Veritas Asset Management LLP
Highlights for Q2 2013
-The Nedgroup Investments Global Equity (USD) Fund outperformed the MSCI World Index by approximately 2% in the past quarter, bringing the year-to-date performance of the fund in line with the benchmark return of 8.5%.
-On a sector basis, positive stock selection in Health Care, Industrials and Information Technology added to relative results.
-Not owning any Materials stocks was also beneficial to relative returns.
-Stock selection in Consumer Discretionary, Energy and Utilities was negative.
-On a regional basis, stock selection was positive within North America and United Kingdom.
The largest relative contributor to results was Microsoft. While the PC market remains lacklustre, Microsoft's share price had more than discounted for this. A resilient set of Q2 results and continued strength in the company's multi- year bookings - as seen in its Business and Server & Tools divisions - underlined the depth of engagement Microsoft has with business customers and the position it's building as a preferred partner for Enterprise Cloud services. In the period we also had the launch to Developers of Microsoft's new OS - Windows 8.1 - addressing head-on many of the concerns raised with Windows 8 and its next generation gaming console, the Xbox One. Despite recent outperformance, the shares remain favourably valued, trading as they do on < 10x 2014 calendarised PE (adjusting for its significant net cash balance) and a FCF yield in excess of 10%.
The largest detractor to results on a relative basis over the quarter was COPASA. Concerns around Brazil finally came to bear on COPASA with the share price declining sharply on the back of popular protests over Government spending and the quality and cost of public services. We are confident that water prices are not an issue for the demonstrators as water and sanitation costs in Brazil are very low and represent only a small part of household expenditure. Over time we also see a substantial amount of investment required in water and sanitation projects which should ensure that the regulators maintain an attractive allowable return in order to induce the necessary investment. At current prices, COPASA has a 4.5% dividend yield and trades for around 7.5x earnings which are forecast to grow at around 6% until 2017.
Despite generally rising equity markets during the quarter the prospect of the US Federal Reserve easing its foot off the monetary accelerator pedal led to some heightened volatility towards the end of the quarter. Such volatility is positive for long term investors as it sometimes provides the opportunity to accumulate positions in high quality companies at attractive valuations for long term investment. This proved to be the case in the latest quarter and one such company we have initiated an investment in is Qualcomm. This is a company that benefits from an inexorably rising tide in the area of increasing demand for mobile data, be it information (local restaurants, shops etc.) communication (such as email and Facebook etc.) or entertainment (TV, games etc.) all of which require mobile internet access to get the greatest utility. Consequently the company has all the right attributes to be a 2020 Rising Tide Industry Winners. Despite the solid growth prospects of Qualcomm the shares are available at a very attractive valuation to the long term investor as a result of recent lacklustre quarterly results. With a market cap of just over $100bn, the company has net cash of around $30bn and should generate over $6bn of free cash flow per year (adjusted free cash flow yield of over 8%). Consequently we have used recent weakness to build a position.

Key drivers to investment results
Over the quarter, Financials, Consumer Discretionary and Health Care added to results. Telecoms, IT and Energy were a drag on absolute returns. On a regional basis, France and United States added to returns, but UK was a drag on results.

Largest positive contributor - Citigroup
Citigroup posted strong Q3 results, in particular with its fully-loaded Basel III capital ratio rising sharply (and beyond that of other peers) leading to greater confidence of expected capital return. Moreover, its CEO unexpectedly resigned and, although there is no change in strategy, the market is hopeful of acceleration in the disposal of non-core assets and further reductions in costs. Its valuation remains very attractive.

Largest negative contributor - Vodafone
One or two regulatory headwinds coupled with ongoing macro concerns in Southern Europe weighed on the stock during the period in question. While some incremental caution on European trading is merited, recent commercial initiatives have been more proactive and Vodafone continues to pare costs aggressively in the region, which is supportive to margins. Meanwhile its 45% holding in US Associate Verizon Wireless continues to go from strength to strength providing a key support to group financials. The overall valuation and dividend yield in particular are very supportive at current levels.

We would like to take the opportunity to remind our investors that we are not benchmark investors and therefore, investors should expect our results to differ (sometimes markedly) from a benchmark. This was the case in 2012 when our performance lagged the corresponding benchmark index. While there are explanations for this (the type of company in the benchmark, which performed well, the level of cash etc.), the key issue is that the portfolio is a concentrated stock specific global equity fund that is not constructed like an index. Consequently, in some years we will outperform an index and in other years we will underperform an index, but we will not engage in the short-term performance derby that many other investors manage to. This leads to short termism, herding and a guarantee of ''average'' returns. It is a truism to say that in order to deliver abnormal returns over time, you have to do something that others are not. The herd focus on short-term performance relative to a benchmark and the implications for career risk. At Veritas we focus on delivering good absolute returns to our investors that exceed a relevant benchmark index over long periods of time - we believe the period to best measure this over is five years, which should give a better underlying picture of skill than a shorter term measure. In this light, over five years the Veritas Global Focus Strategy, has delivered a cumulative total return of 13.4% compared with -5.8% for the MSCI World in USD terms.

The Art of Balanced Judgement
In economics, business, finance, politics and investment there are a multitude of examples of the need to balance or to ‘strike a balance’. It sounds dull to the aggressive risk-taker, the experimental policy maker and the optimistic entrepreneur but in most contexts it is important. It is also multi-dimensional: remember the Albert Einstein phrase: ‘Life is like riding a bicycle. To keep your balance you need to keep moving’. Therefore, balance needs not only to be sought but is also a constant forward - moving search for equilibrium.

In today’s world, things are unbalanced. The balance is wrong between savers and borrowers. The balance is absent within increasingly polarised governments. Economies remain unbalanced. Most notably Central Bankers, arguably currently the most powerful policy makers, have lost their balance as they pursue huge scale monetary experiments. Finally, investors have lost that critical balance between risk and reward.

In investing there are also a number of balances that need to be judged and ‘struck’. For example, balancing ‘quality’ (of company and its equity) with price paid/valuation. Within this there is a need to balance quantitative measures and qualitative judgments.
Risk free benchmarks are not risk free. All time low interest rates manipulated by policy makers does not mean it is appropriate to indiscriminately reduce discount rates and return on capital hurdle rates.

It could be strongly argued that today’s environment demonstrates investors’ willingness to buy risky assets at prices that are unlikely to result in considerable returns, or real returns. Equities are a risky volatile asset prone to significant short-term moves, they should not be regarded as bonds and not be regarded as a ‘one way’ bet because of policy. However, owners and investors of capital are manipulated to be attracted by relative returns. They also know that ‘market timing’ is a mug’s game and that cash is eroding in real terms. This is true. However, it calls for some balance in assessing the risks which are above and beyond ‘volatility’.

The key risk is permanent loss of your capital. This happens in equities and happened in the 2007-8 period. In equity investment much is about probabilities and judgment rather than precision and accurate forecasting of the future (which simply does not occur). However, unbalanced risk taking is common in the financial industry. Optimism; extrapolation; career risk; incentives and valuation ‘adjustments’ all lead to this. Certain equity investment methodologies deploying significant capital are price agnostic (passive investment; ETFs and momentum investors) despite risk including ‘the price you pay’. It could be argued that we are at one of these moments of unbalanced risk taking (greed or repressed necessity) in the current equity market environment, although there is no conclusive methodology of judging when it will come to an end.

We are able to find companies that exhibit a good balance of risk and reward in their equity, but the opportunity set has considerably narrowed in the past year. Our argument would be that some equities are not exhibiting sufficient ‘margin of safety’ to allow for uncertainties; for inaccurate cash flow forecasting and for equity risk. However, there are some that do offer the right balance and on our time frame of five years we can envisage in absolute terms receiving a good total real return.

The key point is not to lose sight of the art of balanced judgment on risk and reward. Despite the current environment bear in mind the need for price evaluation; conservatism; judgments on quality of company (and industry) as well as high selectivity/concentration on conviction.