Mackenzie Bluewater Team
Equity markets were strong in the second quarter, rebounding from the sharp drop at the end of the first quarter. On a year to date basis, despite considerable volatility, developed markets are relatively flat. The overall economic backdrop continues to be supportive, with corporate earnings rising, which should be reflected in stock prices over time.
Over the past few months, trade conflicts have dominated headlines, with the United States looking to alter global trading agreements and conventions in their favour. Although the US is a fairly closed economy, with only around 15% of GDP imported/exported versus 30-50% for most developed economies, the sheer size of the US economy, at around 25% of global GDP, coupled with the extreme interconnectedness of global trade, makes trade conflicts disruptive for the global economy.
In our view, supported by careful economic research, the outsourcing and globalization wave of the past two decades has had a mixed to negative impact on the United States. Companies extended their supply chains globally in order to reduce costs and increase profit margins. A portion of those cost cuts were passed through to consumers, who benefited from lower prices, but there was also an offsetting impact on employment, with the economics profession's vision of employees seamlessly moving into new jobs in new areas conflicting with a far harsher reality. Unsurprisingly, at least to anyone who isn't an economist, the transition from line work in a rust belt manufacturing plant to a new career as a software engineer in Silicon Valley proved far more difficult than economic models predicted. As a result, there was a clear disruption for trade exposed workers in the United States, who experienced a long-term reduction in income and elevated unemployment levels.
Despite the current US Administration's focus on terms of trade, as we speak to companies about their plans, it is evident that the great outsourcing wave has already crested and appears, if anything, to be moving into reverse. In our view, rising trade conflict is likely to simply hasten this process. Unlike a decade ago, when it seemed every company was focused on globalizing their supply chain, the leading edge companies are now looking to move to more localized production through the adoption of much higher levels of automation and digital processes.
From a Canadian perspective, we have previously written about the uncertainty surrounding the NAFTA negotiation process and the caution it warrants for the domestic economy. While simplistically, tariffs should reduce growth and create inflation, the actual impact on any particular product is far more complex and influenced by a multitude of variables including the elasticity of demand, substitutability of the products, pricing power of the producers, and many other factors. A recent example is the dispute over softwood lumber, where tariffs applied to Canadian production that were initially expected to impact consumers and producers equally were entirely passed through to US consumers, with minimal impact on Canadian producers.
Broadly speaking, trade with the United States accounts for just under 20% of Canadian GDP, while trade with Canada accounts for less than 2% US GDP. As a result it appears to us that Canada is at a large negotiating disadvantage on NAFTA. Any large dislocations caused by material changes to NAFTA should have a much more material impact on the Canadian economy, which will likely impact both Canadian equities and the Canadian dollar.
Since President Trump was elected, we have viewed his anti-trade rhetoric against Canada as a potential risk and have avoided businesses that could be negatively impacted from tariffs placed on goods which include automotive, lumber, steel, agriculture and dairy. In Canada, we have limited direct exposure to these industries. When we think through the "potential" implications on our businesses, nothing stands out to us that could have a material adverse impact. Historically, Canada's economy has been very much tied to the US economy, which continues to grow reasonably strongly. In our view, the trade conflict may limit Canada's ability to fully benefit from US growth this cycle. As we have been writing for some time now, our direct exposure to Canada (as a percentage of the revenues of our holdings) is only 28%, and a material component of this are in what we believe are very "defensive" businesses; companies that are not highly reliant on GDP growth to continue to grow their free cash flow. In addition, our investment philosophy focuses on companies that have pricing power, as we believe that this is an important indicator of competitive strength. Over time, companies with pricing power should be able to pass through any tariff impact to their end customers, rather than absorbing it themselves.
Ultimately, it is likely impossible to accurately forecast the impact of the current trade conflict on either Canada or the global economy. When thinking about the scale of the conflict, it is important to keep in mind that global GDP is around $80 trillion and is expected to grow by $4 to $5 trillion in 2018. To date, the expected economic impact of the conflict is comparatively small. Unfortunately, we have no way to determine how large it will be or how long the trade turmoil will last. It is reasonable to assume that the larger the conflict, the greater the impact on economic growth.
From our perspective today, the US economy is quite strong, aided by the US Government's decision to run larger deficits. The Federal Reserve has been, and continues to, gradually move rates higher to manage US economic strength. Global growth has also remained generally positive. As a result, barring a material trade conflict, the notion of synchronized global growth remains a tangible possibility. Seemingly oddly, since we are a growth manager, this is the one environment where our style of money management likely does not do as well on a relative basis. Why, you ask? The companies we admire the most are businesses that are able to grow their free cash flows at above average rates consistently over time, with growth rates relatively unaffected by the underlying economic cycle. For our favourite companies, what you see is what you get in good times and in bad times. In an environment of global synchronized growth, businesses that are cyclical and highly leveraged tend to shine, as they experience an outsized acceleration in bottom-line growth. As a result, you have a shift in investor sentiment from stable businesses to more cyclical businesses and money leaves our type of companies in favour of businesses that have more "upside torque". Historically, this rotation has tended to be fairly short lived, as the acceleration of economic growth is met by accelerated central bank tightening. This tightening ultimately creates a slowdown in growth; an environment where our style, and our companies, have tended to return to strong relative performance.
During the quarter we established a core position in Baxter, a diversified US-based medical equipment company. Historically, we viewed the company as having a strong heritage, a number of excellent businesses with dominant positions, but a fairly weak and misfocused management team. As a result, we had never been interested in becoming shareholders, regardless of valuation. In our view, there have been a number of very positive and tangible changes at the business over the past few years, which we believe now make the company suitable as a core holding of the funds.
Baxter has a long history in medical devices, with the business founded close to 90 years ago. The company has a strong position in a number of niche device markets including kidney dialysis, intravenous medication delivery, and clinical nutrition. Over the years, Baxter also became a dominant player in the biopharmaceutical treatment of hemophilia. This is a high margin pharma business, and is extremely different from a management perspective than the lower margin device business. Pharma is a high risk/high reward business. Drug development costs can run into the billions of dollars, with no guarantee of product approval. If a drug is successful, there is a fairly brief patent window where the drug has monopoly status and pharma companies are massively profitable. When the patent ends, generic competitors flood the market dropping prices by 90%. As a result, pharma is a constant treadmill of trying to develop a strong enough pipeline of new drugs that can offset the inevitable collapse of current top selling drugs. This is extremely different from the device business, where product development tends to be steady and incremental and companies can maintain dominant positions for decades.
Unfortunately, in our view, Baxter had difficulty managing the two businesses simultaneously, and began managing the combined entity as if it were entirely a pharma business. This resulted in a product development process which emphasised high risk/high reward "hit products" and weak cost control. Both of these attributes are appropriate for pure pharma companies, where hit products can result in billions in sales and gross margins can be 80%+. However, in the medical device world, where hit products are comparatively tiny, and gross margins rarely get above 55%, it is not an effective way to run a business. In addition, our understanding is that over time the employees in the medical devices business began to feel like second class citizens; there to produce the cash to fuel the exciting bio-pharma segment, but with no way of creating either the growth or margins that the pharma business could generate.
In 2014, Baxter decided to spin-off the biopharma business into a standalone company called BaxAlta, which was subsequently acquired by Shire Plc. The continuing Baxter business became a bit of turn around with low and unpredictable growth due to the hit and miss nature of R&D and a bloated cost structure. In 2016, the company brought in a new CEO: Jose (Joe) Almeida, the former CEO of Covidien, which had been a core holding in our funds prior to the business being acquired by Medtronic, and who is, in our view, a very competent medical device company CEO.
Over the past 2 years, Baxter has begun to transform into what we believe will be a top performing medical device business. A recent meeting with CFO Jay Saccaro helped to confirm a number of the changes. The R&D area has been completely transformed, and is now focused on reliable and steady innovation. The organic growth rate of the company has begun to increase, and we believe a further acceleration is likely. Profit margins have improved, but remain below comparable companies, which should allow for further expansion and faster bottom line growth. The company is actively looking for small tuck-in acquisitions, with the old M&A team replaced by the former Covidien M&A team which we held in high regard, which should add to growth in a fairly low risk manner. Finally, and most importantly, post a period of elevated turnover, there has been a clear improvement in the morale and culture of the company, with employees knowing that they are now the core of the business, rather than a less exciting afterthought. In light of all of this, and with the business trading at a discount to our estimate of fair value, we established a core position in Baxter across all our funds. Baxter is yet another great example of the kinds of businesses we love to own; stable and steady organic growth, operating leverage from this growth and mid-teens free cash flow growth trading at a discount to fair value based on our discounted cash flow model.
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.