Mackenzie Global Equity and Income Team
What happened in the previous 3 months?
For Q2 2016, Mackenzie Global Dividend Fund returned 1.8%. This compares with the MSCI World Total Return Index ($CDN) return of 1.4%. Stock selections in consumer staples and financials were the largest contributors to returns. A lower allocation to energy and no exposure to utilities detracted from returns.
On June 23rd Britain voted to leave the European Union almost 25 years after signing the Maastricht Treaty, triggering a massive sell-off in global equities and enormous currency volatility both on the upside (USD, Japanese Yen) and downside (Pound Sterling, Euro). While the knee-jerk reaction from the markets was not surprising given that some bookmakers had the odds of a “Bremain” vote approaching 90% prior to the referendum, the “carnage” for the entire week was actually quite limited, as markets had previously run up in anticipation of an intact EU post-result.
Indeed, Mackenzie Global Dividend Fund ended the month down just -0.2%, outperforming the benchmark. Notwithstanding this rather uneventful net result so far, we will not be surprised if the markets remain volatile in the near term. Despite the flood of recommendations from sell-side economists, strategists and stock analysts on how to “play” the post-referendum result, the truth is, no one really knows how this is going to unfold over the coming months and, for that matter, years. The process of Britain fully leaving the EU is going to be a long and complicated process – they will have two years to negotiate leaving after giving its formal notification to the EU, and it is estimated the UK will have to renegotiate 80,000 pages of EU agreements! And it’s not just a renegotiation of its trade agreements and immigration policies within the EU. Many of its agreements are via the EU with the rest of the world. In other words, it’s renegotiating with everyone.
What are the key risks and opportunities you see?
While this will likely put a pall on global growth sentiment for the time being, we do not view this as a pre-GFC Lehman bankruptcy “event”. Compared to 2008, the financial system has recapitalized and banks (particularly in the U.S.) are in a better position to deal with uncertainty. With low energy prices, low interest rates, near full employment in many developed economies, and less household indebtedness, the global consumer is also in a stronger position to weather this uncertainty.
And while we do our best to be mindful of the potential macro implications from such events and what it may mean for certain industries and regions, the Mackenzie Global Equity & Income team will continue to do what it does day in, day out: refine our Dividend Dream Team list and ensure the companies in our Funds represent the best possible value from that list. Markets don’t like uncertainty, and while we most definitely do not enjoy days like June 24th, it is times like these that often create great opportunities for long term investors.
What happened in the previous 3 months in the Fund? What contributed positively to performance?
Our top contributor to performance in Q2 2016 was Cetip S.A., a Brazilian financial services company and one of our lesser known businesses. It is also one of our highest quality companies, as Cetip is Latin America’s largest depositary of private fixed income securities and Brazil’s largest private asset clearinghouse. It also controls the National System of Liens (SNG), a near-monopoly of vehicle financing, processing and custody guarantees that connects car dealerships, financial institutions, and government authorities. It recently started to offer a similar product/service for mortgage contracts, whereby Cetip will act as the middleman between individuals, banks, and notary offices. Finally, late last year the company announced that it was in merger negotiations with BM&F Bovespa, one of the largest exchanges in the world by market cap and the only securities and derivatives exchange in Brazil. The stock, which was helped by a strengthening of the Brazilian Real and solid operating results this quarter, also moved higher on the anticipation that the merger would be approved by shareholders and signed off by regulators. Upon closing, this new combined entity is expected to effectively operate three financial service monopolies in Brazil – four, if their real estate venture proves successful. These businesses, due to the beauty of network economics, will potentially all generate tremendous free cash flow off of a limited capital base, pay out over 75% of earnings in the form of dividends, and grow revenues organically at rates well above GDP as the Brazilian capital markets are coming off a bottom and are still in their relative infancy compared to developed economies. Barring stretched valuations or a sudden change in the underlying regulatory environment (not out of the question given the country they operate in and, ironically, their highly advantaged competitive position), the Cetip/BM&F Bovespa franchise is likely to be held in the Fund well into the foreseeable future
Monsanto, after having been one of our worst performing stocks last quarter, became one of our best performers in Q2 after German drug maker Bayer AG approached Monsanto about an acquisition of the company to complement its own crop science business. After the merger of Dupont and Dow, and ChemChina and Syngenta, Bayer and Monsanto are the only two large global agriculture companies without a dance partner. Monsanto is the leader in global agriculture with the highest returns, margins and strong historical growth rate. The shares have been depressed as three years of bumper crops have depressed earnings and commodity prices. Lower oil prices have also hampered the demand for corn used to make ethanol. Monsanto and Dupont have an oligopoly in seed production and Bayer, Syngenta, and Dow all provide agricultural chemicals to protect and nourish those seeds. Monsanto needs Bayer crop protection business and chemicals now that Dow and Syngenta products are owned by competitors and Bayer needs Monsanto seeds now that Dupont is merging with Dow. At the time of the announcement of the bid the market quickly dismissed the transaction, however even though Bayer may not be able to get to the price Monsanto needs (thought to be $140 per share), we believe both parties need to do this deal for strategic purposes. While we see the merits of combining Monsanto’s seed and trait business with the Bayer crop protection division, we are confident that regardless of how this courtship plays out, we believe we own strong asset in Monsanto and that its intrinsic value is well in excess of the both the current $110 per share trading price and the initial offer from Bayer.
What detracted from performance?
Our worst performing company was Telefonica Deutschland AG, which reacted to sell-side fears focused on near-term price competition at the low end and subscriber losses due to a bundled offering that is perceived to be insufficient. We feel this narrative misses the point: management continues to make progress positioning its O2 brand as a premium LTE network provider and the German market in particular offers significant opportunities for operators to capitalize on increased per capita data usage over time. Management, which is buying back stock outright, is already halfway through executing on their strategy to take out over €800million in costs by 2019. The shares continue to be supported by a solid balance sheet, rapidly expanding free cash generation and a dividend yield approaching 7%.
Performance was also dragged down by Motorola Solutions, Microsoft, and Apple. While all three ostensibly operate in the “technology” sector, their offerings all focus on very different end markets: business services, enterprise software, and consumer products, respectively. The thing all three had in common last quarter? The dreaded “earnings disappointment”, which caused a sell-off in all three names after announcing their most recent quarterly results. There was nothing in said results that altered our long term views on any of the companies, and we continue to maintain our position in all three names.
What are the key opportunities you see?
The Fund purchased Safran SA, a Paris-based commercial aircraft engine manufacturer. It operates in a four player oligopoly with tremendous barriers to entry, which include decades of cumulative investment in engineering expertise, scale, brand, supply chain complexity, regulation and the need to be designed into massively complex programs which have high technical and procedural requirements. The scale to train the MRO workforces globally alone from scratch would be daunting. Safran partners with GE in the CFM program, and together are half of a duopoly (the other is a Pratt & Whitney-led consortium) that control the narrow body aircraft engine market, which will account for over 2/3 of demand for aircrafts over the next 20 years. Customers Boeing and Airbus is estimated to account for over 80% of all aircraft sold over this time frame. Safran is the middle of a transition from the most profitable engine in aviation history, the CFM56, to the next generation, the LEAP engine, the first of which entered service in 2016. By 2020, Safran is expected to go from producing 1,800 CFM56 engines to 0, with LEAP production ramping up from 0 to about 1,700. While Safran earns a modest profit on its CFM engines (which is highly unusual as engine makers usually sell these at a loss), it earns as much as 40% EBIT margins on service and spare parts, where it has material pricing power. It is estimated for every $1 in revenue generated by an engine sale, $4-5 are generated on an NPV in service and parts over time. The stock price has come off over the past year as the market frets about this fairly significant engine transition, and what any hiccup in LEAP production ramp-up and/or concurrent CFM decommissioning could mean to the P&L. We view this as short-sited: any LEAP production delay, altered CFM servicing schedule, or even Airbus order postponements will not change the fact that over the next decade Safran is expected to be a major beneficiary of the commercial aerospace cycle. We feel paying 15x earnings (and a 2.7% dividend yield) for a company with these long term prospects is excellent value.
Spectra Energy Corp was bought last quarter. Spectra is a leading North American midstream natural gas/NGL pipeline company that was formed in 2006 from the spinoff of utility Duke Energy. Pipelines can be an attractive investment as they are “toll roads” transporting essential energy from areas of supply to areas of demand. Spectra has relatively low pure commodity exposure, as it is comprised of mostly U.S. gas pipelines and a Canadian gas utility. Their U.S. assets are positioned to benefit from the growing Marcellus/Utica shale with a number of projects in various stages of development. It is considered to be among the highest quality (read: conservative) companies in the space, with a safe and growing dividend yield of over 5% and attractive reversal projects, which is expected to help drive double-digit distributable cash flow growth over the next three years.
We initiated a small position in traditional Chinese medicine manufacturer Tong Ren Tang Technologies. Despite the high-tech moniker, Tong Ren Tang actually possesses perhaps the oldest “brand” in our entire portfolio, as the company was founded in 1669 by the Yue family and was the sole supplier of medicinal herbs to the Imperial Court from 1723 until 1911 when the Qing Dynasty collapsed. Tong Ren Tang is by far the most prestigious name in traditional Chinese medicine, with many of its unique product inputs/ingredients and formulas being recognized as national secrets by the government. The growth runway for this business is both broad and deep, as the company has only monetized one tenth of its traditional portfolio and is also porting its brand equity into health supplements, cosmetics, food and herbal teas. The industry has been growing in excess of GDP for two decades and is expected to continue based on aging demographics and regulatory support, as the government views Chinese medicine consumption as a low-cost/preventative way of improving overall population health. At 20x forward earnings, we still view the shares as undervalued given this irreplaceable and growing franchise is supported by attractive profitability metrics (20%+ margins and ROIC) and a pristine balance sheet (net cash position).
The positions above were used to replace MTU Aero Engines AG, Conoco Phillips and Fosun International Ltd, respectively. We also exited Baxalta Inc., which was acquired by Shire PLC in early June.