A solid fourth quarter concluded one of their stronger recent years in equity markets. A big driver of returns was the forthcoming corporate tax cuts and the strength of US corporate earnings. Among developed markets, Japan was a standout, supported by October’s snap election which produced a clear majority for Prime Minister Abe’s ruling coalition. Emerging markets led global markets for the quarter and the full year. European markets underperformed during the quarter. Volatility continued to remain very low.
During the quarter there was a continued shift in monetary policy towards tightening. The US is leading the way with 3 interest rate rises expected by the market in 2018 in line with Fed guidance. The Fed raised the US benchmark rate by 25bps (to a target range of 1.25%-1.50%) as did the Bank of England, lifting rates to 0.50%. Meanwhile, the ECB and BoJ left rates on hold but indicated they may begin moving toward a modestly tighter stance next year.
Quality growth stocks led in Q4 and for 2017 overall. Technology, consumer discretionary and material stocks led returns during the quarter. The healthcare, utilities and telecoms were the underperforming sectors.
The fund returned 4.2%, after the cost of protection, for the quarter trailing the benchmark which returned 6.0%%. For the year the fund returned 16.6%, after the cost of protection, ahead of the benchmark which returned 14.9%. Top performers during the year were PayPal, Visa, Heineken, Unilever and Microsoft. The main detrators to the performance for the year were Johnson & Johnson, Gilead Sciences, Charter Communications, Priceline.com and Celgene Corp. Top performers during the quarter included PayPal, Microsoft, Visa, Zoetis and Accenture. The main detrators to the performance were eBay, Cognizant Tech Solutions, Priceline, Charter Communications and Celgene Corp.
The pharmaceutical sector continues to exhibit weakness due to the continued negative rhetoric around drug pricing. Despite trading on attractive valuations versus history and generating high ROICs until we get a more positive resolution around drug pricing the sector may continue to struggle. We have a smaller exposure to the sector than historically and are exposed to companies where there is a healthy pipeline of new drugs and where current profitability is high.
The other major detractor during the quarter was Charter Communications. This was driven by comments from Comcast over experiencing losses in the number of video subscribers. The raised concerns over chord cutting. The business models of cable companies are rapidly changing
where an increasing proportion of revenues is now coming from high speed broadband which is also more profitable than video subscribers. Charter Communications is the second largest cable company in the United States.
Competition between cable companies is extremely limited as cable companies have already been granted “franchise rights” by local governments allowing them to utilize public right-of-ways to lay core infrastructure which deters entry. Secondly, cable benefits from very strong economies of scale. There is little incremental cost for wiring an additional home or delivering an additional service. As the demand for high speed broadband accelerates return on invested capital, cash flow and profitability will continue to increase. Cable companies are a clear beneficiary of this megatrend for high speed data.
Monster Beverages and Twenty First Century Fox were the two significant positions added during the quarter. Market analysis has shown that the consumers have been buying less amount of soda and increased amount of energy drinks. Monster Beverages is one of the leading players where the top two players control a large part of the market. Penetration of energy drinks is still low, estimated to be circa 5% of the carbonated soft drinks market, and therefore provides a long run way of growth for the major players. The major industry players are very profitable delivering high margins and returns on invested capital. Monster Beverages has been successful in taking market share by volume in the United States and this can be transferred to other key markets where the Coca-Cola Company, which owns 18% of the company, has strong distribution. Recent data supports our thesis with international momentum building as they fully transition to the global coke distribution system.
Our analysis indicates that Monster is undervalued based on the sustainability of its profitability and future growth opportunities. Insync’s view is that Monster is extremely well positioned to profitably participate in an attractive growth category globally with the opportunity to also take market share from its competitors.
Twenty-First Century Fox (Fox) produce enough must-see TV programs and cable channels that they should be able to remain relevant to any bundle and to render irrelevant any bundle without them.
Fox is in a strong position to capitalise on the secular growth in the value of high quality content worldwide. What is under-appreciated is that Fox is truly a global company, generating nearly 40% of its revenues outside the United States, and unlike the mature US market, pay-TV is still in “growth mode” in many countries around the world.
One of the key gems in their international business is Star India. Valuing these assets is quite difficult, given the interdependency between various operating segments. The strength of their content business in the US was reflected in double digit top line strength in affiliate revenue. We see an asymmetric risk profile with limited downside risks but significant upside opportunity.
During the quarter, Insync sold its holdings in Medtronic as it had reached our valuation targets.
Outlook and strategy
Volatility has ended the year at record lows. According to the VIX index, also known as the Fear Index, volatility tumbled to an intraday low of 8.56 in November, its lowest level since the index began in 1990. The last time volatility sunk to levels this low was in the run-up to the financial crisis a decade ago and volatility then soared to a peak of 80.86 at the height of the global downturn in 2008. investors are now conditioned to expecting any rise in volatility as temporary. It is instructive to observe history to ensure that you and your clients are prepared when periods of high volatility returns.
The VIX Index is a forward-looking measure of market volatility. It shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is forward looking, calculated from both calls and puts, and is a widely used measure of market risk, often referred to as the “investor fear gauge”. Prior to 2017 (almost 7,000 trading days), VIX closed below the ultra-low level of 10 on just nine days. During 2017, VIX anchored below 10 on 52 days and reached a 23 year low. That’s 85% of all days below 10 since inception.
History shows that higher periods of volatility are normal and can last for a number of quarters and years. Periods of low volatility are followed by periods of high volatility. Many investors were surprised by the period of high volatility in 2008 /9 having anchored on the extreme low volatility years during the mid-2000s. An appreciation of history provides a more rational perspective that can help investors take action to protect their portfolios when high volatility returns.
As we are getting to the point of the longest bull market in history with volatility at record lows it would be reasonable to assume that a period of higher sustained volatility is more likely to re-emerge. Hedging a part of your portfolio from a significant increase in volatility to protect the downside is a sensible course of action
Megatrend – Autonomous Cars and the Internet of Things
A key aspect of Insync’s investment process is to invest in megatrends. Fundamental shifts in demographics or the widespread adoption of technology are significant forces that do not depend on the vagaries of the economic cycle and forecasting the next read on GDP. Investing in these durable trends over many years requires foresight and patience. When this is implemented right the gains can be dramatic. This is especially so if one can invest in these trends by investing in businesses with sustainably high returns on capital.
One of the most significant megatrends is occurring in the automotive industry which is going through a revolution. Whilst some commentators argue that the automotive industry is in decline growth is actually accelerating, stemming from new revenue streams, including shared mobility and data connectivity services as well as continuing global macroeconomic growth in emerging economies. McKinsey have estimated that automotive revenue pools could expand by ~30 percent by 2030, adding up to ~USD 1.5 trillion.
It is important when assessing a megatrend to assess the total size of the addressable market in the future, where you are on the trend and investing in highly profitable companies that will benefit from the trend. Our recent discussions with the automotive companies is that the trend towards fully autonomous cars will take longer than expected.
Fully automated driving will not happen overnight. It is a revolution through evolution: cars gradually learn how to drive themselves. BMW talked about how it plans to bring a Level 3 (autonomous driving in very specific circumstances where the driver should be ready to take over control) car to consumers in 2021 and that fully autonomous Level 4 and 5 ride-hail vehicles will become mainstream by 2025 onwards.
Nevertheless the connected car has the power to shake up the auto industry as profoundly as the first Model T. The implications for the connected car revolution – and the outlook for its growth – are strongly positive. IHS Automotive predicts that sales of connected cars will grow by six-fold globally through 2020 ; by that year, says Gartner, 250 million connected vehicles will be on roadways, “making connected cars a major element of the Internet of Things (IoT).
TE Connectivity is a key partner for many car manufacturers in creating connected car systems. TE products connect almost every electrical function in cars – from alternative power systems to infotainment and sensor technologies. TE is a profitable company with strong capital allocation discipline that is well positioned to benefit from this megatrend.
Insync implements a high quality strategy investing in companies with sustainably high returns on invested capital with strong capital allocation and a long run way of growth.
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.