- Global equity markets continued its positive trend in the third quarter in 2018. U.S. market was strong which continued to be driven by the Information Technology sector. Both European and Asian markets were modestly higher in the quarter, but the gains were muted when measured in Canadian dollar terms. Canadian market lagged the global markets, with the S&P/TSX Composite Index returned slightly negative during the period.
- The MSCI World Index returned 3.1% (5.3%) over the third quarter of 2018 in CAD (local currency) terms. Health Care and Information Technology were the best performers this quarter, while Real Estate and Materials are the weakest. On a country basis, the index led by the United States, Switzerland and Sweden, while Ireland, Belgium and Italy were the worst performers.
Outlook & Strategy
What are the key opportunities you see?
- In the third quarter, Canadian equities languished, extending the divergence between domestic and foreign market valuations. From the peak of the last cycle in 2008, the TSX has generated an annualized total return of only 4%, while the S&P 500 and MSCI World Index have returned approximately 13% and 10%, respectively in Canadian dollars. Although this can be partly explained by sub-par growth in Canada, valuation multiples have also diverged to the point where US and global market multiples are near record highs, while Canadian market multiples remain more reasonable. This is reflected in our current allocation in Ivy Canadian, with 2/3 of our equities invested within Canada.
- The percentage of Ivy Canadian Fund allocated to cash has been steadily decreasing over the past three quarters to the current level in the high-single digits. In the second quarter, we were able to take advantage of a sell-off in global consumer staples. In the third quarter, we increased our allocation toward Canada as we recycled capital out of rising US equities such as W.W. Grainger and Henry Schein and deployed it along with a portion of our cash position into a collection of Canadian equities. Our largest addition was to an existing position in Dollarama following a marked sell-off that we discuss below. We also added three new positions: Brookfield Property, Premium Brands and Encana. Finally, we exited our position in Raging River after its sale to Baytex.
- In the U.S. market, 2018 has been a better year from a participation perspective for our U.S. holdings despite market gains being driven by continued strong gains in technology related shares where we don’t have a large exposure. Henry Schein contributed in the quarter and has recovered much of the weakness it experienced last year as results have been steady, some of the Amazon fears appear to have dissipated and interest in the Vets First Choice spin-out is starting to percolate. Henry Schein is combining their Animal Health business with a company called Vets First Corporation to form a new company. Vets First Choice is a leader in pharmacy services for veterinarians. Vet pharmacy businesses have been under some pressure by web-based players. Vets First Choice provides a front-end web-page for ordering and has direct to consumer fulfilment capabilities which will be enhanced by Schein’s supply chain. Vets First Choice also helps with compliance and renewals which increases total revenue for the vet but also for the manufacturer. Aligning with Henry Schein’s animal health business will allow for accelerated selling into Schein’s market leading global customer base along with the opportunity to leverage Schein’s supply chain for better service levels and potentially new products over time. We see the spin-off as a sensible way to improve both businesses for the benefit of Schein’s shareholders.
- European markets were modestly higher in the quarter, but were slightly negative when measured in Canadian dollars. Ivy’s European holdings outperformed by a substantial margin, driven by a few individual holdings rather than any broad theme.
- We have discussed our investment in H&M at length in prior reports. To summarize, it is an apparel retailer with some great attributes and advantages, but struggling with some internal missteps and a rapidly changing industry. H&M’s fiscal third quarter results were encouraging on several fronts, as some of the investments they have been making in improving their assortment and omni-channel capabilities have started to pay off. There has been a lot of negativity around the company and its prospects in the past year, so these results were enough to prompt a sharp rally in the share price.
- Far East markets were relatively flat in local currency terms during Q3; Japan led the pack, with the TOPIX advancing 5.7% (local currency), while the Hang Seng showed continued weakness with a 2.5% decline. Once again, Asian markets significantly lagged the S&P 500. Ivy’s Far East holdings generally outperformed the broader Asian indices during the quarter, in local currency terms. The strongest performers were Brambles, CK Hutchison Holdings, Hoya, and Seven & I Holdings; the weakest performers were Ansell and Amcor.
- We initiated a position in Japanese-listed Fanuc in the Ivy International Fund during the quarter. Fanuc is a leading provider of factory automation equipment and software – the Company has leading global market share in industrial robots, components for computerized machine tools, as well as integrated machining centres. Fanuc is well known for its deep customer focus, industry leading product quality and innovation, and its highly efficient and highly vertically integrated business operations. Fanuc manufactures the vast majority of its products in its highly automated facilities in Japan, but sells its products and services globally, including in China where it has significant direct and indirect exposure. The share price has been hit of late due to concerns about the impact of trade tensions on industrial demand and capex in China and Japan, as well as general weakness in some of Fanuc’s key end markets (semiconductors and auto). While we acknowledge that Fanuc is a cyclical business and could experience volatility in the near-term, we believe the current share price offers a compelling long-term risk/reward for what we believe is a very high-quality business. We are further comforted by the fact that Fanuc has a very strong balance sheet with significant net cash.
What are key risks that need to be managed?
- We exited our position in Hyundai Motor Company (HMC) in the Ivy Foreign Equity fund during Q3. We have been shareholders of HMC for over five years; we still believe the business is well run and has several attractive attributes including a good cost position and global sales / production footprint, vertical integration, strong and improving brands, and a good balance sheet. However, the overall operating environment has become much more difficult over the last while, particularly in China and the US, and we do not see a clear path to improvement over the medium term. In addition, HMC has faced some company specific issues over the past few years, including its model mix in the US and China which has led to high levels of discounting, ill-timed capacity expansions in China, and heightened levels of investment required across the business. For these reasons, as well as the highly cyclical nature of the business and underlying industry, we modestly downgraded our quality assessment of the stock and opted to exit the position.
- Finding investments that meet our return hurdles has been extremely difficult in the past few years and we’ve been worried about getting into situations where returns look good because you are taking on unknown risks. We really like the companies we own but recognize that longer-term returns from this point are likely to be very low and that a risk-rerating in the market-place could subject us to a significant drawdown. We have a balance of stable companies that likely won’t provide much upside but should provide portfolio stability with some return along the way along with some more sensitive companies in financial, industrial and consumer discretionary sectors that should participate more if the economy stays strong. Our participation in the past few years has been low but we are moving forward and increasing total return while being mindful the best long-term return path at this point may very well be not being subject to a significant drawdown and getting reinvested at better rates of return. It has been a very tough balance especially as U.S. markets continue to soar and particularly in sectors where we don’t have exposure. It’s a tough time in the cycle for us and this has been an extraordinary cycle but we remain focused on our objectives of outperformance with a better path.