Quarterly Performance Commentary
If only every quarter was superb……..Whilst our 1 year returns to the end of the December quarter stood at 37.22% - Global Quality Equity and 32.76% for the Capital Aware option, the 3-month positive returns for both options were slightly less than the index. (MSCI ACWI -ex AUS). These returns did however place us in #2 position in the industry for global funds and has Insync in the top quartile over 1,3,5 and 10 years^. A high batting average again: Pleasingly twenty of the thirty stocks in the portfolio outperformed the benchmark over the year to December 2019, a 66% batting average. Once again this illustrates that our process and approach does not rely on a few stand-out star performers. It’s the portfolio as a whole that delivers the out sized returns for investors. Leading positive contributors were Bristol-Myers Squibb, Adobe, Nvidia, Apple and Domino’s Pizza. The detractors included Stryker, IDEXX Laboratories, Constellation Brands and Intuit. Our view remains unchanged: Market conditions continue to reflect the trend in place since the GFC of low growth and low inflation. Whilst some hint at a possible surprise in inflation this is far from confirmed, and so as this trend continues over the medium to long-term, our portfolio of high ROIC (returns on invested capital) stocks benefitting from global megatrends should outperform. Mostly decoupled from typical global economic indicator gyrations: This is because Insync’s stock holdings are less dependent on often quoted global economic and stock measures to generate consistent profitable growth. The portfolio, which has very specific quality and growth attributes, has a consistent long-term track record of picking up almost all the upside in rising markets. Importantly, this process also acts as a buffer against significant market falls during major market corrections. This has been proven across all 5 big market pull backs over the last 10 years. There is always a risk of a black swan event (and for those worried about this, consider the Capital Aware option).We also recognise that after the very strong returns over the past 12 months the probability of a correction in equity markets is increasing. Yet, the stocks we own tend to recover from market-wide pullbacks faster and better than an index basket or the market in general; and for very sound reasons! Insync’s future-focused insights reaffirms our positive medium-term outlook for equity markets, and with interest rates continuing to remain very low, will continue to support equity market valuations.
Looking ahead, this is what is foremost in our minds. Markets; could they be ‘melting up’? As always there are persuasive arguments both for and against. Pessimists quote potential triggers of falls like the US and China failing to sign phase 2 of the trade deal; Europe continuing to mumble along; and a geopolitical event in the Middle East. Perhaps even a severe spread of the Coronavirus.
How will this impact Insync’s holdings if they are right? The one group of stocks that consistently show resilience during these periods are highly profitable businesses which have strong balance sheets, stable to growing cash flows and more assured growth. They don’t always have low PE’s either, which perplexes many. PE’s are a historical calculation high and only a very short-term future projection of the same. This robs canny investors of real insight into what’s happening beyond the simple headline measures in a company.
Whilst we appreciate there are as always risks of a reasonable market correction, particularly after a very strong market in 2019, it is also important to consider what may drive the markets to continue to move up significantly higher looking FORWARD. We excel at being more future-focused than rear-view looking. These include central banks remaining accommodative (very low interest rates driving investors to seek high returns from equities), global valuations that are attractive relative to bonds and justified on an absolute basis (based on current interest and inflation rates), and investor sentiment that still remains, on balance, negative.
Aren’t Market valuations very high though? Investors are heavily focused on valuations and certainly some markets are more richly valued by historical standards using static measures of value such as P/E ratios. As the chart below shows, Global P/E ratios are not excessive by historical standards. The typical view is that the US in particular is fully ‘valued’, especially the S&P 500.
This graph will surprise many that believe valuations are at the very high end historically. Almost 50 years of data suggests this is not the case.
Currently trading on a forward P/E ratio of 20x, it is at the top end of its historical trading range going back to the 1950s. But, and here’s the big BUT…… these higher valuations are supported by a radically different climate of low inflation (2.1% versus long term average pf 3.5%) and low bond yields (10-year treasury yields, at 1.8% versus an average of 5.6%) impact this conclusion. These facts are forgotten by those quoting ‘fully valued’.
Market Corrections - a reality. "Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves." Peter Lynch (one of the most successful and well-known investors of all time) True; and rarely accounted for properly by investor and advisers. After the recent strong rally in equity markets many are concerned that markets are extended, and a significant pullback is imminent. They cite the previous argument. Market corrections of 5-10% are normal in any year. Corrections in excess of 15-20% tend to happen once over 5-6 years. Both are a normal part of investing in equity markets. Insync provides the Capital Aware fund for those that prefer a buffer of such an eventuality in the latter. Experience shows that short-term market calls are notoriously difficult to be consistently successful in getting right. Don’t be tempted to time switching. Being wrong is very costly and immediately felt. Investors lose the compounding benefits of investing for the long-term in equity markets. Stay with quality and with the fundamental benefit of human endeavour, ownership.
We aren’t all that concerned about historical valuation methods…because quality matters when assessing value. It is important to appreciate that the S&P500 is the most exposed geographic index to the highest value-added business sectors globally, including healthcare and technology. They also tend to benefit from global megatrends. We believe it is thus entirely logical and appropriate that P/E valuations of US stocks should be structurally higher than other major markets which are more exposed to cyclicals, banks and lower value industries (think Australia). Insync has a strong view that the corporate earnings that feed into market valuation measures are also likely to be understated relative to history. This is especially true for the more innovative companies and that we are also entering into the Fourth Industrial Revolution. This is largely because most of the future growth in earnings is driven by investments in intangibles, such as R&D rather than capital expenditure, such as plant and equipment. This hurts current earnings and often shows up in traditional measuring sticks of a company’s health negatively. It misleads analysts and investors. This observation means that we expect future returns to be somewhat higher than the returns that markets at similar valuations in the past ended up producing. Possessing this future-focused insight and the tools to evaluate this properly are a major Insync value add for investors heading into an uncertain future world.
Always pay attention to income relativities! Dividend yields versus bond yields The differential between the S&P 500 earnings yield and 10-year treasury yields continues to be more than one standard deviation from the long-term average. This supports the case that equities are very attractive compared to bonds. Average S&P 500 returns when the gap is this wide in the subsequent 12 month period is in excess of 10% according to research by Strategas. In addition to the S&P 500 earnings yield remaining very attractive versus bond yields, the MSCI ACWI benchmark global equity index provides a dividend yield of 2.4% versus global bonds only yielding 0.8%.
These indices and the relativity do not support equity valuations to be driven down. Indeed, it supports a melt-up not melt-down.
Buffett stated in an interview in 2018 "The most important item over time in valuations is obviously interest rates….If interest rates are destined to be at low level, it makes any stream of earnings from investments worth more money”. Insync agrees. Thus, the direction of interest rates over time is going to be a key driver of returns. If current growth rates and inflation rates remain low, then interest rates and bond yields will also continue to remain low. This results in profitable quality growth companies supported by the tailwinds of global megatrends continuing to drive out-performance.
Sentiment is also not exuberant Recently some sentiment indicators suggest that investors are not as bearish as they were in September of 2019. The exuberance factors present in previous market tops are a lot less pronounced so far. IPO and M&A activity continues to be modest; interest rates are not rising, and high yield and investment grade bond spreads remain tight. Major market corrections have historically been driven in the main by tightening credit. There is no impetus on the horizon for this to occur.
Global growth outlook is consistent with recent history The outlook for growth remains moderate (and it’s in this climate that we have been generating the returns we have to date). If anything, based on the most recent Annual Global CEO Survey by PWC which revealed a record level of pessimism regarding worldwide economic growth, the risk is on the downside. This year, as CEO's look ahead to 2020, PWC see a record level of pessimism. ‘For the first time, more than half of the CEO's we surveyed believe the rate of global GDP growth will decline’. This caution has translated into CEO's’ low confidence in their own organisation’s outlook. Only 27% of CEO's are ‘very confident’ in their prospects for revenue growth in 2020, a low level not seen since 2009. This combined with low inflation should result in central banks around the world remaining accommodative to try and avert a recession which is positive for equity markets. Remember the stocks that meet our selection tend not to be driven in their success by such global economic views or measures. Nevertheless, these views espoused by CEO's support a lack of exuberance.
The Major risk however is earnings Insync sees this as the major fundamental risk over the next twelve months; recessionary-like conditions and thinking resulting in lower earnings. This risk remains elevated but encouragingly central banks are responding with an easing of monetary policies. A change in power in the United States with a Democrat becoming POTUS would be our ‘event’ major risk. Markets are assuming a pro-business Trump to be re-elected.
Insync’s strategy – positive backdrop for profitable structural growth companies Our feet remain firmly on the ground. Having read this far you will see our reasoned, logical and factual evaluation of matters supporting our belief in a positive future. Insync’s view, supported by data, is that the world economy remains structurally in a low growth and low inflation environment. This very environment continues to favour our process of selecting very profitable growth companies with a long runway of growth opportunities to reinvest their strong free cash flows. A key focus at Insync is ensuring valuations remain attractive and the portfolio of companies in the fund are currently trading in excess of a 30% discount to their assessed value. Their balance sheets are multiple times stronger than the average too. We utilise additional proprietary valuation tools to cross check our DCF based valuations. This concludes that the long-term secular earnings growth embedded in the Insync portfolio of stocks is not reflected in the current share prices.
There are many reasons to be positive about the long term and the short. We are going through the most profound period of global transformation driven by seismic technological advancements and the most dramatic demographic shift in our lifetimes. Don’t forget this. The contribution these technological trends are going to create are going to be enormous on our society and business positioned to benefit. This is where we invest.
All the best for 2020!
Disclaimer Equity Trustees Limited (“EQT”) (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity for the Insync Global Quality Fund and the Insync Global Capital Aware Fund. EQT is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT). This information has been prepared by Insync Funds Management Pty Ltd (ABN 29 125 092 677, AFSL 322891) (“Insync”), to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Insync, EQT nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.