- Over the third quarter of 2017, global economic growth was positive over the period as a range of indicators suggested that expansion is under way in most developed nations. Despite geopolitical tensions with respect to North Korea, global equity markets rose in response to increasing corporate earnings, while Canadian equity markets were up only modestly. Given improved growth and lower deflation risks, the European Central Bank hinted that it may tighten its accommodative monetary policy by further reducing asset purchases.
- The MSCI World Index returned 0.9% over the third quarter of 2017 in CAD terms. Energy, Materials and Information Technology are the largest contributors, while Consumer Staples, Health Care and Real Estates continues to be the largest detractors. On a country basis, the index led by winners like Norway, Italy and Portugal, while Israel is the largest detractor.
- Equity market strength was driven by a number of factors – continued hopes of global economic expansion led by the US, optimism around improved economic performance in China, and hopes that growth is returning to Japan following modest improvements in recent economic data. Another key driving force is the steady stream of quantitative easing, as both the ECB and Japan Central bank continue to print money on a monthly basis – this liquidity is finding itself into various asset classes, including equities inside and outside these regions.
Outlook & Strategy
What are the key opportunities you see?
- Domino’s Pizza Group is a new addition to Ivy European and Ivy International, and was a positive contributor in the quarter. Domino’s holds the master franchise agreement for the brand in the UK, Ireland, and Switzerland, and is also active in Germany and the Nordics. In their core UK market, Domino’s strong leadership position gives them the scale to purchase quality ingredients more cheaply and to deliver pizzas faster and hotter than the competition. These scale advantages, combined with a culture of innovation and efficiency, make them a tough competitor to beat.
- During the quarter, we initiated positions in Dollarama Inc., Spartan Energy, and Henkel AG & Co in the Ivy Canadian and Ivy Canadian Balanced.
- Dollarama is a high quality, defensive retailer with attractive growth prospects. Most in Canada will be familiar with this brand and hard pressed to name another dollar store, which speaks to their broad appeal and dominant competitive position. While generating significant excess cash flow, the Company has organically grown its earnings at consistently double digit rates through the build out of new stores and the introduction of higher price points, and although we have factored in slowing growth over our investment horizon, we expect this to be a growth business for the foreseeable future. The key risk to our investment thesis is the potential that the company’s high returns on capital and rapid growth will elicit a more formidable competitive response than we’ve seen in the past. However, we believe that the value Dollarama offers customers relative to traditional retailers is sustainable as a result of its lean cost structure, characterized by low overhead and a simple logistics platform.
- We also initiated a position in Spartan Energy during the quarter. Spartan is a low-cost oil producer in Canada, located primarily in south-east Saskatchewan in the highly economic Frobisher oil-pool. The primary reason we like the company is the quality of their underlying assets, affording Spartan the ability to profitably grow cash flow at current oil prices. With a strong balance sheet, an experienced management team, and a low-cost production profile, we believe the company is well positioned to generate attractive returns in a stable/rising oil-price environment, while being able to navigate through another prolonged downturn if such a scenario materializes.
- Q3 was fairly quiet from a trading perspective on the Far East side, however we did modestly increase our position in CK Hutchison Holdings, Seven & I Holdings, and Brambles in various Ivy funds.
- We wrote about CK Hutchison last quarter – we initiated a position in Ivy Foreign and Ivy Global Balanced during Q2, and continued to build the position during Q3 at what we believe is an attractive valuation.
- Seven & I Holdings was initially purchased in the summer of 2016 – the share price has been fairly flat through the year, however business performance is steady and we believe this will improve gradually over time.
- Brambles reported Q4 F2017 results in August; this was our first opportunity to hear new CEO Graham Chipchase provide an update on the strategy and growth opportunity since he took the helm earlier in 2017. We liked what we heard – Brambles’ leadership is keenly aware of the drivers of competitive advantage for the business, and the Company plans to continue to reinvest in the business to maintain (and strengthen) this advantage. New management plants to improve the capital discipline relative to the recent past, and also provided a more realistic long-term growth outlook compared to that provided by previous management. We found the discussion rather refreshing; the new long-term growth outlook is in line with our assumptions for the business, and we believe improved capital discipline will allow the company to focus on strengthening its core business and on select attractive opportunities in the future. Brambles’ stock was modestly weak during Q3 – we used this as an opportunity to increase our position in Ivy International.
What are key risks that need to be managed?
- Times have changed. Investors seem to becoming more fearful of companies being “disrupted”. It appears that the impetus for this is rapidly changing consumer expectations, partly enabled by new technology. To some this feels like a “millennial” issue, but even for those who don’t identify with that classification, consider your own habits and expectations – 10 years ago the iPhone didn’t exist, 5 years ago voice controlled digital assistants (Siri, Alexa) were in their infancy, and last year same-day delivery was still a new idea. Now, it’s commonplace to order coffee, hail a ride, or shop on your mobile phone – lineups seem unnecessary and waiting has become increasingly frustrating. Times have changed, expectations have changed, companies must adapt. We believe that companies that consistently reinvest in their value proposition, sometimes at the expense of near-term profitability, will be best positioned to adapt to a rapidly changing world and this belief forms a key criteria for us in assessing the sustainability of a company’s competitive position. We believe we have constructed a portfolio of great businesses that are reinvesting in themselves and strengthening their competitive advantages, which will allow them to outperform over the long-term.
- At Ivy, we do our best to communicate openly and honestly about our process and the performance that investors should expect from our funds. Historically, our performance has lagged in a bull market and outperformed in a bear market, often coming out ahead over a full cycle with a generally smoother ride. We strongly believe that this path contributes to better outcomes for our investors, helping them to stay the course in times of uncertainty, while enabling them to participate in the longer term appreciation of the market. Given the strong market performance as of late, we would generally expect our funds to underperform and this has in fact been the case. Although it pains us to see our relative performance lagging over any period, we remain steadfast in our long-term focus on full-cycle performance with the expectation that our relative performance will ebb and flow over shorter time horizons (sometimes better, sometimes worse) as the market follows its cycle.
- During the quarter there was volatility in Costco over Whole Foods purchase by Amazon – we do not see this as a long-term issue for Costco. As well, Omnicom sold off on competitor WPP’s commentary on growth along with investor fears over disintermediation and ongoing fee pressure. We think the agencies and Omnicom in particular will do well over time. It is a tough market for them as their customers continue to focus heavily on costs but we find the valuations very attractive for businesses that are flexible by nature and play an important intermediary role in a dynamic industry. Grainger is another business that is subject to intense debate around structural decline. We believe Grainger will be a long-term winner but expect heightened volatility for the next quarter at least. Henry Schein is also suffering from a mix of weak end-market demand for dental consumables along with fears over Amazon’s entry into the dental space. We accept Schein is not trading at a cheap valuation but we believe they are incredibly well positioned in a number of attractive end-markets that should provide a nice balance of organic and inorganic growth opportunities. We do not see Amazon as a factor as this point in time. Nike is suffering from a movement into retro styles driven by Adidas which has opened up the market a bit for the likes of VF Corporation’s Vans brand. We see this as transitory. At the same time their large exposure to U.S. physical retail is providing for the most dynamic end-markets they’ve likely ever had to deal with. Nike is used to adversity in a category that is inherently volatile. Nike is used to adversity in a category that is inherently volatile.
- Two holdings in Europe hurt our performance in the past quarter and year: Publicis and H&M. In the case of communications holding company Publicis, there is some concern about structural change in the industry, as more and more advertising is done online, new competitors enter the arena, and new tools are available to marketers. On top of this, Publicis has been undergoing a leadership transition as well as a major internal reorganization, in an effort to better position the company for industry change. Clothing retailer H&M has also faced challenges, particularly from the growth of ecommerce and the accompanying disruption in some of the company’s major markets. Neither company is standing still. Publicis already derives the majority of its business from digital marketing, and they are positioning the company to be a leader in digital business transformation for their clients. H&M was late to recognize the importance of the omni-channel model, but they have been investing heavily in the past few years to establish world class capabilities in this area – they already sell a substantial portion of their clothing online, and they have continued to gain global market share (albeit not at the expected rate).
- Both Publicis and H&M are very different companies in different situations, but there is a common factor: both are facing questions about industry changes and their respective abilities to adapt. This reflects a broader trend, where investors flee companies facing uncertainty related to disruption. Sometimes there is very good reason for this, as we have seen the economics of entire industries get flipped on their heads due to changing technology and/or disruptive competitors. But in other cases the threat is exaggerated, or the companies’ ability to adapt is underestimated, and this can present investment opportunities. So while we certainly acknowledge the risks facing Publicis and H&M, we believe that they are both quality companies that will still be successful long into the future, and that today’s share prices will reward long-term investors - especially when compared to the very stretched valuations of “safer” companies. We continue to analyze and evaluate these risks, and if our minds change we will act accordingly.
How are you positioning portfolios in response to this outlook?
- There are a number of issues globally that concern us, including highly indebted governments and consumers, and the potential unintended consequences of ultra-loose monetary policy. This, coupled with global equity markets that appear priced for perfection, drive us to be cautious about equity markets in general.
- We continue to believe that valuations in Europe are stretched, particularly for high quality, steady growth-type businesses. We remain patient, both in waiting for more attractive prices, and in waiting for long-term investment theses to play out.
- We remain ‘underweight’ Japan relative to most Far East / EAFE benchmarks, due to high valuations. We have a higher weight in Australia relative to most benchmarks, due to our holdings in what we believe are attractively-priced high quality stocks.