Mackenzie Global Equity & Income Team
- During Q4 2017, Mackenzie Global Dividend Fund (Series F) returned 4.1%, and has now returned 14.4%, annualized, since portfolio manager change. This compares with the MSCI World Net Return Index ($CDN) Q4 return of 6.2%, and 12.7%, annualized, since portfolio manager change. Information technology and consumer staples were the top contributing sectors during Q4 2017. Stock selection in the Health Care sector detracted from performance.
- Mackenzie US Dividend Fund returned 4.3% during Q4 2017 and has now returned 16.0%, annualized, since inception. This compares with the S&P 500 Total Return Index ($CDN) Q4 return of 7.3% and 16.4%, annualized, since inception of the Fund. Stock selection in the Consumer Discretionary and Consumer Staples sectors contributed positively to performance. Stock selection in the Healthcare sector detracted from quarterly performance in Q4.
- By all accounts, 2017 was strong year for global equities. Indeed, 2017 was the first calendar year on record in which the MSCI All Country World Index (in USD terms) had no down month! You did not have to be a genius - stable or otherwise - to make money last year, and fortunately both the Mackenzie Global and U.S. Dividend Funds were no exceptions having returned 14.2% and 14.9%, respectively. In the quarter, ten of the 11 industry classifications within the MSCI World Index rose in USD terms, with IT and materials being the best-performing sectors while utilities was the only sector in the red.
- We try to remain as objective as possible as it relates to the economy, the markets, and of course our individual investments. From a macro standpoint, we see little in the way of tangible evidence that things are getting worse. Although current gains come seven years on from the last recession, investors have cheered positive economic data suggesting synchronized growth across all major regions, while inflation remains strangely muted. Global growth estimates for 2017 as measured by the World GDP Economic Forecast index began the year at 3.2%, but the final numbers are more likely to approach 3.6% as global monetary policy accommodation takes hold outside the U.S. and as China’s deflationary impact from exports declines. This was also the case in Europe, where estimates went from 1.4% at the beginning of the year to 2.3%. Japan went from expectations of +1.0% to +1.7% by year end.
- Inflation and labor cost pressures in the U.S. remained modest all year as sweeping infrastructure policy changes failed to materialize. The more modest tax cuts passed in December kept a lid on the US dollar. Employment growth is strong and consumer confidence is high in Europe, despite several political setbacks for the pro-EU establishment. In Germany, Angela Merkel’s political party was unable to form a coalition during the September elections and pro-independence parties won a slender majority in Catalonia in December, leaving Spain in a somewhat tenuous position. The next hurdle facing the European political establishment comes in March as Italy’s President dissolved parliament last month and called for elections. Populist euro-sceptic parties are expected to do well. From the GFC in 2008 to the sovereign debt crisis of 2011 to Brexit in 2016, we are resigned to the fact that political uncertainty in the Eurozone is now a way of life. Japan’s economic expansion reached seven consecutive quarters, as rising participation in the work force by women and near record corporate profit margins are driving growth rates not seen in almost twenty years. Unlike his Western European counterparts, Prime Minister Shinzo Abe secured his political grip on the country after winning a snap general election in October. And speaking of political grip, on the back of China once again leading all advanced economies in terms of growth at over 6.5%, Xi Jinping’s leadership across all levers of the government was cemented during the Communist party’s 19th congress in October.
- It has been hard to say exactly what is holding back inflation in the context of coordinated global growth and near full employment levels in North America and vastly improved levels in Europe and Japan. Suspected reasons range from low productivity growth, to public sector austerity (in particular in Europe), to automation. Indeed, even fear of automation could be playing a role as workers – unionized and otherwise - are beginning to realize the rise of big data and software-enabled robots and machines means higher wages and only accelerates their employer’s incentive to automate their job function. Of the 3.5 million long haul truck drivers in the U.S., there are likely more than a few following Google and Tesla’s technological progress when it comes to autonomous driving.
- The Fed in December raised the cash rate by 25 basis points to between 1.25% and 1.5% and maintained a projection of three rate increases over 2018. On face value, it has stopped “printing money” via bond and other asset purchases. It appears markets have largely rationalized the threat to stability from the US Federal Reserve’s staggered exit from extremely loose monetary policy as being about normalization rather than inflation taming. As of right now, QE (quantitative easing) continues in both Europe and Japan.
- We have heard arguments for market overvaluations since we took over fund management duties in late 2013 and while we share investor concerns and are sympathetic (we too prefer lower valuations!), we still believe the most prudent response to these arguments given our mandates is to continue to do what we always have done: focus on owning a broad collection of high-quality dividend paying companies for less than what we believe they are worth. The long-term track record for investing in high quality equities and the power of compounding are so attractive that we believe it is not worth the risk to try and exit the market during the periods of time in which equity returns appear less attractive. With the Global Dividend Fund trading at 17.8x next year’s earnings, while certainly not at bargain basement levels we feel this is reasonable given the quality of our names (weighted average operating margins and ROE of 28%) and the projected EPS growth rate of almost 13%. And of course equities are not valued in a vacuum. What discount rate does one attach to equities given that 10 year Treasuries still yield less than 2.6% and German bunds 0.6%? One could make an argument that our continued use of an 8-10% discount rate for our DCF calculations in this context is way too aggressive. (We do not take that view, by the way). Would you rather own a company like Nestle – a company that’s grown its dividend uninterrupted for 59 straight years and counting - at a 4.8% earnings yield or AA Euro corporates yielding 0.5%? Or Euro junk bonds trading at 2.6% i.e. about the same level as US treasuries. For reference, Global Dividend’s yield was 2.9% at year end. To be clear: we are not making a call on which way global bond prices are headed, whether spreads will narrow across geographies, or if a decline in market valuations is imminent. We are simply pointing out that when it comes to valuations, it is often more nuanced and complicated then looking at a single variable and making an assessment.
- So this should come as no surprise when we say our day-to-day concerns don’t revolve around market valuations per se, but rather the idiosyncratic and specific issues facing our companies. Beyond the individual competitive factors that drive each company’s revenue growth, margins, and free cash generation, we also worry about second derivative impacts. Most of our “macro” concerns revolve around how geopolitical issues might have knock-on effects on our investments that aren’t clearly evident or discounted. For instance, last week the Committee on Foreign Investment in the US (CFIUS) declined to approve Ant Financial’s (Alibaba’s online banking arm) proposed acquisition of Moneygram. And as of this writing AT&T just pulled out of a deal to sell Huawei’s Mate 10 smartphone just before a partnership was being prepared to be unveiled. Apparently, the US government cited longstanding concerns among some lawmakers regarding Huawei’s ties to the Chinese government. This shouldn’t come as a surprise given that in 2012 the US House Intelligence Community accused Huawei of being an arm of the Chinese government that stole US intellectual property, which effectively closed the US wireless market off for Huawei’s mobile broadband products. So how might this latest American-Sino relationship salvo impact a company such as Apple, which derives 20% of its revenues from China – it allegedly enjoys 50% smartphone market share in Beijing - and is its second most profitable market? Should China decide to retaliate, there appears to be a pretty obvious target! It is these sort of exogenous events that could have a direct impact on our investments that keep us on our toes, not whether the market is going to value our fund next year at 14.8x earnings vs. 17.8x.
What contributed positively to performance?
- Kweichou Moutai was the fund’s best performing position and one of the biggest contributors to performance in Q4, delivering a 38% return in Canadian dollars. The stock’s Q4 performance is supported by very strong operational performance. This has been the case throughout 2017, and the operational performance suggested that the firm would deliver much higher growth than the “street” expected for Q4. But in Q4 revenue estimates by sell-side analysts covering Kweichou were revised upwards by 69.6% just in the month of December; and operating profit estimates were revised up more than 100%. Why? Kweichou announced they were raising the sell-in prices for Moutai on December 27th – those are the prices that Kweichou charges their distributors – by 18%. However, supply is not sufficient to meet rising demand, and the sell-out price for Moutai increased even faster. Typically, when firms raise prices, they see an impact on volume, but not here. Estimates are that demand is greater than supply by at least 25-30%, maybe more. Moutai announced that it would be increasing volumes 20% YoY during the critical Chinese New Year period, and by 34% for the FY. The combined increased volume and higher pricing will drive revenue growth of 42% during the critical Chinese New Year period, revenue growth of 50% for 2018, and profit growth of more than 60% for 2018. This is the first price increase the firm has taken since 2012, and it demonstrates that Moutai has a lot of pricing power available. Investors are now raising their revenue and profit expectations to include further pricing increases over the next 2-3 years.
- A critical part of our thesis when first investing in Kweichou Moutai, is that it owned one of the most valuable brands in the world, with very high pricing power. This was demonstrated during the China luxury slowdown of 2014. While Moutai’s absolute price came off, its relative sell out price to other luxury Baiju drinks at first decreased, then increased slightly. The price change was beneficial to growth, as consumers abandoned rival spirits, to buy Moutai at what was a “bargain” absolute price. This bargain price was still a very strong premium to its peers, and consumers wanted to hoard it. As a result, while competitors saw negative sales volumes, Kweichou volumes bottomed in the mid-single digits. For perspective, some Chinese view their Moutai investment like a cash equivalent with upside, similar to an art collection, and safer than volatile equities! You can get loans using it as collateral. The business development in Q4 offers further support to our thesis – that Kweichou is an extraordinarily unique and valuable brand that will generate value for us as owners for a long time.
What detracted from performance?
- The most difficult investments are businesses in transition. Sometimes the transitions, as clear as they appear are too difficult operationally. We recently had to accept our mistake and sell Owens and Minor, the largest distributer of surgical supplies in the U.S. The company was transitioning from a cost plus to fee for service model, which would have resulted in significant margin expansion. The company was adding more services and technology into their core distribution business. We once believed that the turnaround in the business would take a year and would be the entire focus of management which accounted for 90% of revenues, however this did not end up being the case. Management instead focused on the European operations and making acquisitions to diversify the business. The last straw was management making a good acquisition after two bad ones. While we believed in the strategic rationale for the acquisition, the debt level of the balance sheet had been taken to a high level. We are not comfortable with high levels of debt in a cyclical businesses. We have sold shares in Owens and Minor and removed it from our Dividend Dream Team.
What changes have we made to the Mackenzie Global Dividend Fund?
- The Funds recently purchased shares of Cisco Systems. Cisco has been the dog of the Nasdaq since the dotcom bust. The reason is they simply charged too much for their core business of data networking, and even though data usage has exploded in the last 15 years, the cost to transmit that data has fallen precipitately. The company has 65% market share in data networking and associated services through their data switching and routing business. The businesses have been in decline due to price cuts, until recently when the company decided to rent their switches, like big brothers Microsoft and Oracle. The two have been successful in transitioning the stickiness of legacy businesses into growing recurring cash flows. Recurring revenue now makes up a third of Cisco’s revenue and is responsible for all of the growth. We have been waiting patiently for a turn in Cisco’s business and believe the current environment positions the shares of Cisco very well. The routing business which makes up 20% of revenues will get a boost from the launch for 5G in 2019 and the company’s $70 billion cash pile (35% of market cap) can be emphasized under the Trump tax cuts to significantly boost buybacks and dividends.
- We initiated a position in New Oriental Education (EDU) in Q4. New Oriental is the largest listed education company in China by revenue, focusing on K12 afterschool tutoring. With a population of 220 million people aged from 0-14, China’s private tutoring service business is estimated to register well over 900 billion (CAD$170 billion) by the end of 2017. Benefitting from both an increasing purchasing power, strong desire for better education service and demographic tail wind, the total industry is expected to deliver double digit growth in the next 3 to 5 years. Industry leaders such as EDU, with its strong brand equity, operational excellence and economies of scale, have started to consolidate the industry, despite commanding less than 2% of market share. This would appear to offer the company a long runway for growth. This is also a highly cash generative business with human capital being the largest expenditure. Gross margins range between 50%-60% with operating margins in the teens and ROE close to 20%. The largest capital expenditure outside of M&A is used to set up schools which is minimal. Growing negative working capital is a result of the business model with tuitions paid up front, leading to a very healthy balance sheet. While shares are not inexpensive, with a very long runway to expand via both organic growth and industry consolidation and an attractive business model, we think the shares justify their valuation.
- Along with the aforementioned Owens & Minor, the fund sold out its positions in Bureau Veritas SA, Hang Lung Properties Ltd, Motorola Solutions Inc., and 3M Corporation. With the exception of Owens & Minor, all four positions were sold as they approached and exceeded our calculation of intrinsic value. We look forward to getting the opportunity to repurchase these names back at more discounted prices in the future.