The Quarter in Review
Equity markets experienced a difficult final quarter of 2018. Investors have had to contend with rising US central bank interest rates, a sharp slowdown in eurozone business confidence, weaker Chinese growth and rising geopolitical concerns (including Brexit, Italian politics and the ongoing trade conflict between the US and China). The fund delivered a return of -10.06% for the quarter compared to the benchmark return of -10.39%. For the 12 months to December 31st 2018 the fund returned +4.59% versus the benchmark return of +0.71%. The positive contributors during the quarter included Twenty-First Century Fox, Tencent Holdings, RELX, Microsoft and PayPal Holdings. The negative contributors during the quarter included Accenture, Facebook, Amadeus IT, Wirecard and Nvidia.
As we have discussed before there was generally indiscriminate selling taking place which resulted in most stocks falling regardless of the future earnings power of the business. The utilities, telecoms and consumer staples were the sectors that performed the best. This is consistent with historical periods of downside volatility. Insync generally do not invest in telecoms and utilities as they don’t meet our criteria of high ROIC companies with a long run way of growth. Historically consumer staples (including food, health and household, beverages) have been a large part of the portfolio. Our extensive work on disruption shows that many of the stocks in these sectors are being challenged, as they are finding it difficult to adapt to a rapidly changing consumer landscape, and their earnings power has in many instances significantly reduced. Consequently we reduced the funds exposure to the sector progressively over the past 2 years. Despite the recent share price performance of the consumer staples sector we hold the view that many stocks in the sector are now quality traps.
Our Outlook for the Next 6 months
Real interest remains low, US growth continues to be reasonable and inflation continues to remain contained. This is a constructive outlook for the global equity markets especially after the significant downside volatility in the 4th quarter of 2018. The market is aggressively discounting a global recession but perhaps this cycle, particularly the US economic cycle, will be very different from previous cycles.
Current US economic expansion - The current expansion has been relatively long-lived but also relatively modest in magnitude
The real funds rate continues to remain low, despite the recent increased in the Fed Funds rate. Historically, according to analysis by Strategas, the real Fed Funds rate has been closer to 2% at the start of a recession.
Probably the biggest risk to inflation will come through from wages. Despite record unemployment levels wage growth is rising well below 4% which appears to be the commonly accepted critical levels for the Fed to accelerate the pace of interest rate increases. This is probably the most important indicator to monitor going forward. It does suggest that the Federal Reserve in the US still has the capacity to increase interest rates a bit further without jeopardising the current path of growth.
Why is this important? There has been a fierce debate over what style will perform better going forward; growth or value. Given that we own quality “growth” stocks this is a very reasonable question. In fact, it is a debate that has taken place throughout our careers. It is generally well accepted that since the 2008/9 crisis we have been in a lower growth and lower inflation global economic environment. If these economic conditions were to persist then there is a very strong probability that quality growth stocks will continue to outperform.
Whilst we are constructive on the outlook for equity markets there is a significant shift occurring at the stock/industry level that will deliver increased volatility in equity markets but also an increased opportunity to generate attractive returns. Stock picking with strong risk management in our opinion will be critical skills to navigate a more volatile period. As we have discussed before we are experiencing rapid and major structural disruption across most industries because of the exponential technological changes exacerbated by rapid demographic shifts and uncertain policy outcomes. Significant changes are also happening at the macro level where we are moving from globalisation, which has been the trend during most of my 28 years of my investment experience, to protectionism and regionalism. These changes are having a profound impact on individual businesses with many CEO’s of leading companies struggling to cope with the pace of change and resigning at an almost unprecedented rate.
A global understanding of these disruptive factors will be critical. Investors who continue to invest with a rear-view mirror are missing the destructive forces shaping the future. Looking through the lens of Bloomberg/Factset or some other screening tool to identify opportunities based on historical measures of value will not be an effective strategy in the current operating environment. Our analysis shows many of the companies trading on low valuation multiples compared to history based on traditional valuation tools such as P/E ratios, EV/EBITDAs and free cash flow yields are in fact value/quality traps. Using similar valuation tools to argue a specific region is attractive is also fraught with risks as this does not take into account the quality of the stocks in the benchmark and the level of disruption. At Insync the domicile of the companies we invest in is based on where we find companies with a high sustainable ROIC on a look forward basis which are in a strong position to benefit from global megatrends. Most of these companies have a global footprint.
The stocks that excite us the most are where company fundamentals are exceeding our expectations and the stock price is underperforming their growth in earnings. This creates a situation where an investor can have both increased conviction in earnings power and a stock whose valuation has become incrementally more attractive.
A Megatrend in Focus – Most significant demographic shift = Millennial's + Centennials
Whilst most investors are focused on the ageing global population and the “silver economy, we believe a much greater seismic shift is occurring with the Millennials (19-35Y) and Centennials (0-18Y) now the most important demographic which together account for 57% of the global population and a similar share of the workforce. Understanding their values and consumption patterns will be critical today and in the future as Millennials have now reached the most important age range for economic activity, when households are formed, babies are born and money is spent not just on going out but on settling down.
Technology is deeply integrated into millennials’ lives and habits. This generation is incredible sceptical of governments and big corporations. None of them want the bland, mass market products sold by huge corporations who built their brands for baby boomers (born between 1965 and 1996). The shifting demographic also includes one of ethnicity and nationality. 43% of US millennials are non-white and China and India each have 400m millennials, more than the entire US population. Understanding the disruption this is creating will be important in identifying the winners and losers.
A baby boomers portfolio has served investors very well for decades generating strong double digit returns by investing in a portfolio of these mass market brands. Investors were attracted to their enduring qualities as they have proven to be resilient through different economic cycles, recessions and crashes including the 2008/9 global financial crisis. The demographic change will have a profound impact on this portfolio.
An example of a company that is being impacted by this generational shift is Harley-Davidson. The motor cycle has been popular with the baby boomers, who recalled when the bikes were featured in movies like “Easy Rider”. In 1987, half of all Harley riders were under the age of 35. By 2008, the average Harley rider was 48. Until the company stopped routinely disclosing the number, the average buyer age was rising steadily at a rate of about 6 months every year since at least 1999, and that consequently the average Harley buyer is now 50, so still a boomer. The average Harley purchaser is a married male in low 50s with household income of $90k+ who owns a bike for recreational/hobby/lifestyle purposes vs. transportation. The primary reasons why millennials buy a new motorcycle is ease of transportation. If a potential buyer is primarily motivated by 'ease of transportation,' one can conclude that is likely to be a lower-priced, lighter weight and lower margin bike.
Harley needs to attract younger, more diverse customers in order to sustain its market share. To their credit management have set an ambitious goal of gaining 2 million new riders in the next 10 years through introducing a H-D rider training academy, reducing the entry level price for new bikes, introducing electric bikes and enter the small displacement market in Asia with the launch of a 250-500cc motorcycle in India. There is always the possibility that some of these strategies may arrest the decline in sales they have been experiencing over the past few years but comes with high execution risks simply because consumer tastes are changing so fast. Recent trends in revenues and profits do not paint an optimistic picture with the decline in sales seen from the peak in 2014 continuing in 2018 with guidance provided by management of further deterioration in 2019.
Harley-Davidson is an example of a quality trap; it appears attractive based on historical measures of profitability and valuation and therefore would be a strong candidate in any quality based portfolio. However it is suffering from the fast pace of disruption as a result of the different consumer behaviour of millennials. Focusing on disruption is at the core of Insync’s investment process. Companies that cater successfully to the millennial/centennials generations focus on authenticity and wellbeing will be the enduring companies of the future.
Insync Funds Management
EQT Responsible Entity Services Limited (“EQT”) (ABN 94 101 103 011), AFSL 223271, is the Responsible Entity for the Insync Global Capital Aware Fund and the Insync Global Quality 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.