Mackenzie Global Equity & Income Team
- During Q1 2018, Mackenzie Global Dividend Fund (Series F) returned -0.4%, and has now returned 13.4%, annualized, since portfolio manager change. This compares with the MSCI World Net Return Index ($CDN) Q1 return of 1.6%, and 12.3%, annualized, since portfolio manager change. Stock selection in Financials contributed positively to performance during Q1 2018. Stock selection in the Technology sector detracted from performance.
- Mackenzie US Dividend Fund returned 0.4% during Q1 2018 and has now returned 15.0%, annualized, since inception. This compares with the S&P 500 Total Return Index ($CDN) Q1 return of 2.1% and 15.9%, annualized, since inception of the Fund. Stock selection in the Financials and Health Care sectors contributed positively to performance. Stock selection in the Energy sector detracted from quarterly performance in Q1.
- After having gone up virtually every single month in 2017, Q1 2018 marked the return of volatility to global markets as stocks fell in 9 of the 11 sectors in the MSCI World Index. Indeed, last quarter was the worst-performing Q1 (in USD) for the MSCI World Index since 2009. A litany of reasons can be blamed, including the risk of a trade war between US and China (let alone the dissolution of NAFTA), as the Trump administration imposed tariffs on steel and aluminum. This is what prompted Trump’s top economic adviser Gary Cohn to resign and added to the uncertainty surrounding the current White House regime. From a geopolitical standpoint we are obviously concerned with rhetoric over tariffs being tossed around between both the US and China, but still believe a full blown trade war is unlikely as both parties recognize it would negatively impact both economies. Other geopolitical hot spots weighing in on the market include, as usual, Europe after anti-establishment parties won 55% of the popular vote in Italy and left the country with a hung parliament. Japan stocks suffered as a cronyism scandal threatens to put Prime Minister Shinzo Abe’s leadership at risk this fall.
- A hint of wage inflation during the quarter drew the commensurate concern global central banks would be forced to tighten monetary policy more than anticipated. The U.S. raised rates another 25 bps and signaled further hikes, ceteris paribus, and the Bank of England, while leaving rates unchanged, also indicated that will likely change next quarter. Even the ECB indicated that it may soon begin to reduce monthly asset purchases. That leaves the Bank of Japan as the last major developed central bank that has held off pivoting to a tighter monetary policy.
- Added to the mix was heightened regulatory scrutiny of some of the world’s biggest (read: widely held) technology companies and the evolving role governments may play as it relates to capital markets. Concerns over data privacy and moves by the EU to tax tech company revenues based on where their users are located stoked fears. There are a number of high profile potential M&A transactions that hang in the balance as the regulators grapple with antitrust concerns (i.e. Time Warner and AT&T, Monsanto and Bayer, Fox and Disney). Others have already been shut down (Qualcomm and Broadcom) over slightly more arbitrary claims, as CIFIUS speculated that any change of control from Qualcomm to Broadcom could pose a threat to the national security of the U.S.
- From our vantage point, talk of central bank tightening in the context of an improving global economic backdrop is not a bad thing. The US economy continues to tick along at a solid clip, with initial unemployment claims at the lowest level in 45 years and healthy (but not excessive) wage growth. In Europe, it is also more of the same from last quarter. Government deficits narrowed, business confidence remains high, and households are starting to borrow money again. In Japan, many indicators show an economy that is stronger than any time post the early-1990s bubble, and unemployment is at its lowest level in decades. China, the world’s second-largest economy, while showing signs of slowing down continues to grow in excess of every other developed economy as it benefits from a growing middle class, a more transparent banking system, and ongoing urbanization. And while the recent constitutional amendment to remove the presidential term limit gives fans of western-style democracies reason to pause, it is likely a positive for China’s economic development and allows President Xi to pursue his reform agenda with greater certainty.
- Today the multiple on global stocks is a little higher than the long term average, but both bond and cash yields are also less attractive than their historic averages. We’ve used this analogy before, but would one prefer to own a business at a P/E of 17 that’s likely to grow its cash flow and dividend streams mid to high single digits over time, or a bond P/E of 33x (in the case of US) or 40x in the case of Canada that definitely will not grow? We welcome the return of volatility and being able to purchase high-quality companies that have a great long term outlook but reflect a more pessimistic immediate future. In short, we like an expanded opportunity set the market is starting to give us.
What contributed positively to performance?
- All five of our stock exchange holdings made money in the quarter, with the standouts being Deutsche Boerse and CME Group, which were also our two largest exchange positions at quarter’s end. Deutsche Boerse is the largest exchanges operator in Europe and owner of Eurex, Europe’s largest derivatives trading and clearing platform, and Clearstream, Europe’s second-largest settlement and custody platform. The company is benefiting from both structural growth drivers (i.e. regulatory push to on-change trading from OTC) and cyclical tailwinds such as the reemergence of market volatility as bond yields normalize and central bank tightening comes into focus. We particularly like stock exchanges because, unlike banks, stock exchanges benefit from rising rates and volatility but do not take on trading or balance sheet risk to do so. Deutsche Boerse also recently named a new CEO, Dr. Theodor Weimer, who had previously run UniCredit’s German business and is well-regarded by investors for his close relationship with German regulators and politicians – a key “skill” to have when operating a national stock exchange.
- Norway-based Marine Harvest ASA, the world’s largest producer of Atlantic salmon, was one of the Fund’s best performing stocks this quarter. The salmon farming business is pretty straight forward: fertilize a salmon egg, grow it in a freshwater tank for about a year before transporting to a floating seawater cage in the ocean for another two years. Once grown to a harvestable size (around 5kg), transport back to a plant where the fish is gutted and then either sold whole fresh or processed further into value-added products such as cutlets and fillets. On the surface, this would not appear to be a typical investment for us, as we generally avoid commodity-oriented businesses. But the market dynamics make this a somewhat unique situation. Firstly, there is a structural supply/demand imbalance which should continue to support a very positive salmon pricing environment over time. Demand has grown 8.6% per year over the past 20 years for a number of reasons, the main one being more people in the world wanting what is a very efficient and healthy source of protein. Supply growth is constrained to 0-3% per annum as there are only a handful of regions in the world where salmon can be farmed due to natural ecological requirements (sea water temperature and current). And not surprisingly this is a highly regulated business where farming licenses are finite and operators are strictly monitored. The industry has consolidated over the past decade such that the top five players control over 80% of the market. Marine Harvest commands approximately 23% share which is well over two times the nearest competitor. We were able to pay under 12x earnings for a company that generates mid-teen ROCE, 20%+ operating margins and pays out 75% of its earnings as dividends for a 5.5% yield.
What detracted from performance?
- Our largest detractor in Q1 by far was Micro Focus International plc. Micro Focus stock price fell from 1885p to 1011p in one day, and in fact hit 850p intraday at one point. This represents the largest one day decline by any stock held by the fund since taking over management responsibilities over four years ago. Micro Focus has since rebounded to approximately 1300p as of this writing. Micro Focus is a successful acquirer of legacy software infrastructure businesses. The savvy capital allocators who lead the firm grew shareholder value at over 30% per annum in the 10 years up to the end of 2016, and the stock is up 11 fold in that time period. Micro Focus did the largest acquisition in its history when it bought Hewlett Packard’s legacy infrastructure software business in September 2016.
- The stock fell dramatically for a few reasons, all related to the HP acquisition. First, the company guided to a larger first year revenue decline than anticipated, which translated to a 7% “miss”. Second, the company had an integration issue with the new IT system being applied which “impacted sales force efficacy” leading to higher sales force attrition and sales execution issues. This is mostly in North America, and pertains to the HP business they had just taken control of three months prior. The third and last reason for the panic is because the CEO resigned. The CEO who resigned was formerly the leader of acquired business HPE Software. He was not intrinsic to the culture that developed the track record cited above, so this is less of a concern. He was replaced by a key driver of Micro Focus’ historical performance, which we view favorably.
- We believe the market overreacted, and valued the stock irrationally. It is normal to have integration issues; it is also expected that there will be higher sales force attrition given merger uncertainty. Those turned out to be higher than the market expected, but variability is part of business. Those problems will be solved, while the customer stickiness, and its concomitant cash flows, will persist.
- Kinder Morgan was our second-largest detractor of performance as energy companies and in particular high dividend paying pipeline companies underperformed. The company is in the process of de-levering its balance sheet while selectively allocating capital to extensions of its best-in-class natural gas pipelines. Natural gas is still the fuel of the future and Kinder Morgan handles 40% of all natural gas in the United States. A large portion of Kinder Morgan’s business is regulated supply of natural gas to utilities for the purpose of electric generation. Kinder is a primary beneficiary as generation shifts away from coal to natural gas. The company recently increased its dividend from 2% to 5% as it gets back to a normal payout ratio. While the company is no longer the growth story it was, it is now focusing on generating free cash flow while paying a healthy yield to investors. And finally, Wells Fargo slid after the Federal Reserve took the unusual step of banning the bank from expanding its assets until the lender can show it has resolved its “widespread consumer abuses and compliance breakdowns”. While the best-in-class premium the company historically held is a distant memory and the stock represents good value, we acknowledge it will take time to win back the confidence of investors.
What changes have we made to the Mackenzie Global Dividend Fund?
- Starbucks is the largest coffee company in the world, with nearly 30,000 locations. The business now spans most geographies and is growing fastest in the Far East, in particular China, where 12% of its locations are located. Starbucks, a long-time dream team name operating at the top of its value chain has been in transition for the last three years. The company’s strategy to build a bigger presence in food as well as the operational challenges of fulfilling mobile orders have kept the shares in a range as the company grew into its elevated valuation. The maturation of business have reduced same store sales growth from 7% to 3% in North America where two thirds of the company’s profits come from. On the positive side, the company continues to open stores at a growth rate of 10% per year. Most of the company’s stores are leased locations and have a payback of less than a year. The store openings in emerging markets, while lower grossing than developed markets, are important for promoting coffee culture in new markets. While coffee is a morning ritual in North America, Starbucks’ principal traffic in China is in the afternoon where people come to the location with their friends. The company has recently fixed its mobile ordering issues, which required the reallocation of resources and the North American business has stabilized. The company has now given up its premium valuation on an operating profit basis relative to other consumer companies, but continues to have superior growth with a modest 2% dividend yield. We expect Starbucks to continue to generate double digit earnings per share growth and for the first time were able to purchase shares in this compounder at a discount to our intrinsic value of future cash flows.
- Goldman Sachs is the world’s largest independent investment bank. Over its 140 year history the company has been at the center of every financial boom and crisis. The Company’s primary operating activities include market making, Investment Banking, Investment Management, and Investment and Lending. The most significant is market making or trading activities accounting for nearly half of revenues and profits. This business is the primary beneficiary of volatility in the financial markets. The business has been flat for the past five years due to the shift to passive investing, but a temporary reversal is likely coming. For its role in the last financial crisis the Federal Reserve has restricted the company and other investment banking firms from any excessive risk taking. GS now has generation-low, leverage ratios. Taking out deposits with the Fed, the company is levered 10X. If this was to begin to reverse the company will be a big beneficiary of deregulation.
- From a market making perspective the key opportunities are fixed income spreads, commodity trading and cryptocurrencies. As surprising as it might be, Goldman is actively exploring launching a cryptocurrencies desk. While we do not like investment banking business due to their embedded leverage low returns on capital (1.5%), we have to be smart on how we get exposure to new emerging technologies. During the dotcom bubble, Goldman Sachs was a major beneficiary and a great way get exposure to people’s madness. The blockchain phenomenon is no different. If it continues Goldman, as the arms dealer, will benefit, if not GS will continue to benefit from higher interest rates and deregulation. This is an exposure investment like an ETF versus a high quality compounder that our team typically invests in. The shares have underperformed and are selling for 1.2 times book or 11 times forward earnings. The company favors buying back shares at a rate of 5% per year versus increasing its 1% dividend yield. GS shares represent a unique opportunity to get exposure to where we would otherwise abstain.
- We sold Anheuser Busch this quarter. Primary research suggests the challenges facing the company are tougher than we thought, and tougher than what the market believes. The market is pricing ABI to overcome the structural challenges it faces, while there is no evidence as to how this would be achieved. The main challenge is in the US market, where ABI continues to experience volume declines to craft brewers and from a demand shift. Anheuser Busch’s two biggest brands are Budweiser and Bud Light. These two brands generate over $20B in revenue, and over $10B in EBITDA; together they are worth 40-50% of the group’s $300B enterprise value. The brands were dominant in the old consumption landscape. Consumer demand in the US continues to move away from what those two brands represent. In the US the industry sales were -1.3% while ABI was at -3.0% with -3.5% volume decline – and the top two brand’s did significantly worse. Nothing the very enterprising ABI leaders attempt has helped to rejuvenate the two top North American brands.
- There were other reasons including that long term demographics over the next two decades will to be less favorable than that of the past two. Also, the firm seems to have less pricing power than was commonly believed. Effectively, the “pricing” ABI report in Revenue/HL is strongly driven by mix – mostly the penetration of premium end brands in less “developed” markets. Actual price increases rarely exceed inflation. All beer companies have also enjoyed a pricing tailwind from increased taxes, where over 10 years, taxes increased from 30% to 47% of gross revenue. The tax increases provided a pricing umbrella.
- Some of our reasons for buying the stock did materialize. We bought the stock at the end of 2016. Prior to the buy, ABI’s stock price flirted with highs of €120 per share from late 2014, through 2015 and most of 2016. Then, it fell rapidly to €94 over two months at the end of 2016. ABI’s big Brazil business collapsed in 2014 & 2015 due to that country’s recession. We began to see it turn around in 2016, and this was part of our thesis. The turnaround fully materialized in 2017. Average volume was -0.3% for 2017, while 3.0% in Q4, with price/mix of +6.4%. A second reason was around the synergies and strategic opportunities available following the SAB transaction. ABI is well ahead of its synergies target of $3.2B. Strategically, Budweiser and Stella Artois are being deployed aggressively into former SABMiller territories, with success. However, Heineken has been aggressive in competing with SAB’s broader offering (e.g. less premium) in places like South Africa. In the end, the larger strategic questions led to our reallocating our capital to another firm which offers better growth and returns, but at much lower risk – as Anheuser Busch carries a significant amount of debt.
- We sold shares of General Mills after a very strong Q4. The company has great brands in cereal and yogurt but the categories have become challenged as pricing ability has degraded across the sector. Our purchase at 4% yield and attractive valuation accounted for these challenges. However, after an impressive run up we were able to reallocate capital within the Dream Team. Since that time the shares have once again fallen by 30%, due to an ill-advised acquisition of Blue Buffalo Pet Products. While, the stock is cheaper than it was before, the company paid too much for the target and numbers in the core have continued to degrade. General Mills continues to be on the watch list, but we are reluctant because of management’s poor capital allocation decisions that continue to erode value.