Did QE Work?
“Well, the problem with QE is it works in practice, but it doesn’t work in theory.”
Ben Bernanke (Brookings Institution, Jan 2014)

When the US Federal Reserve meet this month it is extremely likely that Chairperson Yellen will announce the end of large-scale asset purchases, otherwise known as Quantitative Easing (QE). Since the global financial crisis in 2008 / 2009, the Federal Reserve has bought $4,000 BILLION of securities issued by the US Government or Government-sponsored agencies under the auspices of QE. These purchases have had the desired effect of reducing the yield and thereby pushing up the prices of financial assets. Furthermore, it seems (to date) to have occurred without any inflationary consequences (at least in terms of reported inflation). Presumably therefore can we confidently describe QE as a success?

Unfortunately, as this is a real world experiment we do not have a ‘control’ economy that did not ‘benefit’ from QE to see how it might have fared. Certainly the Federal Reserve stoked up animal spirits and got the asset price inflation that they desired. Unfortunately, this does not seem to have had any material positive impact on the real economy: earnings growth is lacklustre, employment continues to remain at low levels (especially when taking into account the participation rate) and in general consumers do not feel like the recovery is benefitting them. The problem is that the transmission mechanism from QE-driven asset-price inflation to a self-sustaining economic recovery was always the weakest part of the academic argument for QE. There was talk from the previous chairman of the Federal Reserve, Ben Bernanke, of a trickle-down effect as the wealthy; who are by far the biggest beneficiaries of rising asset prices as they own the bulk of financial assets, spent some of this additional wealth and this spending would ‘trickle’ down through the economy benefiting everyone.

I think we can safely say this has not occurred to any great extent and QE has turned out to be fantastic for the top 1% (and the banks that were in intensive care when QE was first announced) and pretty poor for the other 99%. What is clear is that unless a large proportion of the 99% feel some significant benefit, there will not be a self-sustaining economic recovery in an economy that is largely driven by consumption. Moderate GDP growth, earnings growth and employment growth would seem to be the most likely outcome for the US. Elsewhere, this is probably the best that can be hoped for with the Eurozone looking sclerotic, China slowing sharply (and having built up a lot of debt that is financing unproductive assets) and emerging markets generally suffering from both the China slowdown and weak currencies - a consequence of tighter monetary conditions in the US.

Over the past quarter, the Nedgroup Investments Global Equity Fund returned 3.7% (Class A, USD, net of fees), which was lower than the benchmark MSCI return of 4.9% (USD). Year-to-date the fund is approximately 2% ahead of benchmark.

Over the quarter, energy and healthcare were the most notable contributors to absolute performance. On a regional basis, the United States and United Kingdom added to returns.

Largest positive contributor: Allergan

On 22 April 2014, Allergan became subject of an unsolicited bid approach from Valeant Pharmaceuticals, lifting the share price from the mid $120s to mid $160s. Allergan has been vehement in its response that it does not favour the Valeant business model and wishes to remain an independent R&D-driven company. Allergan have consulted with shareholders and have twice addressed the market firstly with strong growth projections and second with a late stage pipeline update, which together defend the elevated share price. Investors have been made aware there will be further steps made by the company to deploy capital for greater shareholder returns, both in the short and medium term. While the thesis is playing out, the stocks having seen a substantial rise in the share price over the last two years, and at our estimate of Intrinsic Value of just over $170, Allergan is not a company we would add to today.

Largest negative contributor: Millicom International Cellular

Millicom has underperformed following Q1 results which entailed some minor (growth-driven) downgrades to profit forecasts, primarily associated with a step up in commercial costs in the African region. This has been accentuated by a 6% depreciation in the Swedish krone / US dollar exchange rate in the quarter. Performance over the last year has been much more respectable. We also recently met with management who offered reassurances on the health of the Latin American operations and absence of any incremental regulatory hits in the region; on the timing and implications of the UNE acquisition which is expected to be a material fillip to Millicom's existing operations in Colombia that are among its highest growth territories today; as well as the continued optionality around the mobile financial services and online opportunities.

Key drivers to investment results for the Global Equity Fund: Q1 2014

Over the first quarter of 2014, the portfolio returned 4.5% and the MSCI 1.3%1 (with 1 year numbers to 31 March at 21.3% and 19.1% respectively). Health Care, Consumer Discretionary, IT and Industrials were notable contributors to absolute returns. On a regional basis the United States added to returns. The portfolio has had a relatively good 12-month period, which is satisfying given that markets have been so strong and that we typically tend to do better on a relative basis when markets are weak.

Top absolute contributor: SES

The company delivered a solid set of FY13 results, emphasising strong underlying rates of growth in sales and EBITDA. The dividend was again increased 10% as the anticipated improvement in cash flow came to fruition. With Astra 5B now safely in orbit, Astra 2G scheduled for launch late in Q2 and the next cluster of O3b satellites due to be launched later this year, barring unforeseen anomalies, the business is well placed for another strong operational year. With leverage ratios declining, the Board and new CEO have the healthy predicament of deciding how best to utilise the incremental debt capacity at their disposal; even after investment in new growth satellites and some M&A, we would still anticipate scope for further incremental returns to shareholders.

Top absolute detractor: BG Group

During Q1, BG Group revised down production guidance for 2014 and 2015, primarily due to the political situation in Egypt and a reduction in its North American rig count. The group also raised its expectation for operating expenses in 2014. However, key growth projects in Australia and Brazil remain on track, providing BG Group with one of the most attractive production and FCF growth profiles in the peer group.

The largest contributor to absolute performance in Q4 was Google. In a strong market for internet stocks, Google reported Q3 results that underlined its positive exposure to secular growth tailwinds. Search revenues beat expectations, while reading between the lines, Google has seen continued momentum in mobile click growth. Improvements to the core algorithms seem to be bedding down smoothly; YouTube continues to gain traction with key brand advertisers and the Android mobile OS goes from strength to strength. Google also demonstrated welcome restraint in its opex spend. Capex is rising, but reflects investment behind new and existing initiatives to fuel future growth. The Google ecosystem looks to be in fairly good health right now with plenty of optionality around future services.

The largest detractor from absolute performance in Q4 was Worley Parsons. In a November trading update, Worley Parsons revised its full year guidance due to weaker than expected trading conditions in Australia and Canada. New contract wins have been strong in the second half of 2013, but delayed start-ups, especially in the Middle East, will result in revenues from some of these projects booked later than expected. Management is implementing a rigorous cost reduction program across the entire group, the benefits of which will be realised in the second half of 2014. We met with senior management following the announcement, and continue to closely monitor both internal and external developments related to the group. Worley Parsons have a strong balance sheet and remains highly cash generative, with a FCF yield of 6.5%.

Portfolio activity

Fortunately, opportunities do occasionally present themselves even when sentiment is as bullish as it is today. These opportunities typically arise as a consequence of some negative or disappointing news concerning a company or industry leading to many managers selling as the price declines.

In the most recent quarter we have established a position in Oracle, the world's largest enterprise software provider (including but not limited to a dominant c.50% market share in relational database software) and one of the largest providers of high performance enterprise hardware. The business model is attractive (software is c.90% of gross profits) with a material amount of highly profitable recurring revenues-Oracle's software is critical intangible infrastructure for enterprises with extremely high switching costs, allowing Oracle a degree of pricing power. This maintenance revenue stream accounts for the overwhelming majority of cash flows and is very resilient, even during economic downturns.

Concerns around competition from alternative databases (including in-memory databases) as well as sales execution issues around the transition to a Cloud-based subscription model resulted in material underperformance of the stock. We believe the competitive concerns are over-stated and are not permanently debilitating to the business: in fact, recent developments at the company point to materially improved sales execution as well as an upgraded product offering which places Oracle favourably to take advantage of the opportunities ahead. Corporate IT spend in general has also been anaemic in the recent past, which should normalize on a longer term timeframe.

Management have also shown willingness to return capital to shareholders via both dividends and material net buybacks (which are value accretive at these levels). A 9% FCF yield afforded us an attractive entry point into a resilient earnings stream with the expectation of modest future growth in revenues. This is driven by several tailwinds, most notably the continuing rise in data intensity in structured data as well as the increasing importance of integrated high performance hardware within corporate IT deployments.

Over the past quarter, the Nedgroup Investments Global Equity Feeder Fund returned 6.3% versus the market return of 9.7% Industrials, Energy, Telecommunication Services and Health Care were the most significant contributors to absolute returns. On a regional basis United States and United Kingdom added to returns.

Lockheed Martin (largest contributor)

Despite the challenging backdrop in Washington with sequestration affecting defence budgets, Lockheed has continued to execute exceptionally well. They have taken out costs pre-emptively to preserve margins in the face of potential cuts as well as stuck to their disciplined capital return program via both a sizeable dividend payout as well as consistent stock buybacks.

Lockheed also recently finished negotiating the next two production contracts on the crucial Joint Strike Fighter program (F-35) at better than expected terms. This has resulted in the market now having increased confidence in the near to medium term prospects of the corporation, buoying the stock.

Fresenius Medical Care (largest detractor)

FMC shares were shaken by a proposed 9.4% reduction in Medicare reimbursement for dialysis service provision in the US. Whilst negotiations between the industry, Medicare and Congress continue, the proposed cut would make a third of dialysis clinics unprofitable and, the industry argues, would limit access to life-saving care.

Some compromise is likely, with a reimbursement floor set by the Statutory requirement for Medicare to cover the cost of care for an efficient provider. Meanwhile, FMC aims to optimise the mix of commercial patients (where reimbursement is 3-4x higher), build out ancillary services and reduce operating costs across its global business.

Longer term perspective

Equity markets have rallied substantially since 2009. In the recent past (since mid 2012) much of this appreciation has been driven by a change in valuation rather than strong earnings growth. In fact, earnings forecasts have continued to decline and the market has seemingly ignored the weakness. Forecasts for 2013 are now for earnings growth of 6.3% (although analysts currently expect this to leap to around 11% for 2014).

This combination of low earnings growth but rapid share price appreciation has led to a substantial rerating of equity markets. While it is impossible to attribute causation, it seems likely that zero interest rate policies and substantial quantitative easing have, through a process of financial repression, contributed to the rise in equity markets. While this could continue for some time, it cannot continue indefinitely and as Herb Stein famously said "if something cannot continue forever, it will stop". The appointment of Janet Yellen as the next head of the Federal Reserve may prolong the indefinite but cannot prevent it.

What should be made of absolute values today? Before considering the Veritas view we can look to other "real return" based investors who publish their assessment of the absolute "value" of the market. One particular one is GMO who have a particularly accurate track record in their long term forecasts and recently published their forecast for real (i.e. inflation adjusted) returns for the next 7 years. They forecast that US large cap will deliver an annualised real return over the next 7 years of -2% (yes, that is a minus!) and that International large cap will deliver an annualised real return of +1.9%. If they are correct then we have pretty meagre returns to look forward to from the index huggers!

Turning to the Veritas Global view, when we look across our universe of high quality companies, the average annualised total return we expect over the next 5 years (not inflation adjusted) is c. +6% which, while a little more optimistic than GMO, can largely be explained by the skew to quality (GMO separately assess US "high quality" will deliver annualised real returns of +3.3%).