Mackenzie Bluewater Team
The first quarter of 2018 was extremely volatile, with markets rallying globally in January, plunging in February, before rallying again, and then selling off at the end of March. The heightened volatility is not particularly unusual historically, and over the past decade we have had several similar periods, including sharp double and triple dip sell-offs in 2015 and 2011 respectively. In general, the overall economic picture remains strong, with corporate earnings continuing to grow, and valuations, based on current earnings, at reasonable levels, given the low levels of inflation and bond yields. This combination of factors suggest the near term backdrop for equities remains supportive. Despite this, over the past year we have begun to gradually position the fund for the inevitable end of the current economic expansion.
Before delving into how we think about economic cycles, it is worth outlining why anticipating them can be helpful for equity investors. From a fundamental standpoint, over time, stock prices tend to follow corporate earnings. Since earnings generally fall during periods of economic contraction, it seems reasonable to assume that stock prices are also weak during recessions. This intuition is quite easy to test. In the United States, the National Bureau of Economic Research (NBER) tracks historical US recession dates. Based on NBER, the US has experienced 7 recessions over the past 50 years. For the full time period, the S&P 500 (price only) index has compounded at roughly +7% a year. During NBER recessions, stock prices have fallen at 9% a year, while the compound return excluding recessions is around +10%.
Generally, we assume that the stock market is somewhat forward looking, which is why we are concerned about positioning the fund ahead of a recession. Based on the historical data, this seems to be a valid concern. If we modify the analysis slightly, and look at time periods starting 3 months before an official recession through to 3 months before the official end of the recession, the annualized returns are -20% during a recession and +12% per year when not in a recession.
Given that recessions appear to be important to anticipate, it is worth considering why they happen. Contractions in economic growth have historically been fairly infrequent, as the economy tends to grow over time, with growth driven by technological improvement, productivity improvement, and population increase. In addition, developed economies tend not to be particularly cyclical as much of GDP is service or government oriented. Areas such as healthcare, education, military spending, and much of basic needs consumer spending (food, utilities) tends to be very stable over time. This leaves a limited number of cyclical areas.
The most prominent cyclical area of the economy is housing, with declining housing transaction volumes and prices tending to precede recessions. Clearly this was the case for the 2008-9 recession in the United States, but the track record of housing as a recession indicator is much stronger than that. Arguably, all but one US recession in past 60 years was led by a housing slowdown. The lone exception? The 2001 recession, which was driven by a collapse in business investment from extremely elevated levels as the internet bubble imploded. In our view, there are fairly limited parts of the economy that are both cyclical enough and large enough to cause a recession. As a result, we attempt to monitor them over a cycle, watching for both unusual ramp-ups in activity which may foreshadow a major economic problem, and more standard cyclical overheating which tends to result in central bank tightening, and an interest rate driven housing and economic downturn.
From an investment standpoint, all recessions are not created equal, in terms of both the severity of the downturn in equities and the performance of individual sectors and stocks. The performance of the Canadian market during the internet collapse (August 2000 – September 2001) is a case in point. Although the overall market was down a fairly shocking 45%, 6 of the 11 industry sectors went up during the downturn. Extreme overvaluation and optimism around a handful of technology companies pulled the entire market down, as the Information Technology sector dropped over 95%.
From a portfolio management perspective, less cyclical, less leveraged, and less expensive businesses have tended to outperform during downturns. Nonetheless, we are extremely cautious about trying to draw broad conclusions as to the relative performance of individual sectors or companies from history. For example, the “lesson” from 2001-2 was that information technology should be avoided during a downturn, while sectors like financials and real estate were “safe” and would provide positive absolute performance. Clearly, this was not a great strategy during the real estate and financial collapse of 2008-9, with several sub-sectors in the real estate and financial areas down over 90%.
As always, rather than relying on a sweeping top-down view, we continue to go through both our current holdings and our universe of potential investments from a bottom-up perspective. For each company, we have gone back to original financial filings from prior downturns to understand the degree of cyclicality shown in the past. In addition, we attempted to adjust for material changes in Balance Sheet strength, business mix, and valuations. As a result of this process, there has been a gradual adjustment in the fund towards less cyclical and less expensive businesses.
At this point, we do not see clear signs of a broad global, or North American, recession. If anything, current data shows the opposite; corporate earnings are growing rapidly, leading economic indicators are signaling more strength ahead. As a result, it seems likely that the economic expansion will continue, which should be supportive of equity markets, particularly given that current valuations are generally reasonable, given the low level of bond yields. Nonetheless, with employment levels high, inflation gradually increasing, and central banks beginning to tighten, we suspect that the cycle is gradually winding down. We have been suspicious for some time that the economy is more sensitive to changes in interest rates than in past cycles, as a result we suspect that central bank tightening may have a larger impact than central bankers anticipate.
Jamieson Wellness is a new name recently added to the Canadian funds that exhibits all the characteristics we look for in a company. As Canada’s premiere vitamins and dietary supplements manufacturer, Jamieson has nearly 21% market share in these categories in Canada – larger than the next 3 competitors combined. Their pharmaceutical grade manufacturing processes have been a clear differentiator, going above and beyond even what the most stringent of regulations require. This has allowed them to gain a dominant market position in the geographies they compete in, including Saudi Arabia, where they enjoy a near monopoly and Jordon, where they have nearly 50% market share.
The company has a long track record of stable organic growth, having delivered 6% organic growth consistently since 1980s with no notable contraction even during recessionary periods. Going forward, the company envisions approximately 6% organic growth as well, driven by population growth, increased penetration of vitamins and dietary supplements as well as innovation and expansion into new categories and geographies. With China introducing a more streamlined regulatory process for foreign manufacturers to enter the market, there is tremendous long term potential in that market as the company has nearly 20 products awaiting certification.
Organic growth is further supplemented with strategic acquisitions that provide manufacturing capability, entry into adjacent markets and distribution channels, geographic expansion and meet Jamieson’s internal hurdle rate of 20%. In addition, there is significant operating leverage in this business given the highly automated nature of their manufacturing. With 6% organic growth, margins are expected to expand nearly 100 basis points per year due to improved utilization of facilities and higher absorption of the fixed cost base of manufacturing. As such, the company generates significant free cash flow while capital requirements are limited to approximately $6 million per year, or approximately 2% of revenues. A less cyclical business, with a healthy balance sheet, abundant free cash flow and an enviable market position in the geographies it competes in are attributes we expect will provide downside protection, particularly in a recessionary environment.
We continue to own a group of companies that we believe are among the best businesses in the world, with strong economic franchises, strong balance sheets, strong free cash flow generation, and superior management teams. Many of the companies have been successfully operating for 50 plus years; some have businesses that trace their roots back to the 1800s. Over time, across economic cycles, across market events, these companies have proven to be winners. We do not see any reason why that is not the case today.