Mackenzie Global Equity & Income Team
During Q4 2018, Mackenzie Global Dividend Fund (Series F) returned -7.4%, and has now returned 10.4%, annualized, since portfolio manager change. This compares with the MSCI World Net Return Index ($CDN) Q4 return of -8.5%, and 9.9%, annualized, since portfolio manager change. Stock selection in Communication Services contributed positively to relative performance during Q4. Stock selection in Industrials detracted from quarterly performance.
Mackenzie US Dividend Fund returned -13.8% during Q4 2018 and has now returned 9.8% annualized, since inception. This compares with the S&P 500 Total Return Index ($CDN) Q4 return of -8.6% and 13.6%, annualized, since inception of the Fund. Stock selection in the Consumer Staples and Industrials sectors detracted from quarterly performance.
In Q4, global stocks staged their worst quarterly performance in more than seven years after tighter US monetary policy, tensions between China and the US, and political uncertainty in Europe fanned doubts about the global economic outlook. During the quarter 10 out of 11 sectors fell in the MSCI Index fell (in local currency terms), led by Energy and IT, with Utilities being the lone sector that posted gains. Global companies that were linked to investment cycles were harshly punished as we approached the end of the year, as factories and companies suddenly began losing or delaying orders as concerns over a full-blown trade war began to impact management decisions. Highlighting how difficult it is to make broad asset allocation decisions in such an environment, this month is turning out to be one of the best January’s in decades as the Fund has made back nearly all the losses that occurred in 2018.
US stocks slumped in the fourth quarter as political uncertainty intensified and the Federal Reserve disappointed those who hoped the central bank would end its rate increases when it delivered an expected US cash rate increase in December of 25 basis points to 2.25%. This was the ninth increase since the global financial crisis and investors were disappointed (along with Trump, who implied he might “look into” firing Powell) that the Fed only reduced its forecast for rate increases in 2019 from three to two. Since that time Jerome Powell has dialed back his hawkish rhetoric somewhat by suggesting the Fed will take a more pragmatic approach to its rate hike path as it explicitly acknowledges the increasing global risks. That being said, the US ended 2018 with the jobless rate at a 49-year low of 3.7% and inflation largely contained to about 2% on key barometers.
Concerns about the Trump administration grew after Defence Secretary James Mattis quit in December over the President’s decision to pull US troops from Syria. Concerns rose further when an impasse with Congress about paying for a wall along the Mexican border led to a partial government shutdown, taking pay cheques away from over 800,000 federal employees and gumming up a range of services, from national park garbage collection to airport security to product launches for craft brewers.
European stocks fell as political concerns in France, Germany, Italy and the UK grew and the risk of a recession in the eurozone rose after Germany’s economy contracted in Q3. Even though concerns grew that the eurozone economy barely expanded in the third quarter, the European Central Bank said it would end its net asset-buying by year end. In France, Emmanuel Macron took a political hit when he gave in to the widespread demands of the yellow vest protesters. German politics also was jolted when the political party led by Chancellor Angela Merkel fared poorly in two state elections in October, forcing her to announce her intention to step down as the leader of the Christina Democratic Union at year end. How long she can continue to be the leader of Europe’s biggest economy without leading a domestic political party remains to be seen. And finally, the UK government of Theresa May postponed a parliamentary vote on Brexit from Dec 11 until mid-January. In the last week of January May defeated a proposal to delay Brexit if the UK fails to formalize new commercial agreements with the EU. So…Brexit will proceed as planned, even though the plan remains unclear. The European Commission president recently warned that Britain’s attempt to reopen its EU divorce deal had increased the chances of a disorderly Brexit and that EU leaders should “prepare for the worst” with less than two months remaining before the UK is set to leave the union. If such an event were come to pass, it would make the partial shutdown in the US look like a cakewalk.
Japan stocks stumbled after the Bank of Japan trimmed its inflation forecast for fiscal 2020 to 1.5%, which is under its goal of 2%. As of the end of January, investors buying the equivalent of a $1000 in 10-year Japanese bonds now PAY about 10 cents per year to own such a security. By way of comparison, Canadians receive about $20 per year in interest owning the same 10-year government instrument. Chinese stocks fell as the trade dispute with the US and a crackdown on shadow lending intensified doubts about the strength of its economy. Emerging markets overall slid on the gloomy global outlook
Market chaos notwithstanding, it should be noted that, using the US market as a proxy, the bull market that began in March 2009 has had 23 corrections of 5% or greater, yet the market has subsequently rebounded each time. Despite the change in growth rate turning negative, growth is still positive overall. Actual economic numbers are solid, unemployment is low, inflation is tame and valuations had compressed 15-20% from their highs as a result of this uncertainty. At the end of the day, lower valuations in the face of a fairly benign economic backdrop is a good thing, all else being equal.
We would also like to take a moment to reflect on what will be the five-year anniversary of our having taken over managing the fund at the end of January. Despite what was a less than stellar 2018, we are proud to have been able to add value above our benchmark and compound capital at a more than double-digit rate over the past five years. Interestingly, we have been able to do so in an environment that has not been conducive to dividend investing. It was late 2015 when the Federal Reserve raised rates the first time since the global financial crisis. We have been able to maneuver the fund to withstand the headwinds of a rising rate environment by focusing on companies that offer healthy dividend yields but aren’t necessarily sensitive to the direction of interest rates. While we still have an above average exposure to certain sectors that have historically offered high yields and are generally negatively correlated to rising interest rates (i.e. household products, food and beverage companies), from early 2016 onwards we oriented most of the portfolio more towards those industries that do not necessarily depend on the direction of interest rates despite their solid dividend yields (i.e. stock exchanges, semiconductor manufacturers, aerospace companies). And despite the very recent pronouncements by the Fed chairman that they will take a more measured path as it relates to raising interest rates given the well-known global uncertainties, our sense is that if they could continue to raise rates, shrink sovereign balance sheets, quantitatively tighten, etc., most central banks would. At some point, whether it’s a China-U.S. trade war resolution, Brexit coming to a conclusion, or some semblance of stability returning to the White House, it may offer central bankers confidence to continue the path they were on. And if it isn’t and we’ve seen the near-term peak in global rates, we still feel owning a diverse collection of high-quality, reasonably valued dividend-paying equities is a very rational way to generate returns in that environment. In either scenario, we feel owning a diverse collection of high-quality, dividend paying companies is a good way to compound capital over the long term.
What contributed positively to performance?
Starbucks contributed the most to returns this quarter, as it surged after faster-than-expected sales growth of 4% in the Americas and 3% globally beat expectations for the third quarter, and the coffee chain said it would cut about 5% of the workers based in its headquarters in Seattle to reduce costs. Both CME Group and B3 SA were top contributors in the quarter. One of the largest financial exchanges in the world, CME has an effective monopoly on most U.S. futures, currencies, equities and Treasuries, giving it significant pricing power. B3 has a similar position in Brazilian derivatives and equities and is also the dominant clearinghouse for fixed income securities. They both have significant proprietary data sets that they can monetize due to their strong positions. Further, market volatility is a positive not just for CME and B3 but for all our exchange holdings, as volumes tend to rise as a result.
What detracted from performance?
Apple tumbled after earnings downgrades by key suppliers raised concerns about the strength of demand for Apple’s latest devices, combined with the oddly timed decision to stop providing the street with iPhone volume data, ostensibly to shift the narrative away from looking at product and instead get investors to focus on the strength of their overall ecosystem (iTunes, App Store, Apple Music, Apple Pay, wearables, etc.). We have owned shares for many years and have experienced the ‘End of Apple’ numerous times. In our experience, whenever the market discounts the company at a double-digit free cash flow yield, implying a company that has a 1.4 billion unit installed base and generates over $60 billion in free cash flow will cease to exist in under a decade, it usually represents a buying opportunity.
Allergan sold off dramatically during the quarter resulting from a recall of one of its breast implant products in Europe. There appears to be disagreement with the regulator over the information needed to renew regulatory approval, and the product, which represents less than 1% of the company’s sales, had to be withdrawn. However, the issue raised fears that there might be a significant product liability issue. There is no evidence of any dangers associated with Allergan’s breast implants, as the risks of these products are well known, well disclosed and have long been viewed as acceptable relative to benefits. In addition, the recall is only in Europe where product liability is a far smaller risk than it is in the US. In any event, while we are frustrated with the underperformance of the shares not just this quarter but since first taking a position over two years ago, the underlying thesis in owning Allergan has not changed. The core medical aesthetics business which includes Botox and Juvederm continues to grow double digits and accounts for over 50% of the company’s profits, and most likely the majority of the company’s value. The company continues to be a top holding as it trades – both at the current price and our cost - well below our calculation of intrinsic value.
In Q4, all of our tobacco holdings detracted from performance, led by British American Tobacco (BAT), which declined over -30% in the quarter. The stock declined because of industry factors but also company specific issues. The tobacco sector in Europe was down over -40% for the year, the worst of any sector, as investors woke up to new regulatory challenges and intensifying threats of disruption. Tobacco investors do not have an interest in thinking about disruption, they choose this sector for stability, expecting high cash generation, anchored in sticky market shares and pricing power, to fund generous dividends. On July 25, 2017, BAT bought out the 58% of Reynolds American Tobacco that it did not own, at a total enterprise value of $65.7B. With the acquisition of Reynolds, owner of brands such as Newport, Camel, and Pall Mall, BAT immediately got a strong position in the second largest tobacco profit pool in the world (after China). The acquisition was also a bet on menthol, as the combined group would earn about 25% of its profits from US menthol sales. Fast forward one year to November 2018 and Scott Gottlieb, the new head of the FDA, announces that the organization will seek a complete ban on menthol cigarettes to fight smoking among teenagers. Regardless of how likely it is to be implemented, the risk of a ban on menthol went from potential to real, and the likelihood went from negligible to possible. The increased risk of a catastrophic outcome drove BAT shares down. In the unlikely event that the ban is successful it would not take effect until 2023, or even later due to tobacco firms’ legal recourse. Despite that, a large part of the $65B BAT spent on Reynolds would have been money wasted, while the debt incurred would still need to be repaid.
More broadly, the tobacco industry is facing the risk of disruption from e-cigarettes and “next generation products” or NGPs. The Global Equity & Income Team was aware of these risks from our ownership of Philip Morris International (PM) and Altria and prior ownership of Japan Tobacco (JT). Philip Morris first introduced its “heat not burn” product iQOS in Japan, where it rapidly won over 15% market share in less than two years. This is extraordinary given that tobacco market share changes in mature markets are usually measured in basis points per annum. Observing this early adoption in cities in Japan, we sold our position in Japan Tobacco. We were aware that the assumption of sticky tobacco market shares had been disproven. At the same time, JUUL Labs won 75% of the e-cigarette US market over three years. This showed that the questions posed about tobacco market share stickiness should not be limited to the Japanese consumer context. Not since the introduction of light cigarettes in the 1980s (riding the same consumer trend as diet sodas), and the success of the aggressive long-term Marlboro Man campaign in the 1960s had such shifts in market share occurred. An argument can be made the tobacco companies lost their brand building capabilities as the restrictions on marketing became severe. Product innovation became a game of driving pricing through mix rather than identifying consumer needs.
The responses to JUUL’s hyper growth added uncertainty. The FDA became more aggressive, first by limiting the number of flavours allowed for e-cigarettes. Then they indicated that they would seek to regulate nicotine levels in e-cigarettes to non-addictive levels. The response from the tobacco companies was also notable. All the large players initially dismissed JUUL making one excuse after another, but ultimately, Altria invested $12.8 billion for a 35% stake in JUUL. This valued JUUL Labs at $38 billion. For perspective, Altria is worth $92 Billion, so it valued JUUL at 41% of itself. Altria is expected to have almost $11B in EBITDA this year, a figure that is 7x JUUL’s $1.5B in 2018 sales. Whether JUUL ends up a long-term commercial success or not, it is likely that this investment will prove an extremely rich proposition and a poor allocation of capital. Following that, Altria bought into Cronos, a Canadian cannabis company, paying $1.8B for a 45% stake. When one player does this type of deal, especially category expansion deals, there is a lemming-like urge to copy. This is also a concern.
We have been investing in tobacco for literally 20 years and this is not the first time the business has been under perceived threat, whether it was class action litigation, excess taxation, contraband share gains, and of course various regulatory measures meant to shrink the business. While we view the threat that comes from e-cigarettes as real, we also believe the final bell has once again been incorrectly rung on the industry. It is also important to note that the U.S. market is somewhat unique in that the allowable nicotine content is over twice what is allowed in other markets…for now. Regulators in the US may in fact change the nicotine content of e-cigs if there is the slightest risk that this new (i.e. young) generation of “vapers” start becoming cigarette consumers, defeating the whole purpose of NGPs. In any event, the company’s we own today are trading at levels that assumes the tobacco industry’s profit pools are set to disappear completely over the next decade. We disagree. Even with the aforementioned concerns, they still represent an oligopoly of an addictive product that costs nothing to make, sells at high prices and generates tremendous cash flow and dividends. But we acknowledge the risks and as a result the sector is a much smaller percentage of the fund than it was several years ago, and we are very vigilant as to our positions.
What changes have we made to the Mackenzie Global Dividend Fund?
We finished selling down our position in Atlantia S.p.A., Cielo and Johnson Controls to make room for what we think will be superior investments over time.
The Fund established a position this quarter in AIA Group Ltd., the largest independent, publicly listed pan-Asian life insurance group in the world. AIA meets the savings and protection needs of individuals by offering a range of products and services including retirement planning, life insurance, and accident and health insurance. The company was previously owned by AIG and during the financial crisis, the business became distracted by the issues at AIG. Now as an independent, public company, AIA has shown the ability to improve its margins and return profile. It has wholly-owned main operating subsidiaries or branches in 14 markets in Asia-Pacific and a joint venture in India. China’s life insurance market in particular is booming. As incomes rise and the country’s middle class grows, people are looking for ways to protect their families’ wealth. Over the past 10 years, per capita spending on life insurance has risen more than fivefold, from US$44 a year to $225. While the growth is impressive, China has a long way to go before catching up to the developed world, where the average per person premium is $1900 a year. Estimates suggest that the life insurance gap in Asia is ~$30-35T and twice that amount when one considers health insurance, accident insurance, etc. AIA has the ability to sell its products into this large unmet need and provide consumers with a social safety net. AIA has been successful in China, even with regulations that restricted its operations to just three cities and two provinces. Despite its limited market, its value of new business grew from $68m in 2010 to over $825m in 2017. Its future growth may be even more robust: in November, China announced it will allow foreign insurers to operate throughout the country within five years as part of a liberalization and financial regulations. In preparation for a nationwide expansion, AIA has struck distribution agreements with large banks and other companies. It recently announced a deal to sell life insurance on WeDoctor, a Tencent-backed health care platform with over 110 million registered users. The volatility last quarter presented us with an opportunity to establish a position in this long-watched Dream Team company at under 15x earnings with a 2% dividend yield.
Constellation Brands is the third-largest beer company in the U.S. The company dominates the Mexican category with nearly 80% share with brands like Corona, Modelo and Pacifico. The category has grown nearly double-digits while the rest of the US beer category has remained flat. Constellation has been the major beneficiary of this trend because it acquired 50% of its JV with Budweiser when the company was purchased by InBev over ten years ago. This gave Constellation 100% of the powerhouse Corona brand and the platform to launch Modelo and Pacifico. This transaction was as serendipitous as it was astute due to the unique circumstances at the time and is not likely to be repeated. The second part of the success story is Modelo which has grown in excess of 20% per year for five years, with prospects for continued double-digit growth over the next several years. The brand now makes up more than 40% of Constellation’s beer sales. Further, the company has less than 12% value share of the U.S. beer market and makes up “only” 260 million cases out of a 3 billion case market. Constellation’s beer business is growing at a 10%+ pace while generating 40% margins, making it among the most profitable beer businesses in the world. The company is just concluding a brewery expansion that was five years in the making, such that Constellation can now produce internally all of the beer that it sells despite the volume growth. The upshot being capex is set to materially decline and free cash is poised to explode. The fly in the ointment (and what has allowed us to purchase at a reasonable price), Constellation also owns a wine & spirits business that is average, perhaps even subscale. This still accounts for over one-third of sales, but materially less of profits. This business will continue to be an overall drag on results until it is either turned around, or the continued success of the beer business makes it a non-factor to investors. Lastly, as most Canadians that follow the markets know, the company has entered an agreement to purchase up to 51% of Canopy Growth Corp, the largest publicly traded cannabis company. While we do not have a strong opinion either way on this emerging industry, we appreciate the free option we are receiving (on top of the $1.3billion paper profit the company has made). We view Constellation Brands as one of the best values in consumer staples.
Keyence Corporation is Japan’s leading maker of sensors and vision systems used for factory automation. Keyence’s products perform essential visual tasks on a factory assembly line such as inspection, counting, and measurement of goods. While these tasks were traditionally performed by human factory workers, global issues of labor shortage and the rising cost of labor at factories around the world have led to the rapid uptake of automation in recent years, fueling demand for Keyence’s products and solutions. Benefitting from this tailwind, Keyence has been able to compound revenue and operating profit organically at 19% and 24% per year over the last five years. Notably, during this time Keyence has also achieved significant business growth outside of its home market of Japan, and today more than half of the company’s revenue is generated outside of Japan from a client base that includes some of the most established and prominent global multinationals. The foundation of Keyence’s success is that it is highly differentiated from competitors. Keyence is widely regarded as the most innovative company in its field. For example, 70% of new products developed by Keyence qualifies as either the “world’s first” or “industry first”, which serves as a testament to the company’s product development capability. Another source of differentiation is that while most of Keyence’s competitors rely to a large extent on distribution networks to sell products, Keyence employs an in-house salesforce which builds relationship and sells directly to end-users utilizing a consultative sales approach. Under this model, Keyence not only can provide end-users with valuable cost-saving proposals but can also better grasp the precise needs and on-the-ground challenges that end-users face, which become proprietary data that can be leveraged in developing new products and solutions for customers. Keyence’s differentiated business model, as well as its use of a highly efficient and flexible fabless production system, allows the company to generate an operating profit margin and return on invested capital of over 50% and 150% respectively, which makes Keyence one of the most profitable companies in our portfolio. Admittedly, companies with exceptionally high-quality business characteristics like Keyence rarely goes on sale for cheap, but fortunately the indiscriminate selling of the market last quarter provided us a chance to initiate a position in Keyence at mid-single digit free cash flow yield, which to us is a reasonable price to pay for a world-class industrials business with a long runway to grow profitably. We had began selling industrial-robot manufacturer Fanuc in the spring/summer on valuation concerns and used the balance to underwrite the Keyence purchase. We look forward to revisiting Fanuc again when prices warrant.
The fund initiated a position in Eurofins at the end of the quarter. Eurofins provides testing for food, feed, environment and pharmaceutical products. It is a leader in independent testing and laboratory services for agroscience, genomics, discovery pharmacology and to support clinical studies with over 400 laboratories. The company was founded in 1987 with a single lab by 24-year-old Dr. Gilles Martin. We have followed the testing industry for years, during which we observed Eurofins’ management, and admired the culture and business they were building. The company grew organically and by acquisitions, to deliver the highest return of any stock in Europe since its IPO in 1997. Given the quality of the business and its high growth, the stock has always traded at an unaffordable valuation. Last year, the market became concerned Eurofins had grown too fast. The company effectively completed its 5-year external growth plan in 18 months, and now needs to consolidate its operations. The market punished Eurofins shares at the prospect of slowing growth to execute internal value-add. Blocking and tackling is less sexy to investors than high growth and deals. The indictment was swift with the shares falling 44% from its high of €559 in late October 2017, to a low of €313 in late December 2018. At our average price we are paying under 13x EV/EBIT to become owners of Eurofins. This compares to an average of 34x EV/EBIT multiple over the past five years, with a peak EV/EBIT of 47.6x! We believe the earning power is going to increase from growth and positive margin developments in the medium term. In addition, there is value embedded in the M&A they’ve completed. The Eurofins investment offered all the important characteristics we seek in opportunities for the Global Dividend Fund. A great business that is relatively non-cyclical and that we know well, managed by great leaders, and available at an attractive valuation. Dr. Martin, now 56 years old, is impressive: humble but aggressive; technically gifted; high on accountability; focused on driving of excellence. He leads by empowering his managers at all levels of the organization and incentivises them thoughtfully. Most importantly, he is extremely disciplined on capital allocation. The Martin family owns 36% of the company, with Dr. Martin owning 25% and his brother Dr. Yves-Loic Martin owning 11%. His brother was the long time CTO of the company and is currently a board member. We believe this will prove a great long-term investment for the fund.