Mackenzie Global Equity and Income Team
- During Q2 2017, Mackenzie Global Dividend Fund (Series F) returned 3.1%. This compares with the MSCI World Total Return Index ($CDN) return of 1.3% in Q2 2017. Financials, Consumer Staples, and Information Technology sectors were the biggest contributors to returns this quarter. Not surprisingly, Energy was by far the biggest drag on performance, followed by Real Estate. Since taking over management of the fund in early 2014, Mackenzie Global Dividend has returned 15.0%, annualized, versus 12.2% for the benchmark.
- Mackenzie US Dividend Fund returned 5.1% during Q2 2017 and has now returned 18.3%, annualized, since inception. This compares with the S&P 500 Total Return Index ($CDN) Q2 return of 0.4% and 16.5%, annualized, since inception of the Fund. Stock selection in Information Technology and Consumer Discretionary contributed to performance during the quarter. Slight detractors included stock selection in Consumer Staples.
- The global economy’s fragile recovery is showing signs of life, with manufacturing improving, some non-oil related commodity producers recovering, and trade and investment picking up from low levels. The OECD now predicts world GDP growth will accelerate to 3.5% in 2017 (from 3.0% in 2016), and 3.6% in 2018. Despite lingering concerns about healthcare and tax reform, the US market grinded higher in Q2. The Fed raised the cash rate by a quarter point to between 1% and 1.25% and outlined a plan that was seen as credible to reduce its balance sheet. Economic reports released over the quarter were judged as passable. They showed the US economy expanded at an annual pace of 1.4% in the first quarter while the jobless rate fell to a post-crisis low of 4.3% in May. European markets ended only slightly positive (albeit more positive in Canadian dollar terms) after a nice move post the French elections, as the Conservatives were only able to form a minority government in the UK and talk is mounting of another general election before too long. Bond yields rose after the ECB said the reflating economy might allow it to reduce its asset purchases in early 2018. The German 10 year government bond yield rose from 0.20% to 0.46% over the 3 months, while a report showed the Eurozone economy expanded 0.6% in the first quarter, and 1.9% from a year earlier, thanks to a rise in investment. Stocks reacted positively as investors were reassured when the pro-EU Emmanuel Macron defeated the anti-Euro populist Marine Le Pen in the French presidential election that was held over two rounds in April and May. Macron’s election may also see the re-emergence of close cooperation between France and Germany, giving the EU the strong leadership it needs and presenting a united front against both internally divisive issues and external pressures (read: the Trump Administration).
- Strong economic activity and easing concerns over China’s financial system integrity were positives for that market as well. Fixed investment for infrastructure increased by more than 23% through April (YOY). Combined with a robust housing market and a healthy domestic consumer, China’s ramped up stimulus program helped drive better than expected growth last quarter. Indeed, China is on pace to account for around a third of global growth in 2017. Financial reforms centered on the regulation of securitization products and the reigning in of reckless credit extension was also an encouraging development, as was the announcement that MSCI would include Mainland equities in its global equity benchmark going forward. We believe over time Chinese equities will increase their prominence in global investors’ portfolios as the size and significance of the underlying economy is more accurately reflected across such benchmarks.
- At the end of the day, as it is with individual companies, market’s generally decline when there are declines in real earnings, and the single biggest driver of earnings for an overall economy is employment. And while we can argue whether or not the official job figures represent the true amount of “slack” in the labor market, the fact is Eurozone unemployment is the best it’s been in eight years at just over 9%. Additionally, the Eurozone has moved from a small current account deficit to a surplus of over $400 billion since the GFC. Most investors are unaware that Europe’s GDP actually outgrew the US in 2016 (although, to be fair, has lagged behind in terms of corporate earnings growth). The U.S. employment situation is even better: if the US maintains its current pace of job additions, its unemployment rate will drop below 4% next year. In short, things look pretty good from an employment standpoint in the world’s two most important capital markets.
- BUT…while the economic news was generally positive, growth remains below historical norms despite a boost from planned fiscal initiatives. Investor concerns include elevated stock and bond valuations, high debt levels, overheated property markets, unsustainable interest rates and central bank policies, weak productivity and wage growth, and geopolitical uncertainty, among others. Negative interest rates remain prevalent, with about $9.5 trillion of “risk free” sovereign debt still trading at a negative yield. In the context of hundreds of years of banking history, the notion of guaranteed losses on held-to-maturity fixed income investments is hard to get our heads around. In emerging markets, 10-year bond yields (in USD) for Russia and Brazil are priced at under 4.5% and 5%, respectively. For some context, the U.S. 10 year averaged 4.9% in the decade leading up to the financial crisis. Today, Italian bonds trade at a lower yield (2.15%) than that of the U.S. (2.30%), despite facing weak economic growth, a troubled banking system, and ballooning public debt. How does this make sense?
- Negative interest rates and Italian bonds aren’t the only thing that has us scratching our head. Argentina was able to come to market with a 100-year bond paying only 7.9%. Keep in mind this country has defaulted on its debt eight times (including twice since 2001). Another one: most people would not be aware that the Swiss National Bank (SNB) owns nearly $80 billion in just U.S. stocks. The SNB now owns more publicly traded shares of Facebook than Mark Zuckerberg! The rapid adoption of ETF trading has probably created some distortions in the market. The two most popular, the SPDR S&P 500 ETF and the iShares Russell 2000 Index ETF have turnover rates that exceed 3500% - an average holding period of about a week. This is dozens of times greater than the trading liquidity of its most liquid constituents. Just last month, the Nasdaq 100 shares gave up $400 billion in a series of rapid-fire sell offs, only to gain it all back in eight straight days in July. Be prepared for some very unusual ETF behavior when volatility arrives back into the market!
- If you are confused, good. That was the point. As the aforementioned comments suggest, there is never any shortage of macro ammunition to support one’s viewpoint, whether you are pre-disposed to be bullish or bearish, hawkish, dovish, or anything in between. Single data points can move markets depending on the day, the source of the news, and the general sentiment at that time. As global investors focused on owning dividend paying compounders, we try to maintain a long-term view and constantly stress-test our company’s competitive advantages as best we can. If we are confident that the stocks we own can continue to reinvest in their business at above average rates, grow – even modestly – without the use of leverage, and return excess capital to shareholders via not just dividends but also, when it’s appropriate, share repurchases, we think such equities continue to be the best house (asset class) on the block.
What contributed positively to performance?
- On the back of the Macron victory, our European names were big contributors to performance, and Safran was a standout in that regard. Safran – along with partner GE – has been taking global market share in jet engines and is currently rolling out its biggest product launch ever: the LEAP (Leading Edge Aviation Propulsion) engine. Our confidence in GE is due in no small part to the Safran partnership, which is the most valuable part of GE Aviation and has thus far hit every project milestone – an impressive feat given this is biggest and most demanding engine launch in aviation history. In addition, Safran stock reacted positively when the company revised down its tender offer for commercial aircraft equipment supplier (and habitual underperformer) Zodiac Aerospace, increasingly the likelihood that once completed the deal will be highly accretive to earnings. We continue to believe that Safran is trading at a large discount to intrinsic as the LEAP engine installed base grows, enabling the company to generate highly predictable parts and service cash flows over the ensuing decade.
- Copenhagen-based Novo Nordisk also recovered nicely and was up over 21% (in CAD) for the quarter. More data was released this quarter confirming the differentiation GLP-1s offer as a superior form of diabetes treatment compared to insulin. And while all GLP-1s control blood glucose and have beneficial weight effects to varying degrees, only Novo’s Victoza LEADER trial and the company’s semaglutide SUSTAIN-6 trial have shown a reduction in cardiovascular risk so far. As the evidence mounts it will be harder for payors in the U.S. to discriminate against Novo’s products purely on price. Q1 earnings also came in above expectations, but we put less stock (pun intended) on that factor as it was mostly driven by one-off outliers such as inventory management that drove higher gross margins. Our long term thesis continues to be that the release of their oral GLP-1 therapy in three years’ time will be a transformative event that reshapes the global diabetes industry.
What detracted from performance?
- Schlumberger was our worst performing stock as oil prices entered bear market territory this quarter on persistent oversupply fears. While the correlation to the price of oil is obviously higher than that of the overall market, over time less than a third of the stock’s longer term performance variation can be explained by the performance of the underlying commodity. The oil-well productivity gains provided by Schlumberger’s innovative technologies and services are key drivers of long-term value creation, particularly as drilling and completion intensity in North American unconventional basins inexorably rises. Schlumberger is in a position to provide value to customers and shareholders whether oil stays at $45 or goes to $65 per barrel. Despite the overall market concerns (and ours!) about long term threats to oil prices brought on by demand destruction as a result of electric vehicles and everyone having a solar panel attached to their roof, we think that is still many years off. According to the EIA, U.S. onshore production has risen just 350,000 bbl/d above its fall 2016 trough, which should be more than offset by global demand growth of 1 million barrels and OPEC cuts of an additional 1 million barrels. Sub-$50 oil is going to challenge even the best North American operators. And the short term price action notwithstanding, we are now over three years into a period of constrained investment in the development of large-scale fields, which should lead to a supply-demand imbalance at some point. Schlumberger will be in a position to benefit both from a demand and pricing standpoint when that time comes. In the meantime, we receive a 3% dividend coupon while we wait.
- GE was our second biggest individual drag on performance. Shareholders are starting to get anxious with the progress the company is making as it relates to their reorganization. As a result of such pressure, long time CEO Jeff Immelt has announced his retirement and that John Flannery, currently the CEO of GE Healthcare, will take over August 1st. Well-regarded CFO Jeff Bornstein will remain CFO and be promoted to the role as Vice Chairman. In addition there were some downgrades of the stock by sell-side analysts following their Q1 results, citing a lower conversion of earnings into cash flow and questioning their earnings quality. We are less concerned, as the company has been preparing for big product launches in two of their longest cycle businesses and has by design been less efficient with working capital in order to ensure smooth rollouts. This is explainable by where they are in the launch cycles and that the cash flows they’re going to produce from those launches are well worth any short term mismatch between GAAP earnings and cash flow. This is particularly the case for their biggest and most profitable Aviation division (see the comment on outperformer Safran). Their Power business, despite also being a relative drag on current reported cash flow, continues to offer significant upside through cost synergies and cross-selling after the Alstom purchase. Their medical equipment business is well positioned in its core ultrasound and imaging markets and has good growth potential in emerging markets with an expanded product line for the development of biologic drugs. Their energy business, which they combined with Baker Hughes near the bottom of the cycle in an asset-light way, is under-earning. In short, we still like the core of GE’s business which revolves around selling a big piece of OEM equipment at a low margin and then collecting a 40 year stream of high margin service revenues that the customer is essentially locked into. With long term earnings power in excess of $2.25 per share and with a 3.5% dividend yield, we think our patience will ultimately be rewarded.
What changes have we made to the Mackenzie Global Dividend Fund?
- We purchased Johnson Controls (‘JCI”), the global leader in commercial building automation and fire and security equipment and services. After completing a recent merger with Tyco, the company has 18% global market share of a fragmented $120 billion market, more than twice the nearest competitor. JCI works closely with architects to make sure the company’s products are built into the original plans according to the local fire code. The legal expertise in understanding fire regulations all over the world is a key source of competitive advantage for the company. Half of JCI’s equipment is installed in new builds and half are retrofits. Once the equipment is installed JCI offers monitoring and servicing of the equipment under contract. Unlike residential monitoring, the commercial and industrial monitoring end markets have very low turnover. Growth in the business is primarily driven in non-residential construction growth. Nearly 65% of the building automation business is recurring when retrofitting is included. The company is currently undergoing an integration with Tyco, which management has stated will take out over $1 billion of redundant costs and significantly increasing margins. The two companies will also have increased abilities to provide a full building automation package for large projects. JCI is a quality business with high incremental margins that has underperformed, but has the potential to emerge as a much stronger combined company. The shares were purchased at 13.5X forward earnings with a 2.5% dividend yield, a sizable discount to the market and other comparable industrials. We believe the company is a unique and overlooked opportunity for both the Global and U.S. Dividend Funds.
- We initiated a position in the Japan Exchange Group (JPX) this quarter. JPX is an entity formed from the 2011 merger of the two largest investment exchanges in Japan, the Osaka Stock Exchange and the Tokyo Stock Exchange. The Global Dividend team has an affinity for stock exchanges by virtue of their operating natural monopolies that result in significant returns on invested capital and distributable free cash flow. Because of the key role they play in the smooth functioning of a country’s capital markets, their balance sheets must remain pristine, and JPX is no exception. The company is vertically integrated and dominates listing, trading, and clearing in cash equities, derivatives, and OTC for the Japanese market. The key asset is its ownership of the country’s only central clearing house, giving it a near monopoly over the nation’s equity and derivative clearing businesses. And while JPX is the dominant exchange operator of the world’s third-largest economy, its market cap places it below that of Brazil’s stock exchange and just ahead of Singapore’s, underscoring the aversion Japanese investors have to risk-based assets (the Nikkei still trades almost 50% below its all-time high reached over 25 year ago!). If people were ever to more fully embrace the notion of equity ownership and move their money from bank deposits earning negative interest to stock investments, then the full strategic value might be realized. We purchased shares at a free cash flow yield approaching 6% and a dividend yield of 3%.
- Madrid-based Aena SA is the owner and operator of 46 airports in Spain, including Madrid-Barajas and Barcelona-El Prat – two of Europe’s top 10 airports. Aena is the world’s largest airport operator by passenger volume (230 million in 2016) and has been public since February 2015. The Spanish government still owns 51% of the shares and has benefited greatly since privatization, as the stock is up almost 3-fold since its IPO. Airports are usually monopolies and are often very attractive assets, but as monopolies governments regulate them. Air transportation is viewed as critical to an economy much like a water utility or cellular networks. How the government regulates the airport can be very important to the value of the asset. Airports make money from their aeronautical operations and their commercial operations. In the former, they charge airlines for use of the air infrastructure. Airlines pay fees for landing, parking, baggage handling, passengers, and more. Airports also make money on commercial operations, which includes from leasing space to retail stores, restaurants, and advertising. Think of it as a mall with captive affluent customers. As one of the Fund’s few pure infrastructure positions, we believe Aena’s business quality is high, considering the company’s monopoly position in Spain, its large and modern network, and diversified customer base. Aena operates at low utilization levels relative to peers and has significant capacity to support future traffic growth. They also have substantial headroom to expand retail sales per passenger, as comparable operators such as London’s Heathrow and Paris’ Charles de Gaulle are currently delivering over 2x the commercial revenues per passenger. Despite a healthy balance sheet, good profitability and impressive cash flow that is likely only to improve in the coming years, Aena is still valued at a discount to other airport companies. Their strong cash flow can support very progressive dividend growth well into the future, despite already paying a 3% dividend yield. A recovery in European air traffic could benefit Aena given its exposure to discount airlines and its location in Spain, the world’s third-most popular tourist destination.
- We took advantage of May price strength and sold out our position in Japan Tobacco. The decision to exit was not because the company disappointed per se, but rather a function of the quickly evolving competitive landscape combined with the unique characteristics of the Japanese tobacco industry. Japan has by far been the most rapid adopter of reduced-risk products (RRP) for tobacco, much to the benefit of top 10 holding Philip Morris International (PMI), which dominates the market with their iQOS platform. PMI’s HeatStick products alone could cannibalize almost 20% of Japan industry cigarette volumes by 2020, and exports to Japan year-to-date are already greater than in all of 2016. PMI management recently announced yet another increase in their Italian-based production capacity as uptake accelerates not only in Japan, but in Italy, Germany, Greece, and Russia. Japan Tobacco’s answer to iQOS is Ploom Tech and is widely considered to be an inferior product to both iQOS and even BAT’s Glo. Ploom is a more cumbersome device, produces an inconsistent taste variability, and a much weaker nicotine kick. While the company has rolled out the product in various test markets across Japan, they have provided limited detail on its commercial results and so we decided not to wait around.
- The fund sold its position in Telefonica Deutschland this quarter. The position did not work out, and we consider it a mistake. We began investing on July 31, 2014. For our holding period, we enjoyed a 9.2% annualized return, for a 30% total return. We invested when Telefonica, the #3 player, bought E-Plus, the #4 player. Our thesis was two parts, first the deal offered real synergies, and for Telefonica to execute a business turnaround of the KPN assets. Secondly, it increased industry consolidation and would lead to improved oligopolistic competitive dynamics. Up until then, E-Plus had been the most aggressive player on pricing among the top 4 players, who together held a 90% market share. By buying E-Plus, Telefonica and the top 3 players would hold 90% market share, all of whom had consistently demonstrated pricing discipline. However, the German anti-trust authorities imposed a requirement as a condition for the transaction which successfully changed the incentives for cooperation among the participants. It forced market share to be given to two smaller firms, on terms that made the smaller players price-insensitive in the short term. The effect was to stimulate near-term price competition. Fortunately, due to the complex nature of the Telefonica-KPN transaction, which included a 1-for-1 rights issue, we were able to invest at an extremely cheap price. Even more fortunately, the merged firm was able to execute on internal opportunities and modestly mitigate the impact of the external challenges. We wish to be so fortunate as to make modest profits in more of our “mistakes”.