Mackenzie Cundill Team
- It has been our view that value-oriented, cyclical stocks have been ripe for rotation throughout the first half of 2016. We encountered a speed bump in the rotation to value with a surprisingly low U.S. employment number in May and the unexpected results from the UK referendum vote in June.
- In recent months, we have seen our view validated, most notably via the change in stock market leadership. Investors have begun to warm up to companies that are most sensitive to the economic cycle — banks, energy, and industrial firms — while spurning those such as utilities and consumer staples. This has been manifested in cyclical stocks and sectors exceeding the market return by a wide margin. Consequently, our overweight exposure in Energy and Financials sectors contributed to outperformance relative to our benchmarks during the quarter.
- Obviously a few months does not constitute a trend, however we believe that we are in the early days of a multi-year reversion from growth and low volatility stocks back into value. Lending credence to our view is the fact that deep cyclical stocks like Caterpillar, for example, is now the top performing stock in the Dow Jones Industrial Index and has quietly outperformed the likes of Amazon and Facebook.
- Chesapeake 5 ¾ preferred securities, held across all our portfolios, was the top contributing security during the quarter. Continuing from the recovery we’ve been experiencing since its trough in February, Chesapeake nearly doubled in value during the quarter. Over the last year, Chesapeake has materially improved its financial position and has a line of sight to further de-leveraging. Chesapeake’s renegotiation of its midstream contracts with Williams, its sale of its Barnett shale acreage in August 2016, and its tender offer for its convertible and non-convertible notes, are concrete steps that have lowered its cost structure and made for a manageable debt maturity schedule in 2017 and 2018. We think it is likely that Chesapeake’s borrowing base will be renewed around its current $4.0B level, given that the elimination of the minimum volume commitment in the Barnett has increased its present value by approximately $550M, as well as the fact that it has more unencumbered assets to pledge, if so required. Lastly, our analysis suggests that the market is underestimating Chesapeake’s capital efficiency, as well as its ability to hit the mid-point of its 5 to 15% production compound average growth rate target in 2018, both of which are key to the company hitting its 2x Net Debt/EBITDA target. Given the aforementioned analysis, and assuming stable natural gas prices and a gradual recovery in WTI crude, we believe that Chesapeake’s 5 ¾ preferred shares have substantial price appreciation potential over the next twelve months.
- Our financial holdings performed well during the quarter, with AIG, Citigroup, and Bank of America among the top five contributors during the period. AIG delivered a set of results that handily beat expectations and demonstrated that its turnaround is on track. The company’s core underwriting business has improved while impact from non-core holdings diminished. Our U.S. bank holdings generally benefited from increasing odds of higher interest rates and improving economic conditions. Citigroup delivered second quarter results that surpassed expectations as nearly all of their net income came from their core businesses and the company showed significant sequential improvement in their efficiency ratio, return on assets and return on tangible common equity. Munich Re delivered profits that were much better than expected and continued to maintain a solid capital position. We believe the restructuring of their domestic division, Ergo, will further reduce cost and improve earnings potential of the company.
Outlook & Strategy
What are key risks that need to be managed?
- Overall, there are well publicized risks in many international markets due to policy decisions and macro forces. However, it is in such an environment where opportunities exist. We are cognizant of the need to balance return opportunities vs risks. Our portfolios have broadened investment drivers from a wider array of sectors and unique business drivers and we maintain a focus on finding undervalued opportunities while quantifying the risks where we can.
- Despite headline risks on Brexit and the upcoming Italian referendum, we believe European economies in general have been on a path of recovery. Data on employment, housing and consumption have largely been positive. This recovery has been bumpy, however. The timing and outcome of Brexit negotiations are still highly uncertain and that is putting a pause on business investment decisions in the near term.
- In Japan, the quantitative easing of Abenomics has not produced much real economic impact. Bank of Japan’s buying of government bonds has resulted in banks holding deposits at the BOJ, as there is no loan demand growth. BOJ’s buying of equities is potentially distorting the price discovery mechanism of the market. How much structural change will come from Abenomics remains to be seen.
- In China, there are currently no convincing signs of “hard landing”. Consumers seem to be in decent shape. However, there is clearly been overbuilding of infrastructure. Level of debt in the financial system remains a concern.
- As the U.S. election approaches, drug pricing has become a political “punching bag”, putting pressure on the healthcare sector and drug distributors. This has caused the price of some of our Health Care stocks to dislocate, including McKesson, Sanofi, and Novartis. We are confident in our view that we are holding strong franchises that are leaders in their fields. We continue to hold these companies as they display attractive valuation.
What are the key opportunities you see?
- Our expectation is that interest rates will inevitably normalize and act against bond-like equities like gravity acts on matter. Note that we do not need to see yields soar – just normalize. As bond yields rise, defensive names are expected to underperform. Our portfolio is not tethered to defensives. In fact it is considerably underweight these sectors, and positioned to benefit from a rate rise. That said, our financials have performed better as they continue to manage their costs and the economy improves. While higher interest rates would ultimately be beneficial to their earnings they are not the only drivers for increased shareholder value. We maintain our overweight in U.S. financials and have been adding selective names in U.S. industrials (Deere, Nielsen Company) and U.S. information technology (Oracle, IBM) that are expected to benefit from company specific drivers as well as the market rotation to cyclical sectors.
- Recent U.S. economic data and earnings have generally been surprising to the upside. Post-Brexit referendum, bond yields have started to move higher and financials have outperformed the market. Transports have also outperformed, which is usually a healthy sign for the stock market, as these two groups represent in our view are the arteries of the U.S. economy. We continue to find value ideas in the U.S. During the quarter, we materially increased our exposure to the U.S. in the Mackenzie Cundill Value Fund to be overweight relative to the index.
- U.S. companies exceeded profit estimates by the most since 2014, while almost two-thirds of European firms beat projections. In Japan, earnings surpassed forecasts after two quarters of falling short. Globally, analysts’ upgrades to earnings estimates are outnumbering downgrades for the first time since 2014. We therefore remain constructive on cyclical equities in the second half of 2016, on the premise that an economic re-acceleration has begun.