Mackenzie Global Equity & Income Team
- During Q3 2016, Mackenzie Global Dividend Fund returned 4.2%. This compares with the MSCI World Total Return Index ($CDN) return of 6.1%. Stock selection in health care and energy were contributors to returns. A higher allocation to consumer staples and stock selection in financials detracted from returns. Since the Mackenzie Global Equity & Income Team took over management, the Fund has returned 13.5% (annualized).
- Mackenzie US Dividend Fund returned 7.6% during Q3 2016. This compares with the S&P 500 Total Return Index ($CDN) return of 5.1%. Stock selection in consumer discretionary and energy were contributors, whereas security selection in information technology was a detractor.
- Global markets increased to new highs in Q3, spurred on by receding fears of a hard landing in China, a steady, if not spectacular, economic recovery in Europe, and continued reassurances by Janet Yellen that U.S. Fed rate hikes would be “gradual”, indicating that interest rates are likely to remain low for a significant period of time. This is being underpinned by a U.S. economy that continues to grow at a very manageable pace, evidenced by growing personal consumption expenditures, rising consumer sentiment and an improvement in labour market conditions. At this time we believe one or two rate hikes will have limited impact on slowing expansion and will potentially help restore back some credibility to the Fed. In short, the storyline of the last seven years continued as central banks around the world made every effort to provide ample liquidity to financial markets. In response to Brexit, the Bank of England cut the Bank Rate for the first time since the global financial crisis and announced a new round of quantitative easing along with a £100 billion term funding scheme to lower funding costs for banks. In a more unorthodox move, rather than seeking to reduce interest rates directly through large scale purchase of Japanese Government Bonds, the Bank of Japan is now effectively setting rates along the yield curve until inflation rises sustainably above its 2% target, as well as increase its purchase of ETFs on the Japanese stock market. Even the Swiss National Bank is now buying equity stakes. We are unsure how and if these more creative monetary policy approaches to spur lending growth will ultimately work out. Given the tepid global growth outlook and the massive amount of debt attached to central bank balance sheets, the outlook is for an extended period of low to even negative (in the case of Japan) real interest rates around the world. As such, we will do our best to take advantage of any volatility created by a 25 or 50 basis point increase in the federal funds rate over the coming quarters.
- Another area of uncertainty is the U.S. election. While it appears Hillary Clinton will win the Presidency, a new wrinkle was thrown into the mix when FBI Director James Comey (a Republican) dropped a proverbial bomb by disclosing a revived investigation into Clinton’s private email server practices 11 days before the election. Beyond how this might play out in the polls leading up to November 8th, the races for the House and Senate should provide an additional source of suspense on election night. There are concerns that if the Democrats were to control the White House along with the Senate and the House, it would allow the party to carry out their more left-leaning public and fiscal policies unencumbered. Pharmaceutical companies (both IP owners and distributors) and carbon-emitting industries would be high on their agenda. We are less concerned: while the Democrats need only five seats in the Senate race to take control, the House race is not likely to swing democratic as they would have to win all 17 uncertain seats. Republican leadership has mobilized in securing as many seats as possible, now that all but the most fervent Trump supporters have waived the while towel. So the most likely post-election is the great American approach of bipartisan decision making, one the markets are generally comfortable with. Then again, a lot can happen between now and election night which can make any such “predictions” moot. In any event, we will have our list of Dividend Dream Team companies on the ready to take advantage of any inordinate fallout from unforeseen results.
- Turning to other parts of the market, European shares have recovered most of their lost ground since the Brexit vote, with the UK being one of the strongest major European markets, helped by a weak pound. While investor sentiment towards the region remains negative (not helped by concerns over Deutsche Bank’s legal problems, Italian bank capital shortfalls, and the continued rise of economic populism), the reality is actually not so dire. We were surprised to see that for the previous quarter EU’s inflation-adjusted GDP grew faster than the U.S. (+1.8% vs. +1.3%). More importantly, it was fairly broad-based with retail sales, household borrowing, and investment all positive. Unemployment, while still higher than in North America, is falling steadily. Things could be worse in the EU and UK.
- The overall health of the Emerging Markets improved this quarter, driven by stabilization in China. Government deficit spending and a recovering property market boosted construction activity and consequently commodity prices. Excess capacity closure and restructuring of State Owned Enterprises are underway, while bad debts are gradually being cleaned up. Retail sales continue to grow at 10% per annum, house prices across the 100 largest cities are up 13%, and wage growth is 3%. Industries like healthcare are reforming to improve corporate transparency and consumer protection, in order to ensure stable growth. While the days of 8%+ GDP growth is no longer in the cards and the marginal consumer continues to struggle as the economy transitions, a $10 trillion economy that can expand at half that rate can still provide a significant boost to global growth.
- And finally, India saw the passing of the Goods and Services Tax (GST), which was thought to be impossible to get through Parliament. We believe the GST should bring the Indian economy many long term benefits beyond the obvious i.e. widening the tax base and improving collections. It will also potentially help improve productivity by providing for a nationally uniform tax system for trade and significantly reduce the cumbersome and byzantine taxes and duties levied by the country’s over two dozen states and territories.
- In summary, while global growth appears to be solid (but not great) and equity markets on the whole do not look especially cheap, in a world of elevated financial assets – be it government bonds, real estate, or investment grade and high yield corporate debt - we still believe owning a diversified portfolio of high-quality, dividend paying equities is the preferred path to achieving acceptable returns over the long term.
What contributed positively to performance?
- Motorola Solutions, held across all our portfolios and the biggest position in Mackenzie Global Dividend Fund, contributed to performance as it was up almost 18% this quarter. The company acquired Airwave Solutions, a first responder services business in the United Kingdom, only to have its acquisition devalued in its home currency following Brexit. The acquisition price was at five times EBITDA and accretive in year 1 and despite pound devaluation, this is still a very good acquisition for the company. Motorola continues to make progress in boosting margins in its core business of radios and systems. The company remains a core holding selling at just over 12 times normalized earnings.
- Mackenzie Global Dividend Fund holding SAP returned over 20% this quarter. SAP is the leading European enterprise software firm dedicated to helping companies run their operations. Dominant enterprise software franchises have typically been considered to be among one of the best business models in the world, as at its core is a “make once – sell many” offering, albeit with massive amounts customization around its client base. It launched its first product, a database, in 1973. It gained great commercial success in 1979 with SAP R/2, which allowed companies to computerize material management and production planning. Today, SAP serves a company’s full enterprise resource planning (ERP) needs, including financial transaction management, human resources, supply chain, and more. SAP’s products generates information that is the blood of its customers’ operations, deeply integrated into processes and workflows. The customized SAP platforms creates very high switching costs. The fund had an opportunity to invest in SAP as the company modernized its suite of applications to the cloud. This effort faced several headwinds. Because clients customize SAP, the firm built deep knowledge bases in industry verticals. These customizations were typically deployed through an ecosystem of consultants, such as Accenture and IBM. To really benefit from leverage on the cloud, a degree of standardization is required and thus the level of customization represented a challenge. Furthermore, once the consultants help the customers get on the cloud, with a more standardized offering, there would be less work in aggregate for the consultants – a conflict of interest. The other challenge is managing investor expectations. Transitioning to the cloud costs margin today in exchange for a higher net present value. You invest heavily, move customers online at what is effectively a lower dollar rate, but it becomes more profitable as it scales. The market worried about the short term margin impact, giving us an opportunity to take advantage of our long term point of view. The Mackenzie Global Equity & Income Team has experience investing successfully in such transitions, notably in Microsoft, which is held across all our funds. We also have studied software companies as they effected this change both successfully and unsuccessfully. Our research gave us conviction that SAP would be successful, that the market short-term orientation was reprimanding the firm for doing what was best for the long term. SAP continues to deliver and continues to trade below our estimate of intrinsic value. And finally, due to the robust free cash flow generation, it is expected to increase its dividend for 2017 to €1.20 per share – a level that would be almost 40% higher than when we first invested.
What detracted from performance?
- Wells Fargo shares declined 7% in the quarter and while on the surface not a disaster, was disappointing in the context of what was a very good quarter for most banking stocks. The reason for the decline is by now well known: what had been considered one of the most respected, well-managed U.S. financial institutions had disclosed that the Consumer Finance Protection Bureau fined the company $185 million for inappropriate sales practices in its consumer business. Management also disclosed that roughly 5,300 employees (out of over 230,000) had been fired since 2011 in connection with opening unauthorized accounts. While we believe this was a result of sales incentives and not intentional harm, the end result was unacceptable. As a result, both CEO John Stumpf and their head of retail banking resigned and forfeited tens of millions of dollars of past compensation and equity rewards. We believe Wells Fargo is and will remain a strong, stable business with a growing dividend yield that should support the stock going forward. And the ultimate end expected result will be a company that reforms its practices and operates with stronger corporate governance, with modest ongoing impact to profitability. The market currently embeds additional fines (estimates have been up to $5 billion) in excess of what we believe is likely. We expect the company’s quality and ability to compound value for shareholders to remain intact.
What changes have we made to the Mackenzie Global Dividend Fund?
- Hang Lung Properties was added to the portfolio last quarter. Hang Lung is a Hong Kong-based holding company, and through its subsidiaries, predominately engages in developing and managing retail real estate properties in Hong Kong and mainland China. Prime locations, superior quality of construction, as well as successful mechanization are the keys to managing premium shopping malls. Hang Lung Properties, through decades of operation history, has demonstrated its discipline in only procuring the best land slots in tier 1 and 2 cities, building what is considered to be one of the highest quality of malls in China as well as securing long-term partnerships with world famous brands. Our position in the company represents a contrarian view that the sector has been traded at near all-time lows because of rapid development of e-commerce and seemingly oversupply of retail outlets in China. Actually we believe that the long term scarce value of the best bricks and mortar will not be compromised but strengthened as their effective branding function and unparalleled consumer experience become increasingly obvious in the e-commerce era. At our purchasing price, our unit holders will get a stable 4.7% dividend yield at 0.6x book value. Continued growth in rental income will not only support dividends payout but also help rationalize the valuation, which we believe will drive strong returns overall in the coming 3 to 5 years.
- We initiated a position in one of the great American brands, Harley Davidson (HOG), the leading maker of motorcycles. The company was founded in Wisconsin in 1903 and has thrived to become the most admired company in motorcycles with over 50% U.S. market share. The company has a loyal customer base of over one million members, of which half of them meet annually in South Dakota. The company has 700 independent dealers in the U.S. and over 1,500 globally. The company’s brand and scale drives the industry highest margins and return on equity of 28%. Part and accessories and merchandise make up 20% of company revenues. The weakness in HOG shares has been caused due to reemergence of HOG’s oldest competitor, Indian Motorcycle owned by ATV maker Polaris. In addition, HOG has refused to cut prices and instead chose to give up a little market shares to Japanese competitors that have been benefitting from a weaker yen. HOG shares have declined where the stock sells at over a 30% discount to intrinsic at nearly a 9% free cash yield and a 3% dividend yield. While short term pressures persists we believe Harley Davidson will continue its long history of being the envy of the motorcycle industry. HOG is fiercely loyal to its heritage and its customers are loyal in return. The company’s strong brand name gives it the ability to earn a premium price, while its scale, dealerships, and pace of innovation give it a substantial edge on competition. The company is focusing its efforts on taking back market share the old fashioned way – spending money on R&D, upping advertising, increasing the pace of innovations, etc. – and it’s been successful. Case in point: the company has recently announced the first new engine platform in 18 years which will drive upgrades from the company’s existing customer base. Further, the company is one of the largest beneficiaries of construction industry expansion which we believe should be boosted by infrastructure spend in the upcoming year.
- The positions above were used to replace Spectra (which hit our estimate of intrinsic value after a takeout offer by Enbridge) and Baxter, which also exceeded our intrinsic value calculation in the quarter