks in the portfolio reaches 15-17.
This year we have expanded our product line-up, adding three new high conviction products:
1. Top 8 Technology portfolio, which includes 8 technology and IT companies primarily from USA (64%) and Asia (22%) in portfolio’s current composition;
2. Top 15, which includes 15 carefully selected companies from USA and Europe, which operate primarily in health care (30%), IT (30%) and consumer staples (19%) industries.
3. Top 25, which consists of 25 quality companies from USA, Europe and Japan which operate primarily in health care (28%) and IT (28%) industries (current composition).
«DIVERSIFICATION IS A PROTECTION AGAINST IGNORANCE. IT MAKES VERY LITTLE SENSE FOR THOSE WHO KNOW WHAT THEY’RE DOING. »
– WARREN BUFFETT
Financial Characteristics of Top Portfolios vs. MSCI World
Strong balance sheet and excellent capital profitability are definite characteristic traits of the stocks included in the Top portfolios.
The financial and growth ratios look solid for all High conviction portfolios as compared to the market levels. The selected stocks have pronounced growth profile, exhibiting fast development pace, particularly within the tech sector. Even more impressive are investments in R&D, which, coupled with envious profitability levels that provide a solid base for further business development and maintaining competitive advantage.
WHY TO INVEST IN QUALITY?
Trade wars could lead global economy to cool off – Quality stays resistant
The plague of trade wars is spreading from US-China territory to other regions. We were faced with rhetoric about possible US H1-B visas restriction – head-pain for Indian IT companies, duties for Mexico’s export to US, trade tensions between Japan and South Korea with regard to high-tech materials. Obstacles in international trade have already forced a string of companies to review their development plans and cut their growth ambitions. Baidu, China Southern Airlines, Archer Daniels Midland, Qualcomm, Apple among others reported lower or even negative earnings growth, citing US-China trade tensions. Weaker growth inevitably becomes apparent, which leads to the prolongation of the low interest rate environment. And it does not not seem to end soon. This is the thesis we put
forward in 2011 after the signs of the lengthy slow growth period appeared and now we face it in reality. 1 So, one has to learn to navigate during that period. The chart below provides the evidence that Quality stocks were able to demonstrate growth, while the general market showed rather depressive movement during the Japanese ‘no-growth’ time. The growth achieved by quality stocks was supported with the sound financials and solid business models. We elaborate more on these factors further.
Resilient business models should help
In an uncertain environment characteristics that might actually help a business to survive or even thrive is to have enough flexibility and agility hidden up the sleeve to move around and balance things out. Diversification – regional, client, supplier – is another strong card that helps in winning the game. It should not come as a surprise that majority of quality companies have those features embedded in their business model set-up. Ability to easily move the production with little to no additional costs is extremely beneficial trait, especially when trade wars are raging and Brexit is having a real chance to turn into a disaster. So is capillary manufacturing set-up, where you have local production to serve local customer needs. When one or several major clients of yours are having troubles, it can be regarded as no big deal if another 90% of your portfolio remains strong. However, if those several clients account for over a half of your revenues (and they are Chinese export-oriented companies), your are more likely to find yourself in a big trouble than not. The quality of business models usually translates into sustainable strong financials regardless of the market phase. Well-managed quality companies are able to navigate through the uncertain environment and deliver the results, making their shareholders happy. Lower financial leverage of quality stocks also provides enough room for share buybacks, driving the total return higher. Additionally, quality companies are characterized by lower operating leverage (Fig.2), having relatively low fixed cost burden. Thus, they are able to sustain their profitability, which becomes vital during the ‘no-growth’ environment that is usually accompanied by ever increasing competitive pressure.
Fig.2 Operating Leverage, 30.06.2019
Reference: 1. “8 Years in Search of Japanese Excellence””, 2013, CE Asset Management
Source: Hérens Quality AM, MSCI, Reuters
Sound financials at still attractive valuations
It is true that the markets are not cheap now in historical context, and neither are quality stocks, but their premium to the markets is justified by better forecasts, stable or even expanding margins, solid business models. It should be noted that there is no significant valuation gap between the market and quality stocks. The
average valuation of both, quality stocks and the market, falls within 18-22x earnings range in the US and in Europe. And this is the valuation level, which is the most fruitful for the quality stocks when they record the highest out-performance figures in USA, as well as in Europe (Fig.3).
Fig.3 5Y trailing performance since 2001 based on PE level
Source: Hérens Quality AM, MSCI, Reuters
Hérens Quality Asset Management AG is a highly entrepreneurial and solutions-oriented investment management boutique focused on Quality investments since 2003. Our investment style is traditional, timeless and has its own performance and risk character. We believe that a clear, disciplined and systematic analysis offers the key to sustainable investment success. In both the bond and equity asset classes, our analysis is based exclusively on proprietary research and analysis tools.
Source: Hérens Quality AM, PerTools, Reuters
* Composite: incl. transaction costs, div. reinvested, without management fees
** Annualized Alpha (risk adjusted)
*** For Japan till 31.03.2016 was taken Quality Japan Equity Composite performance, from 01.04.2016 is taken CAP Japan Equity Fund (ticker: CAPJPYI LE
Equity) performance including Management Fee.
**** For Quality Japan’s strategy till 31.03.2016 as a benchmark was taken Nikkei 225 TR index in JPY, since 01.04.2016 benchmark is Topix TR index in JPY.