Mackenzie Ivy Team
- US markets had a very strong Q4 and year in 2017. The market appears to have evolved from one being stubbornly pushed higher by unrelenting Central Bank efforts to one that is self-sustaining and accelerating in its upward momentum.
- European stock markets were up modestly in Q4, and quite strongly for the year as a whole, against a backdrop of decent economic growth and a lower-than-usual dose of the European political/economic drama that investors have become accustomed to in the past decade. The end of the year was driven primarily by Materials and Energy stocks as commodity prices firmed, while 2017 overall was led by the Technology sector.
- Far East markets capped off a strong year with big returns in Q4. In local currency terms, the Topix (Japan) was up 8.7% (+22% for the year), Hang Seng (Hong Kong) was up 8.8% (+41% for the year), Australia was up 8% (+13.5% for the year), and KOSPI (Korea) up 3% (+22% for the year). The MSCI Asia Pacific index as a whole was up 8.6% in Q4 and up 23% for the full year in CAD. Far east equity market strength was been driven by a number of factors, including continued monetary stimulus by central banks, along with modestly improved global economic performance following years of ultra-low (or even negative) interest rates, and slightly higher earnings expectations for Asian-listed multi-nationals from lower corporate tax rates in the US. Another contributing factor was strength in technology-related stocks as several of these companies saw a significant increase in earnings and future guidance during Q4, driven partially by continued strength in the semiconductor investment cycle.
- The MSCI World Index returned 6.2% over the fourth quarter of 2017 in CAD terms. All sectors in the index reported positive returns, with Information Technology, Materials and Consumer Discretionary being the best performers. On a country basis, the index led by winners like Singapore, Japan and Australia, while Sweden is the largest detractor.
Outlook & Strategy
What are the key opportunities you see?
- We initiated a new position in Dorman Products Inc. (“Dorman”) in Mackenzie Ivy Global Balanced during the quarter. Dorman supplies replacement parts for passenger cars and light trucks. When your car breaks down, you have three options: 1) go to the dealer, 2) go to an independent mechanic, or 3) fix it yourself. When a car is new (0 to 5 years old), often the only place you can get a part is from the dealer. Dorman has carved out a niche for itself by focusing on creating a second source of supply for parts that were previously only available from the dealer, and charging a lower price than the dealer for said parts. Dorman sells its parts to retailers and distributors who sell to mechanic and DIY end-users. We believe we were given an opportunity to acquire Dorman at an attractive valuation in part due to an industry-wide slowdown due to factors that we believe will ultimately prove to be transitory.
- On the European side, we added Reckitt Benckiser, a healthcare and homecare consumer products company, to Ivy European and Ivy International in the fourth quarter. The stock price had been weak due to a confluence of shorter-term factors, including a failed product innovation, a cyber attack, uncertainty over a recent large acquisition, and a few executive departures. Taking a long-term view, we believe that the company’s core strength, its unique corporate culture, remains intact and could be strengthened following the announced internal split of the company into two independent units. Unlike several consumer goods companies, RB remains a committed brand builder and innovator. We believe this strategy and culture will lead to long-term success. Longstanding Ivy followers may recognize this name, as RB was a core holding for several years. We sold the stock following RB’s leadership transition, due to a few worries that were building up. We continued to follow the company closely, and over time we have regained confidence that RB is a high quality business, even if not the dominant powerhouse it once was. The recent price decline provided an opportunity to become (small) shareholders again.
- We also initiated a position in Brambles in Ivy Foreign Equity and Ivy Global Balanced during the quarter. Brambles has been a holding in Ivy International since February 2017, and we have written about our attraction to this business in previous Ivy quarterlies. The share price had drifted down with high volume during Q4, which presented an attractive opportunity to purchase the shares in additional Ivy funds.
What are key risks that need to be managed?
- The market appears to have evolved from one being stubbornly pushed higher by unrelenting Central Bank efforts to one that is self-sustaining and accelerating in its upward momentum. Animal Spirits have awoken. Commentary last year by GMO around the idea of whether we were in return purgatory or return hell was as a very fitting analogy for where markets were pre-Trump. Was there going to be a slow grind higher with low returns lasting for a significant length of time (hell) or were we simply at an expensive point in the investment cycle (purgatory) that would be followed by a correction allowing for reasonable returns from that entry point (heaven). It certainly felt like hell for 2014 – 2016 but it now feels as though markets are acting in a more common late cycle way that may provide the opportunity for a move into heaven. Either way, we like our long-term positioning but recognize we are in an incredibly difficult short-term position that feels as though it may become a lot more difficult. Unless history doesn’t matter at all stocks are extremely expensive and based on historical relationships the return outlook from this point is low. But valuation doesn’t matter much in the short-term. Winning in the long-term at this point to us is going to be a case of losing the least but navigating towards heaven is going to be extremely difficult given the emotive state of the market and its participants.
- The other dynamic we are dealing with at the stock level is what we see as potentially an excessive discounting of current industry and business dynamics for certain parts of the market. This is not unexpected at any point in an investment cycle but we feel it is especially notable in markets driven by Animal Spirits. A number of our holding have been impacted by changes in the markets they operate in driven by digital technologies changing what they sell and how their customer’s buy and consume their products. The transition to digital is real and presents both risk and opportunity. Our research has exposed to us that new pure digital business models may be getting credit for all the opportunity while established players are being assigned a lot of the risk. We believe there is an opportunity for middle ground and the ‘winners’ will be a function of a lot of different things centered around competitive position, resources, the quality of a company’s strategy, and their ability to execute it. From a stock return perspective valuation can remove the need for a ‘perfect landing’ and we’ve added to our exposure for a number of the names in the portfolio that suffered from this overhang during the year. Given we have a number of holdings that are in the midst of this debate relative short-term underperformance was greater than we might otherwise expect, with Henry Schein, Omnicom and W.W. Grainger being relatively weak performers – but we are always open to the market serving up unexpected outcomes. We need to be sensible around the risks we are taking and those that we aren’t insofar as what we don’t own but we do also need to take a long-term view on these things and act accordingly.
- Apparel brand H&M had a difficult year, and was the largest performance detractor among our European stocks, both in Q4 and in 2017 as a whole. With a constant stream of headlines in the media during the year about retail bankruptcies and difficulties, it is worth explaining why we own H&M, which still generates most of its sales in physical stores.
- 2017 was indeed a difficult year for retailers, as consumers continue to change their buying habits. Most of the retail failures involved companies selling primarily third-party brands, and/or companies with high levels of debt (many private-equity owned). With increased price transparency and online convenience, selling other people’s brands has become a race to the bottom in terms of pricing. As for debt, it has an enduring capacity for magnifying errors (committed both by companies and by investors), which is part of the rationale for our preference for strong balance sheets. H&M is as an own-brand retailer with no net debt on its balance sheet (although, like most retailers, it does have some off-balance-sheet lease liabilities). So it does not suffer from these two factors that have brought down some high profile retailing names. Despite that, revenue and profits were weak throughout 2017 – we had expected a difficult year, but not as difficult as it turned out to be.
- The common narrative around H&M is that it is a bricks & mortar retailer that is suffering in a world where customers are increasingly buying clothing online. We believe things are more nuanced than this. No doubt, there are some online platforms that have been very successful in Western Europe, which remains H&M’s core market. This has contributed to the company’s difficulties, especially since H&M’s long history in the region has left it with some stores in smaller cities that are no longer as economically attractive. However, H&M also sells a substantial (and increasing) proportion of its clothing online, and has been investing heavily in improving its omni-channel capabilities. We believe current difficulties are the result of a collection of factors, which are possible to overcome.
- We are fully aware that the environment for H&M is not an easy one, and is changing rapidly, so success is not guaranteed. But the company has several strengths: significant brand goodwill, a world-class sourcing organization that allows it to buy-in clothing at lower prices than most peers, successful smaller brands that are gaining critical mass (COS, & Other Stories), growth headway in several regions of the world, a culture of entrepreneurialism, and family control that allows for the necessary investment for long-term success. Given these factors, combined with a stock price that is at its lowest point since early 2009, we believe investment at today’s price will ultimately be rewarded. As always, we may change our minds, and this remains a topic of intensive analysis.
- We removed TGS Nopec Geophysical from Ivy Global Balanced in Q4, and reduced our exposure in Ivy European and Ivy International. This seismic imaging company is extremely well run, but is highly cyclical and tied to oil prices. The recent run up in oil led to a higher share price for TGS, pushing it to a level that we are less comfortable with from a long-term perspective. We also removed Pfeiffer Vacuum Technology from Ivy European for valuation reasons. Pfeiffer has substantial exposure to the semiconductor equipment market, and like other semiconductor-related stocks it rose very strongly in 2017, beyond our comfort level.
- Our assessment of risks facing Asian markets has not changed in the last several months. Valuations are high, on top of optimistic growth assumptions and earnings estimates. One of the most significant risks facing global markets is the reversal of aggressive monetary policy. Quantitative Easing, or “QE”, is now gradually (perhaps temporarily) giving way to Quantitative Tightening, or “QT” (of course, “tightening” is a relative term). The US Fed has already proceeded to raise short-term rates and is now reducing the size of its balance sheet, albeit very gradually. In Japan, the BOJ’s move to target the yield curve rather than guide to an exact dollar amount of monetary stimulus is being viewed by some as the first step in modest reversal of its massive QE program. The European Central Bank (ECB) too will also start to gradually reduce the amount of liquidity it is injecting. Central banks believe they can predict how this will all play out – but the reality is that the recent period of very loose monetary policy was an experiment of significant proportions, and nobody really knows what the result of gradual reversal will be. Here is what we do know – the money printing experiment that has depressed bond yields and led to significant asset price inflation and depressed volatility is now slowing, or going in reverse. There is a reasonable probability that this will cause disruption in financial markets across various asset classes – these effects would be compounded by significant amounts of debt in various pockets of the financial system.