Mackenzie Global Equity & Income Team
- During Q3 2017, Mackenzie Global Dividend Fund (Series F) returned -0.9%, and has now returned 14.2%, annualized, since portfolio manager change. This compares with the MSCI World Net Return Index ($CDN) Q3 return of 0.9%, and 11.9%, annualized, since portfolio manager change. Stock selection in information technology and consumer staples detracted from performance in Q3 2017. The portfolio benefitted slightly from underweight exposure to the consumer discretionary sector.
- Mackenzie US Dividend Fund returned -3.0% during Q3 2017 and has now returned 15.9%, annualized, since inception. This compares with the S&P 500 Total Return Index ($CDN) Q3 return of 0.6% and 15.4%, annualized, since inception of the Fund. Stock selection in information technology, energy and health care detracted from performance during the quarter. Stock selection in consumer discretionary contributed positively to quarterly performance.
- As was the case last quarter, the major economies appear to be in good health. The U.S. continues to grow and the European and Japanese economies continue to recover. That is not to say we are popping champagne by any means. In Europe, Brexit negotiations are proving to be challenging, Macron’s popularity in France has been in decline since being elected, and the now fourth term German chancellor Angela Merkel is having trouble finding common ground with what is now a coalition of incongruent political parties. In the U.S., after striking out on healthcare reform the President is hoping to avoid going oh-for-two by pushing through a federal tax overhaul. We find it ironic that Donald Trump, of all people, is trying to act as conciliator among the Republican Party as ousted chief strategist Steve Bannon backs insurgent candidates in the hopes of overthrowing Senate Majority Leader Mitch McConnell. Oh, and there’s the small matter of North Korea to contend with on top of the domestic issues. Trump’s popularity is now lower than any other modern president at this point in his first term. We are taking the under on the chances of anything substantive being passed before next year’s midterm elections.
- All eyes continue to be on the Federal Reserve and the upcoming rate decisions. Data continues to be mixed. Companies as diverse as JP Morgan to Target have passed along minimum wage increases which in theory should be inflationary, but it’s hard to see how these cost increases can be passed along to consumers in the form of higher prices. Pundits that have been calling for a recession based on the premise that we are “overdue” because past expansions have never lasted so long often fail to point out that the “boom” has been rather anemic. Bears also like to point out to an imminent collapse of China’s banking system. While we are not yet so confident that we would actually own a Chinese bank, we are a bit more sanguine when it comes to the country’s long term prospects. China’s supply side reform initiatives appear to have been successful, as the forced closure of excess capacity in areas such as steel, coal and basic chemicals has resulted in lower pollution and improved industry profits. The positive knock-on from these reforms is that this has helped the government address the banking system’s bad debt problem, as these industries account for about ¼ of all SOE debt. In addition, the economy is significantly more balanced today than it was historically: China’s service sector now accounts for about 50% of GDP and only 20% of urban residents (which in turn now account for 55% of China’s population) are now employed by SOEs compared to 80% in 2000.
- That being said, we are not pounding the table bullish. “Neutral” would probably be the best way to characterize our overall market views. While we monitor overall market valuations and macro indicators, they do not dictate our day-to-day work. We continue to find what we feel to be attractively valued dividend paying companies. Indeed, this quarter was one of the most active since taking over the Fund over three years ago, having bought and sold over ten businesses. That is the advantage of having a flexible mandate that is not wedded to any one country, sector or macro theme. There is never any shortage of ideas from which to pursue in the hope of improving the overall portfolio and generating what we strive to be acceptable long term returns.
What contributed positively to performance?
- AbbVie was a standout performer last quarter as two tenets of the bear thesis were put in question. AbbVie prevailed on several patent challenges for their core Humira drug, making it increasingly difficult to see a path for biosimilars to enter the market before 2022. In addition, the company saw positive pipeline news flow for a handful of upcoming products, particularly for their small molecule treatment addressing RA and atopic dermatitis, the creatively named ABT-494 (aka Upadacitinib). Royal Philips NV benefited from a re-rating, a result of several analyst upgrades and the CEO reaffirming confidence in their ability to hit medium-term margin targets. B3 SA (Brazilian stock exchange and securities custodian) continued its rebound after getting dragged down last December along with the rest of the market as the country’s political drama unfolded. The company saw solid improvement across most of its business lines, particularly in derivatives volumes.
What detracted from performance?
- Allergan plc was our worst performer in Q3. We own the company because of their crown jewel medical aesthetics business spear-headed by the Botox franchise. Their specialty pharmaceutical business is made up accretive but often mature drug franchises, and the market reacted negatively when the company pushed the envelope looking for a regulatory loophole to extend the patent life for the fourth time on Restasis dry eye drops. As of this writing (late October), the Restasis patents have officially been invalidated and will likely face generic competition as early as next year. Sabre Corp was our second biggest individual drag on performance, as the company’s stock reacted poorly following a Q2 earnings report that disappointed the street. The company is having to spend money to close the gap with its number one competitor as it invests in systems that allow smaller airlines and hotel chains to use their reservation system to sell their inventory. In each case, their core businesses continue to grow, the theses remain intact, and we added to both positions during the quarter.
What changes have we made to the Mackenzie Global Dividend Fund?
- We initiated a position in UK-based Micro Focus International (MFI). The company, after having just closed its purchase of Hewlett Packard Enterprise’s software business, is now the seventh-largest software company in the world with over $4.4 billion in annual revenue. MFI has pursued the same strategy for almost 40 years: consolidate the infrastructure software market across proven (i.e. mature) platforms that are considered mission critical for their customers. MFI now operates over 300 product lines for 50,000 customers across dozens of end markets, including security, application delivery management, IT operations management, mainframe solutions, and systems development. By focusing on infrastructure software, the company operates embedded products with high switching costs, limited capex needs, and lots of room to capture efficiencies. Customers like MFI’s value proposition as it allows them to extend the life of their legacy IT investments yet still enables clients to bridge these established tech assets with the latest innovations on an as needed basis. The model has clearly worked: over time MFI has delivered industry leading margins and cash conversion, dividends per share, and EPS growth which has resulted in top quartile capital appreciation over the past 3, 5, and 10 year time frames. We are confident the addition of HPE’s software business will continue this trend, and view the price paid for MFI (11x P/E, 3.3% dividend yield) as excellent value for a company with 65-70% recurring revenues and 40% operating margins.
- Kinder Morgan is the largest natural gas pipeline company in the U.S. The company transports an estimated 40% of all U.S. natural gas. While natural gas is not the growth story that it once was, it is the energy of the future and will grow for decades to come. KMI has four businesses: natural gas pipelines, terminals, liquids pipelines and a CO2 injection business. Nearly 70% of Kinder Morgan revenues and earnings come from take or pay contracts from the pipeline and terminals businesses. An additional 22% of the business are fixed fee contracts. These are volumetric based contracts and are paid out as long as volumes do not decline. Shares have sold off with the rest of the energy complex as Kinder cut their dividend by 75%. Like every other company in energy, Kinder over-levered and paid out an unsustainable dividend. The company has spent the last couple of years repairing the balance and reevaluating its growth capital expenditures. Kinder Morgan’s best business are the interstate regulated pipelines, which account for nearly 45% of the business. These pipelines connect natural gas hubs to utilities for electricity generation. This is one of most steady businesses in the energy complex. Even though returns are capped at 8%, this business allows KMI to take on leverage to expand their network. The average contract term for transportation is 6.2 years. Renegotiation of these contracts are a risk but regulated pipe to utilities needs to be filled regardless of where the natural gas cycle is at the time. While the shares have recovered from the low of 2016, they have underperformed their pipeline peers. A major reason has been the dividend cut to 2.5% and conversion to a corporation. This is a positive move in the long term because it simplifies the structure, however in the short term it restricts the company’s ability to grow and take on more leverage. The company has recently announced plans to increase the dividend to 6% by 2020. Shares are selling nearly one-third of the EBITDA multiple it was selling for in 2014. With less than a billion dollars in maintenance capital expenditures, and an increasing dividend payout, the equity gives new investors an attractive opportunity to purchase shares in a stable business with nearly 95% recurring revenues.
- Taiwan Semiconductor Manufacturing (TSMC) is the largest (and first) independent semiconductor foundry in the world. The industry is characterized by process orientation and scale, and TSMC leads in both. It is the only company in its industry with the financial resources to continue to invest in both R&D and capital equipment/process technologies throughout the business cycle. In short they have become the backbone of the semi industry and continue to gain share. TSMC has manufactured chips for over 500 different customers globally, with a huge array of end market applications, including automotive, cell phones, video games, DVD players, digital cameras, medical devices, etc. Furthermore, they are the leader in next-gen chips necessary for emerging technologies such as AI, autonomous vehicles, and virtual reality. Although cash flow generation has been robust throughout all cycles (they have never realized a net margin below 11.5%), the semi industry can still be volatile. There is reason to believe going forward, at least as it pertains to TMSC, the cycles will be less pronounced due to a combination of end market application growth (more ICs on more products) and market share gains. This relative stability has been implicitly acknowledged by the company, which has more than doubled its dividend over the past three years after having kept it flat the previous eight. We think paying 15x P/E, 7% FCF, 3.5% div yield for a company with ~40% ebit margins that should compound its earnings 10%+ over time (vs a 20 year rev and net income cagr of 20% and 30%, respectively) is reasonable.
- General Mills is a global consumer packaged goods company. The Company’s categories include cereal, yogurt, convenient meals, dough and ice cream. Products are sold under the brand names; Pillsbury, Haagen-Dazs, Progresso, Yoplait and Liberte, and Old El Paso. The cereal business which includes brands such as Cheerios, Chex, and Wheaties are branded General Mills in the U.S. and are sold through a 50/50 joint venture with Nestle outside of the U.S. Nearly 72% of the company’s sales and 80% of profits come from the U.S. The company’s top 5 customers make up 40% of total sales where General Mills’ brands are number one or two across all of the company’s categories. We have followed the company for many years and have met management on several occasions on our travels to Minneapolis. Recently, the company’s shares have been hit by a perfect storm reversing a positive 2016 and reducing the share price by 30%. In the past several years the company was a big participant in the Greek yogurt craze, which has slowed down considerably. Greek yogurt industry declines have been in the high single digits with General Mills’ Liberte suffering worse than that. Greek yogurt made up nearly 7% of total sales at the peak. Further, Amazon’s foray into food with Whole Foods has put pressure on traditional retailers such as Kroger and Wal-Mart and they have responded by pressuring suppliers like General Mills. While these two factors are reasons for concern, we believe that longer term General Mills model of buying by the tonne and selling by the ounce will continue despite short term evolution in the channel. We have been cautious on consumer staples over the past two years due to elevated valuations caused by low interest rates but now see opportunities to add positions in companies that have historically provided investors with downside protection. General Mills has announced a restructuring program that will reduce costs as they look to manage costs in the new retail environment. We were able to purchase long term Dividend Dream Team Company General Mills shares at a discount to the market with an attractive 4% dividend yield.
- Founded in 1940, Kao is the largest Japanese manufacturer of household products. The Company enjoys a well-diversified product portfolio with strong brand equity and superior quality in technology-heavy categories such as diaper and cosmetics. Supported by an established distribution network, Kao enjoyed leading market share in key product segments: No.2 beauty care in Japan, No. 1 premium baby diaper in China and No. 2 in Indonesia. With monthly diaper usage in China and Indonesia still being one fourth of that in Japan, Kao, the market leader, is well positioned to benefit from consumer trade-up and preference for Japan-made products. The recent THAAD situation also provided a favorable competitive dynamic for Japanese cosmetic brands in China replacing Korean brands. With 25% of Kao’s business coming from Asia ex-Japan, we believe the Company will continue to deliver high teens growth in the region. Financially, Kao has expanded operating profit margin from 9.8% in 2007 to 12.7% in 2016, ROE from 13.6% to 18.6%. We believe Kao will continue improving profitability amid new product launches and growing economies of scale in overseas markets.
- Nidec is the world’s largest precision motor maker. Leveraging its know-how in small precision motors, machinery and electronic & optical component businesses, the Company has expanded its business into motors for automotive, appliances and industrial applications in recent years. Nidec’s moats reside in its economies of scale, deep manufacturing know-how and reliable track record. The Company commands 85% market share in HDD spindle motors and 25% market share in key automotive applications. Being the market leaders in those segments, Nidec is well positioned to capitalize on a number of tailwinds: growing demand for spindle motors from data centers globally as data usage exploded; increasing automobile electrification and vehicle safety requirements worldwide. The Company is also under the stewardship of founder & CEO Mr. Nagamori, a very unconventional Japanese businessman with great vision that has historically set (and met) aggressive financial targets. Nidec is aiming to achieve 2 trillion Yen sales by 2020 and 10 trillion Yen sales by 2030 through both organic growth and acquisition. In addition, gross margin is expected to reach 30%+ by 2020 through a series of cost reduction methods and scale leverage. Supported by Nidec’s fantastic track record and competitive positioning, we are optimistic of Nidec’s mid-term target and long term potential.
- And finally, the Fund also invested in Brenntag AG this quarter. Brenntag is the largest global chemical distributor based out of Germany, and has been on the dream team since it went public 7 years ago. It is an outstanding business with competitive advantages and barriers to entry. Large chemical producers like Dow Chemical use it to reach small customers who require many types of chemicals in small batches (less than truckload). For large customers, the producers can ship directly. But for the tail end of customers, there is a higher unit costs, and it isn’t economic – the smallest customers represent 80% of the total customers, yet account for 15% of total spend. Small producers use Brenntag to reach more customers at a lower cost; paying a variable cost rather than having to incur a large fixed cost and the associated operational risks. Brenntag repackages, blends, mixes and labels chemicals for its small customers. It makes sure that whatever chemicals are required for production are there on time and at a fair price. On the customer side then, Brenntag offers low cost for required products, and a high service factor. This means that the customers hold less inventory as a result, relying on Brenntag to deliver on time, and often get the final product already blended rather than having to do so themselves, lowering the activities required in-house. Brenntag’s moat is based on its scale and an oligopoly in distribution of less than truckload chemicals. Its portfolio has local and regional scale advantages through dominant regional volume market shares. Brenntag has lower fixed costs per sale from its volume. It also has lower variable cost per sales through its purchasing power. Size offers market insight advantages, allowing it to identify and capture cross regional arbitrages and alleviate specific market shortages. There is also a very significant regulatory barrier to entry, as there are many rules around carrying dangerous chemicals. The opportunity to invest in Brenntag came because investors simply lost confidence in it. It had done a number of acquisitions, and failed to grow top line for a number of years. It allowed its North American business to become dominated by its operations in the booming oil and gas business of a few years ago. When that reversed, their business in that area also shrank, causing margins to deteriorate. However, it is important to note that Brenntag’s three year return on tangible capital is 28%, even as it shrank the oil and gas business from 40% to 22% of its exposure. This is the same excellent return on tangible capital that it earned from 2009-2011, before the oil and gas boom. One opportunity we see is in the efficiency measures undertaken by the management. In periods of high growth, businesses focus on growth more than costs – so good times are usually followed by periods of consolidation. Lastly, Brenntag is tied to the chemical business, though it earns superior returns to that of chemical companies. The chemical business is tied to GDP growth and especially industrial production, and so is Brenntag. US industrial production has been below expectations for years. The Global Dividend Fund paid a price to take the shares off the hands of disappointed investors that is substantially less than what Brenntag is worth even if a tepid industrial production environment continues.
- The fund finished selling its position in KAR Auction Services this quarter due to the company approaching our estimate of intrinsic value after having compounded at almost 20% per annum over the previous three years. We look forward to adding KAR back into the portfolio if and when we get the opportunity at lower prices. We also exited United Parcel Service this quarter for more attractive relative opportunities that became available to us, as was the case with Japan-based Lawson Inc.