Mackenzie Global Equity and Income Team
- During Q2 2018, Mackenzie Global Dividend Fund (Series F) returned 2.5%, and has now returned 13.2%, annualized, since portfolio manager change. This compares with the MSCI World Net Return Index ($CDN) Q2 return of 3.8%, and 12.5%, annualized, since portfolio manager change. Stock selection in Financials contributed positively to relative performance during Q2. Stock selection in Consumer Staples detracted from quarterly performance.
- Mackenzie US Dividend Fund returned 3.0% during Q2 2018 and has now returned 14.9% annualized, since inception. This compares with the S&P 500 Total Return Index ($CDN) Q2 return of 5.5% and 16.3%, annualized, since inception of the Fund. Stock selection in the Industrials sector contributed positively to performance. Stock selection in the Consumer Staples sector detracted from quarterly performance.
- Most global markets rebounded (in local terms) last quarter after a tough Q1. This was the overall market's eighth gain in nine quarters. There was a fairly wide dispersion of returns across geographies and sectors as the world tried to make sense of a number of different economic and geopolitical crosscurrents. Globally, the Mideast and Canada enjoyed the two best regional returns driven by strengthening oil prices. This was followed by the U.S., which was once again driven by the FANG stocks and, for a change, Energy. Oil prices gained 14% in the quarter as a result of steady demand growth combined with the decision by OPEC to increase output less than expected. Energy is now the second best performing sector globally year-to-date after Technology. Financials declined by 5%, led by banks in Emerging Markets and Europe, where the Global Fund has little exposure. Our only European bank holding (HSBC) was actually up over 6% in the quarter in local currency terms and before dividends. Emerging Markets as a whole had their weakest quarter in almost three years, hurt by trade war concerns and currency depreciation. But overall the market reacted positively to what appears to be fairly balanced global growth, as the U.S. economy headed towards its 10th year of expansion, inflation reached the European Central Bank target of 2%, and Japan's central bank promised to keep up monetary stimulus.
- That being said, the second quarter saw several geopolitical events hit global equity markets to varying degrees. Following the Italian general election, the Five-Star Movement and the League agreed to form a coalition government despite having opposing fiscal beliefs and somewhat differing political views. Although they explicitly came out in favor of the euro, they are both firmly in the anti-establishment camp. Moderate Socialist Pedro Sanchez was installed as prime minister in Spain after Mariano Rajoy lost a vote of no confidence over a corruption scandal. Chinese stocks declined on signs the economy is slowing and, as mentioned, Emerging Markets struggled as tighter U.S. monetary policy boosted the U.S. dollar. The last time the China A share index reached these lows in early 2016 the economy was dealing with several issues: capital flight, heavy industry overcapacity, and the potential of non-performing loans triggering a financial crisis. Today, we believe these risks are much lower as supply side reforms have largely resolved the excess capacity issues, changes to the financial system (i.e. cleaning up the shadow banking system) have lowered the likelihood of a financial crisis, and the Chinese economy is more balanced towards internal consumption versus dependence on exports. As the world's second largest and one of the fastest-growing economies, China will continue to play an important role in how markets progress in the coming years.
- But China is not completely immune to potential policy changes emanating from what is still the world's largest economy and most important capital market. Ongoing concerns over a global trade war escalated again during the quarter due to a series of tit-for-tat tariff moves initiated by the U.S. forcing a response from their trading partners, notably China, the E.U., Canada and Mexico. It would appear President Trump is willing to take on all comers who dare to stand in his way to "Make America Great" again. Except Russia, of course. While in Helsinki meeting with Vladimir Putin in mid-July, President Trump bizarrely blamed "both countries" for the Russian hacking that interfered with the U.S. election. The backlash from his own party was fairly broad and immediate, with Senator John McCain perhaps being the most direct ("No prior president has ever abased himself more abjectly before a tyrant"). The reason behind Trump's reasoning? Well, Vladimir said they didn't do it and the President believed him. This only went against the unanimous conclusions reached by his own intelligence and law enforcement agencies. Naturally, President Trump reversed course on his views shortly thereafter, likely after being informed of this little factoid. Mid-term elections should prove to be great theater, indeed!
What contributed positively to performance?
- In Europe, the highest contribution to return in the quarter came from Safran, whose stock delivered a total return of over 18% in CAD$. Safran's operations developed favourably both in their core LEAP engine product ramp up, and in the integration of the Zodiac acquisition. Safran's end markets remained very favourable with strong air traffic growth globally, and very high airline load factors, supporting Safran's aftermarket development. Our thesis has thus far proven right, and we continue to find Safran an attractive investment.
- After being the single-biggest detractor in Q1, Micro Focus International delivered the highest stock total return, at almost 33% in CAD$, though its contribution to the portfolio was less than Safran's due to position sizing. The fund increased its position in Micro Focus following the collapse last quarter, and benefited from the Q2 share rebound. Micro Focus bought Hewlett Packard's software business and are having problems digesting it…some might even call it indigestion…however, our thesis is intact. The Micro Focus management has a proven long-term track record and should be able to create a lot of value with the HP business. This is because the HP assets were mismanaged, inefficiently run, with lots of bureaucracy. The assets were also neglected: at HP, hardware people dominated the organization and the software business' priorities were set at the group level, often in subjugation to Hardware's strategic priorities. Recent meetings with senior management strengthened our conviction.
- Like Safran, favorable end markets and strong air traffic growth contributed to the performance of Sabre Corp. It continues to be one of the best ways to get exposure to the global travel market. As a reminder Sabre is a toll road on booked travel through its Global Distribution System, largely for airline travel. In addition the company sells reservation systems for airlines and hotels. The company has over 95% recurring revenues with software-type margins. The company continues to grow mid-single digits, basically in line with global airline travel. Further, the company has an opportunity to increase margins as a two year investment in their airline reservation system winds down and appears to be successful. Ironically, this investment was a big reason for the shares' underperformance for the last year as elevated costs impacted reported earnings. Sabre continues to sell at a reasonable valuation, in our opinion, and is a core holding in our portfolios.
- Not surprisingly, the rebound in oil prices benefited long-term holding Occidental Petroleum which was up over 28% for the quarter. This stable, enhanced oil recovery producer in the Permian basin also has a significant mid-stream operation in the area and owns the majority of its processing plants. This is key as other companies utilize third parties to separate out the natural gas and NGLs from the oil, which is less cost effective. Although positioned somewhere between a large integrated major and an independent E&P, Oxy has one of the best balance sheets in the industry, generates cash, and pays a good dividend. It should be able to opportunistically grow its land position in the Permian over time.
What detracted from performance?
- The biggest detractors in our portfolios were tobacco stocks and in particular Philip Morris. The company's shares fell 17% following earnings. The company has been trying to convert smokers from conventional cigarettes to its reduced risk platform call IQOS. IQOS is a heat not burn device that uses real tobacco, and produces vapor without the carcinogenic by-products. In a few short years the product was able to garner 14% market share of all smokers in Japan, with a premium priced product. The product is now being rolled out globally as the company builds out supply. This last quarter results fell short for IQOS in Japan, as the company overestimated demand. The older smokers did not follow in the footsteps of the early adopters in large metro markets. While the company continues to learn how to market and introduce this product to its customers, lumpiness should be expected. However, as the product is rolled out globally with similar success rates, the investment thesis for PM should continue to improve. IQOS is not yet widely available in the U.S. as the company negotiates excise taxes on the new reduced risk product. This delay is concerning investors but States get 8% of their revenues from tobacco taxation and are unlikely to budge. We believe IQOS will be launched in 2019 and the company (Altria has exclusive rights to IQOS in the US) will pay similar taxes as they do on combustible cigarettes. A recent concern for the entire industry has been the emergence of JUUL, a vaping company that has achieved $1 billion in annual run rate of sales and a $15 billion private market valuation (versus Altria's 2017 gross sales of $25 billion). Right now JUUL is undertaxed as it sells liquid nicotine, however JUUL skews to the younger consumer and is attracting the attention of regulators. JUUL is certainly a threat to traditional smoking, however we still believe IQOS will be a very strong competitor once launched in the U.S. The team has invested in tobacco for twenty years and the same was true then as it is now. Although tobacco consumption declines globally at a 2-3% per year, companies having adjusted and have been able to grow earnings per share at double digit rates using a combination of price increases in excess of excise taxes, prudent capital allocation for M&A as well as stock buybacks and of course rising dividend payments. This recent sell off gave investors what we believe was an excellent opportunity to add to a dream team compounder with a 5% dividend yield at a discount.
- Fanuc Corporation is the global leader in factory automation systems, equipment and robots. Driven by rising wages in developing countries and increasing complexity in manufactured goods, Fanuc is well positioned to benefit from a worldwide automation upgrade. The stock underperformed the Japan TOPIX by 17% year-to-date mainly due to market concerns of a slowdown in global smart phone shipments and growing trade frictions in the auto sector – Fanuc's two most important end markets. Fanuc today is trading at the lower end of historical multiple on fairly depressed earnings. With its long-term automation prospects intact and its dominant competitive position unchanged, the Global Equity & Income team decided to hold on to our Fanuc position despite near term negative market sentiment.
- Not surprisingly given the sell-off in Emerging Markets (and particularly Latin America), our holding of B3 SA - Brazil's dominant securities, commodities and futures exchange operator – detracted from performance. As a reminder, we were happy to inherit B3 after it merged with long time holding Cetip in March of 2017. As of this writing, the stock has already recovered two-thirds of its Q2 shortfall. This sort of price action goes with the territory when investing in EM and while never pleasant, the rewards in owning a company of B3's quality have far outweighed the risks over time.
What changes have we made to the Mackenzie Global Dividend Fund?
- We purchased shares of United Technologies in the quarter, a $100 billion conglomerate organized into four business units: Otis Elevators; Climate, Controls, and Security (Carrier, Chubb); Aerospace Systems (Goodrich); and Pratt & Whitney (commercial and military jet engines). UTC has strong franchise assets with leading market share within each segment but had lagged its industrial peers over the past number of years, the result of poor execution (i.e. botched ramp-up of the next generation geared turbofan within P&W) and underinvestment in other areas, most notably CC&S. With the expected late Q3 closing of its $30 billion purchase of cockpit and avionics systems powerhouse Rockwell Collins (another company the Global Equity & Income team is very familiar with), the involvement of some prominent activist investors, and a willingness by senior management to explore strategic options that could unlock shareholder value, we feel the odds are high that the company will generate good returns for investors. The likelihood of management pursuing a break-up increased after the tax reform changes were implemented in December, as it allows the company to repatriate $8 billion in cash that had been trapped overseas and more easily pay down debt following the deal closure. And even if the deal were to get blocked (if anyone, likely the Chinese - Hello, Trade War!), based on peer multiples the stand-alone units are worth far more than what the shares were trading when we took our position.
- We initiated a position in Sony. The Walkman inventor has made an impressive comeback under the current management team. Through a series of restructurings, Sony has re-emerged as a major global operator of digital entertainment and rebuilt its consumer electronic product line underpinned by its best-in-class imaging technology. As global consumer spending on digital content continues to grow, Sony sits in a fairly unique position to capitalize on this secular trend with a large IP portfolio and distribution channels across games (PlayStation), music (EMI, Spotify), film (Columbia, Tristar) and TV (The Crown, The Good Doctor), etc.. On the consumer electronics side, the company regained a market leadership position in the premium segment of TV, camera and imaging equipment, powered by Sony's world leading imaging sensor and digital signal processing technology. As a result, semiconductors now account for 20% of company profits and growing. Despite improving fundamentals, the market has not yet fully recognized the changes that have taken place within the company. With a valuation at 6x EV/EBITDA, 15x earnings, and sporting a 12% free cash flow yield, the team has built a position to benefit from what it believes will be the continued revival of what was once the most valuable brand in Japan.
- Finland-based Nokia is the largest telecom infrastructure company in developed markets. The company's sale of the handset business to Microsoft in 2011 and subsequent purchase of Alcatel Lucent left the company as a pure play in telecom infrastructure, which include cell phone tower components such as base stations, backhaul, routers and associated services. The company's main customers are the largest telecom operators in the world. These customers had been reluctant to increase their capex with Nokia or competitor Ericsson and therefore pricing has been historically challenged. Ericsson was particularly to blame for this as the company chose to compete on price rather than technology for the last decade. This resulted in profitless prosperity despite the need for the hardware given the explosion of demand for data from the end customer. We believe the recent consolidation of the industry down to three players and, more importantly, a management change at Ericsson should allow the industry to earn an attractive economic profit from the 5G build out that will begin late next year. This has been a value destroying industry due to the behavior of Ericsson and to a lesser extent Chinese competitor Huawei, but recent results indicate things are changing. When one factors in this behavioral change along with the tidal wave that is coming in the form of 5G, we feel this is a reasonable risk given the potential upside. Nokia is valued as a declining business giving investors what we believe is a significant opportunity to benefit from the build out of 5G without paying for it. Furthermore, after finally reaching a settlement with Apple over patent infringement last year, the company will earn approximately €1.3 billion per year (and growing) in royalties – well over 40% of today's operating profits. Should the industry finally behave like the oligopoly that it is and exhibit the appropriate pricing discipline, we believe a rerating of the companies to industrial-type multiples could be warranted, offering even further upside. As it stands today, Nokia is a very inexpensive stock with a 4% dividend yield, and offering the best leverage to one of the most powerful upgrade cycles over the next several years.
- Dentsply Sirona is the largest manufacturer of dental consumables and equipment. The company merged with hardware provider Sirona, which makes computer assisted imaging and manufacturing equipment (CAD/CAM). Today, Dentsply is the leader with a 21% share of the $21 billion market. The company's sales are 35% U.S., 40% Europe and 25% rest of world. The business has been very defensible and inversely leveraged to the unemployment rate. To date the merger has under-performed expectations due to a slowdown in consumables and equipment from Sirona. While only 18% penetrated, the CAD/CAM machine is too expensive for all dentists to have. The recent trend toward dental groups with offices joining to gain more bargaining power and sharing resources is largely responsible for the slowdown. While we believe this trend will not end, it is likely to moderate. Dentsply Sirona's consumable dental supplies include endodontic (root canal) instruments and materials, dental anesthetics, prophylaxis paste, dental sealants, impression materials, restorative materials, tooth whiteners and topical fluoride. Consumables represent 55% of the company's sales and are largely recurring in nature. Small equipment products include dental handpieces, intraoral curing light systems, dental diagnostic systems and ultrasonic scalers and polishers. The company's diverse product offering isolates the company from any one product significantly impacting sales. In equipment the CEREC CAD/CAM system is 15% of sales and can have impact on performance. While we understand the market's concerns over performance, with the company trading at multiples not seen since the Global Financial Crisis, we believe the shares represent excellent value for this long-time dream team company.
- We initiated a position in Sika AG, a Swiss business in the building materials industry with an extraordinary track record. The company produces concrete and mixtures, mortar, sealants and adhesives, tooling resins, anti-static industrial flooring, acoustic materials for autos, and waterproof membranes. Sika recently emerged from a protracted battle between its former controlling shareholders and an acquisitive French conglomerate on one side; and minority shareholders and management on the other. Now free of the constraints created by that situation, the management is planning to accelerate the business' growth. The company consistently generates ROCE in excess of 20% and is by far the industry's most trusted brand and leading innovator. Despite their leadership position they still garner less than 10% share across their addressable markets, giving them lots of opportunity to continue to consolidate the industry. Sika is a long term compounder and we expect to be shareholders for a long time.
- Over the course of the past several months, we effectively swapped out our position in General Electric to purchase United Technologies. We have droned on about GE and its travails a number of times, but to make a long story short: GE was a mistake, as our thesis did not unfold as planned and was compounded when a new layer of financial risk was introduced early this year. While the core tenets behind our original thesis remained unchanged throughout (great installed base of equipment with world-leading franchises in jet engines and healthcare equipment), GE had continually tested our patience as the company extended timelines with which it had hoped to achieve normalized profitability in its Power Generation business and execute on the rest of its turnaround plan. In January it announced a $6 billion charge after completing a review of the long-term care insurance portfolio within GE Capital, revealing almost $15 billion of statutory contributions that GE must make over the next six years. After lowering its dividend for only the second time in 100 years earlier this year, another cut appears discounted in the market as of this writing. In short, the investment had been a significant disappointment. And while we still saw value in the shares assuming a normalized earnings power of over $1.25 per share and were well aware that from a sentiment standpoint it was one of the least popular companies we owned, our job is to be as objective as possible. We trimmed the position before year end for tax purposes and decided to wait for a Q1 update before potentially adding back to our position. Given the fact that we had exposure to GE's aerospace franchise via its JV partner Safran (one of our largest positions) and excellent exposure to the healthcare equipment verticals through Philips NV, we decided not to replace our Q4 share sales and in fact effectively replaced GE with United Technologies, which we view to have similar upside but with much less financial risk.
- We sold our position in Admiral Group PLC. We continue to view the company favourably, with its high level of management and employee ownership, and unique culture of underwriting excellence. However, we believe the firm may face some headwinds that could last a meaningful period of time. The firm should do well over the long run, especially when some of the investments in new markets they have been making for years begin to bear fruit. However, after considering the opportunity cost given the risk identified and other opportunities for the portfolio, we decided to exit the position.