PDF version of Quarterly Commentary June 2017.
Global equities once again performed strongly during the second quarter benefitting from solid corporate earnings growth with emerging markets leading the way and developed markets not far behind. Investor sentiment improved markedly in Europe as political newcomer Emmanuel Macron defeated Marine Le Pen in the French presidential election, largely erasing concerns that France may attempt to leave the European Union. The Fed raised its key rate 25bps in June, citing a relatively upbeat outlook on US economic growth and employment.
Quality stocks continued to outperform during the second quarter led by the technology and health care sectors. Globally, technology has been the best performing sector year to date whilst energy has been the worst performing sector as oil prices continued to be under pressure on the back of concerns around a supply glut.
The fund returned 7.73%, after the cost of protection, for the quarter outperforming the benchmark which returned 3.86%. Top performers included PayPal Holdings, Heineken NV, Oracle Corp, Unilever and Reckitt Benckiser. Our only two negative contributors during the quarter were The Priceline Group and Walt Disney.
PayPal is one of the top holdings in the portfolio which was acquired just prior to the de-merger with eBay in July 2015. The rationale for purchasing the shares prior to the demerger was a view that both businesses would be better managed as independent focused companies and capital allocation would therefore improve which was a previous concern of ours. PayPal posted solid fourth quarter results. We agree with CEO Dan Schulman’s statement that PayPal is “just scratching the surface” of the market opportunities that lie ahead. PayPal is well positioned to benefit from increasing consumer adoption of mobile payments. The company processed more than $100 billion of mobile payments during 2016 (up 55%), and more than half of those who used the PayPal platform did so via their mobile device.
Oracle is a long-standing holding of Insyncs as our analysis has indicated that Oracle has an extremely valuable “razor and blades” business model, which is being substantially undervalued at its current share price. The company’s business-model is in transition, where it is transitioning a portion of its on-premise, license based software model into an annuitized, cloud-based revenue model. Given the inevitable market shifts, Oracle’s mantra changed a few years ago, and while it has had to endure shrinking margins during the model shift, ORCL has made meaningful strides and is
now much better positioned for secular growth in SaaS. In the database business, there are many emerging competitors but database technology is very sticky and we believe no one competitor will be able to put a material dent in Oracle’s leading market share anytime in the foreseeable future.
Disney is one of the world’s most powerful brands according to Brand Finance. Disney’s strength is founded on its rich history and original creations, however its now dominant position is the result of its many acquisitions and the powerful brands it has brought under its control. ESPN, Pixar, The Muppets and Marvel are all now Disney owned, but perhaps the most important acquisition of all has been Lucasfilm. It appears the market is concerned about Disney’s cable television business, and in particular ESPN as cord cutting in the United States accelerates. On the other hand, the overall company continues to grow at a high rate, thanks to exceptional growth in its other businesses. We believe that the stabilisation in Pay TV subs driven by new MPVD services and/or from the traction of the ESPN OTT services could result in a significant re-rating of the company. Recent data from Time Warner on their HBO business suggests they are starting to make the transition and adding subscribers again despite the trend in cord-cutting not abating. We don’t see why ESPN can’t make the same transition.
One new stock was added during the quarter. The Priceline Group is a global online travel company (OTA) that offers its customers the opportunity to purchase hotel room reservations, car rentals, airline tickets, vacation packages, cruises & destination services in a price-disclosed manner. Booking.com has emerged as the dominant global OTA, as it has created a very large marketplace that connects travellers with a vast supply of fragmented hotel and alternative accommodation inventory around the world. It is the category leader with unparalleled global scale in online travel and also well positioned for an acceleration in Asian and Chinese travel growth in the years ahead. We anticipate the online share of bookings will grow from one-sixth now to one-third over the next 15 years, a rate of growth consistent with what has been seen over the last decade. Insync believe Priceline will be a major beneficiary of this trend being the industry leader. Our confidence in this is helped by data from specialist industry researchers which show the percentage of consumers researching travel on websites is almost twice as high as the percentage which go on to book. With consumers increasingly comfortable booking online, we expect to see this conversion rate go up, whilst growing levels of internet access will also continue to be a helpful factor.
During the quarter Insync sold its holdings in Zimmer Biomet Holdings, the largest player in orthopaedic products, and Thermo Fisher Scientific, a leading provider of analytical instruments, equipment, consumables, software and services to the Life Sciences, Healthcare, and Industrial, Environmental and Safety Industries. We had increasing concerns around Zimmer’s integration of the acquisition of Biomet and the industry data was showing that they were gradually losing market share, as a result of the complexity around the integration, in what is essentially a very sticky customer base. Thermo Fisher Scientific was sold as it had reached our valuation target. One of our key focus areas are businesses that can increase their return on capital and the trends were not improving in the way we were expecting. Both Thermo Fisher Scientific and Zimmer Biomet have been successful investments for the fund.
Outlook and strategy
As investors continue to remain relatively calm about investment markets where volatility remains at all-time lows as measured by the VIX index, one of the causes of the last financial crisis was the high level of global debt which has now reached an all-time high. The Institute of International Finance (IIF) in its latest Q1 2017 report was the most troubling yet, because what it found was that in a period of so-called “coordinated growth”, global debt hit a new all-time high of $217 trillion, or over 327% of global GDP, up $50 trillion over the past decade.
USD trillion – Q1 of each year
Source – IIF, BIS, Haver
The fresh record was driven by the rapid growth of issuance in emerging markets where debt rose to an eyewatering US$56 trillion for the 2017 first quarter.
Not surprisingly, China continues to be the biggest source of global debt growth, with the country’s total debt-to-GDP load now surpassing 300%. The key takeaway comment from the IIF is that “rising debt may create headwinds for long-term growth and eventually pose risks for financial stability”.
At Insync our view is that the combination of record high debt, ageing global demographics and declining work force will keep economic growth rates lower for years to come favouring quality companies benefitting from global megatrends that are less sensitive to the economy.
Impact of Amazon’s more aggressive move into the grocery channel
Insync have historically had a strong exposure to consumer packaged companies (CPG) because of their persistently high margins and returns on capital. The companies we are invested in also have a long run way of growth because of their exposure to the growing middle class in emerging markets where consumption is set to double to an estimated $30 trillion dollars by 2025. As part of our process we always seek to understand disruptive forces on the portfolio stocks.
With Amazon’s announcement of the Whole Foods bid it is important to understand the impact on consumer packaged goods companies (CPG) of Amazon’s concerted move to disrupt the grocery channel in the same way they have disrupted other retail channels. The company is hoping to be the largest retailer — in all consumer segments — in the world. With this latest move, it’s not just trying to change how consumers buy groceries. As an example, look at the company’s original disruption: bookselling. Amazon not only shifted how and where books were sold, but it also changed how they were made. They eventually forced publishers, authors and everyone else along the supply chain to cut costs. The same thing could happen in food.
Grocery is the largest component of U.S. consumers spend annually and represents just under a third of total spend. In our analysis and discussions with the CPG companies, many companies appear to be poorly positioned from Amazon’s push into grocery which is why a selective stock picking approach is critical.
Our analysis indicates that the companies in the portfolio are better insulated from the Amazon threat. We have been focused on companies that have been significantly investing in delivering new products to the market though innovation, differentiated marketing, including the smart use of digital marketing, and having a multi-channel approach to selling online and through bricks and mortar which generally results in improved engagement with different types of customers and, importantly, pricing power.
The categories we have invested in such as laundry detergents, health and hygiene, beer and spirits have low private label penetration reflecting their brand strength in the eyes of the consumer. In addition a large proportion of
their sales comes from emerging markets (in excess of 50%) where Amazon has a smaller presence. It is important to appreciate that Amazon has not been successful in all the markets where it operates. Whilst they have been successful in the US and UK they have had less success in France and Canada.
As part of our risk management discipline, understanding the impact of disruptive forces is an important part of the investment process, especially in this fast changing world.
Insync implements a non-benchmark approach with the objective to provide equity type returns, seeking to meet the financial needs of investors, whilst reducing the magnitude of losses from sharp and significant falls in equity markets.
We look for exceptional businesses with high or rising returns on invested capital, generating strong free cash flows, with solid balance sheets and a long track record of returning cash to shareholders through growing dividends and/or share buy-backs.
Investing in megatrends provides businesses with more assured and a long run way of growth in a low growth environment. Megatrends are less sensitive to changes in the economic cycle.
Reduces the severity of losses during large share price corrections