Market review

Global equity markets experienced another relatively good quarter, albeit with more modest performance than in the first quarter (Q1). Looking at the indices in US dollars – on a total return basis the S&P 500 Index gained 4.3%, the MSCI World Index gained 4.2% and the MSCI Emerging Markets Index, lagged again, closing 0.7% higher this quarter. The surprising decline in long dated developed market government bond yields, which started in Q1, did not subside. Yield on US 10 year maturity bonds declined from 2.4% at the end of Q1 to 2.0% at the end of Q2 and the yield on 10 year German bonds declined from -0.1% to -0.3%.

In late June, the Federal Reserve (the Fed) indicated that it might cut interest rates sooner than previously thought by cutting the word ‘patient’ out of its policy statement. It added that it would ‘act as appropriate’ to sustain economic expansion. President Trump has often taken to Twitter to share his exasperation with the Fed’s previous rate increases.

Prime Minister Theresa May announced that she would step down as leader of the ruling Conservative Party in the United Kingdom after successive failures to deliver an acceptable Brexit deal. Boris Johnson and Jeremy Hunt are in the race to replace May as leader. Both Johnson and Hunt have claimed that they can renegotiate the withdrawal deal with the European Union and get it through Parliament before the expiry date of 31 October 2019.

Portfolio review

Solid outperformance for the fund in the energy, healthcare and information technology sectors could not offset the market’s negative view of the tobacco industry’s headwinds, which sent stocks in the latter tumbling. The fund’s exposure to these highly cash generative businesses was the overriding cause of underperformance against the MSCI World Index benchmark in the quarter.

The company-specific detractors were Imperial Brands which fell 30%, Altria which was down 17% and Philip Morris off by 10%. These tobacco company sell-offs appear to have been precipitated by sharper than expected volume declines in traditional cigarette sales volumes, possibly exacerbated by somewhat disappointing growth numbers for the so-called ‘next generation products’. Alarmingly, the former declines were reported by the market researcher Nielsen to be of the order of 8%-10%, which was worse than market expectations. However, Nielsen subsequently admitted that their sampling methodology was likely outdated and not accurate.

Another poor performer was Alibaba Group, which fell 7% despite excellent fiscal Q4 results. Market participants worried about the ongoing United States/China trade dispute, as well as a strategic decision by the company to delay ad feed monetisation in fiscal 2020, in order to capture market share in China’s lower-tier cities. Other laggards were Lions Gate Entertainment (-22%) and United Kingdom-based mortgage lender OneSavings Bank (-8%).

The major contributors to performance were United States homebuilder NVR, which rose 22% in the wake of better than expected first quarter numbers, equipment rentals business Ashtead Group (+19%), which reported solid full year results in mid- June and reiterated 15-20% earnings growth guidance for the 2020 fiscal year, and Microsoft, up 14% after their third quarter results printed substantially above expectations. This was on the back of continued strength in their cloud businesses as well as surprisingly good growth in their traditional on-premise revenues.

The fund endeavours to control risk in a rational manner by dampening hard-to-predict factor exposures and focusing its risk budget on proven bottom-up stock picking.

Based on current consensus expectations the fund offers a more attractive valuation than the overall market (fwd P/E: 12.5x vs. 15.6x and Div Yld: 3.0% vs. 2.4%), while producing a better return (ROE: 24% vs. 19%) and better profitability (operating margin: 25% vs. 20%). The fund has an Active Share of 90%.

Market review

Much of the negative sentiment of the last quarter of 2018 disappeared in the first one of 2019. The 12.5% rebound in the total return of the MSCI World Index since the start of 2019 has left the index only slightly below the recent high of 29 September 2018 and only 2% shy of its all-time January 2018 high.

All of this has taken place while German bond yields have fallen below zero again (prompting phrases from the commentariat like “the Japanification of Europe”) and the yield curve in the US has inverted. The latter event has in the past been a fairly reliable indicator of a recession ahead, even if the relationship has been regarded as more tenuous recently.
Portfolio Review

The fund benefited from its overweight stance in Information Technology (+20%), with Micro Focus rising 51% after better than expected results in the aftermath of integration problems with its acquisition of HP Enterprise’s software business. Cisco Systems rose 25% after strong fiscal 2nd quarter results. Performance was further boosted by a partial reversal of the deeply negative sentiment plaguing tobacco stocks of late, in the wake of US Federal Drug Administration pronouncements against menthol cigarettes and flavoured vaping products (Philip Morris International +34%; Altria Group +17%).

TUI AG detracted from performance (-29%) after issuing separate profit warnings in February and on the last trading day of the quarter. TUI blamed lower than expected bookings in its tour operator business in the first instance and the costs associated with the forced grounding of its 15 Boeing 737 Max aircraft in the second. Raiffeisen Bank also negatively affected portfolio performance, falling 11% on unsubstantiated rumours of a money laundering scandal.

From a global geographic perspective, the fund’s lack of exposure to Japan, which rallied only 7% vs. the 12.5% rally in the MSCI World Index, benefited performance, as did the fund’s sole holding in China (Alibaba, +33%). The fund’s UK stock picks (+14%) were also beneficial to performance as asset prices here were beginning to reflect parliament’s resolution to prevent a hard Brexit, even if the details of such an outcome remain opaque. The fund’s holdings in the US detracted from performance overall (Medtronic +1%; HP Inc. -4.5%; Berkshire Hathaway –1.6%), despite rallies in the previously mentioned tobacco names, Cisco and mortgage insurer Essent Group (+27%).

The fund endeavours to control risk in a rational manner by dampening hard-to-predict factor exposures and focussing its risk budget on proven bottom-up stock picking.

Based on current consensus expectations the fund offers a more attractive valuation than the overall market (fwd P/E: 11.2x vs. 13.4x and Div Yld: 3.1% vs. 2.7%), while producing a better return (ROE: 22% vs. 18%) and better profitability (operating margin: 23% vs. 20%). The fund has an Active Share of 87%.

At one point towards the end of the quarter, the MSCI World Index had just about made up all of the gains of the January 2018 high (~7% in US dollars) which were given back subsequently. A minor correction in the last days of the quarter trimmed returns back to just better than 5%, with the fund slightly behind this figure.

The standout sector in the period was healthcare, which bounced 12% after lagging the index substantially in the previous two quarters of 2018. This was on the back of belligerent remarks from the White House about the high cost structure of the industry and renewed fears about a broad swathe of patent expiries. The fund benefited somewhat from this rebound with Medtronic up 16%, Novartis up 14% and Roche up 10%.

The fund’s best sector contribution came from information technology where Apple (+22%), Oracle (+17%), Microsoft (+16%), Cisco (+14%) and the fund’s overweight stance compared to the benchmark helped to boost performance. Other performance benefits in the period came from the fund’s lack of exposure to the materials sector which had negative returns, as well as good stock picking in the energy space such as owning Total (+8%) and avoiding US oil services businesses such as Halliburton (-10%).

Performance detractors came from the consumer discretionary area, where homebuilder (and 2017 best performer) NVR Inc. sank 17% on softer US housing data, while Amazon, which the fund does not hold, continued its inexorable rise (+18%). The fund’s UK-based homebuilder Taylor Wimpey also fell 5% in the three months. Fortunately we sold online retail trading platform IG Holdings in mid-August, prior to a sharp drop in the company’s share price in September which was caused by a disappointing trading update and the surprise departure of its CEO.

From a geographic perspective, the US has been the best performing market of size this year by far. Despite a valuation-driven consensus preference at the start of 2018 for European equity assets over US ones, the latter has steamed ahead in the nine months to date by 11% compared to -2% for MSCI Europe. The US economy has remained in rebound mode, with tax-driven tailwinds. For the quarter, MSCI US returned 7%, while the fund’s holdings in the US produced just under 10% - benefiting from good stock picking (mostly via the technology holdings included above, but also from strong rebounds in the fund’s previously unfairly maligned mortgage insurers Essent Group and MGIC Investment Corporation which both rose 24%). Much of this benefit, however, was neutralised by the fund’s UK-based investments which did poorly (-1.5%), along with most UK domestic equities suffering from rising Brexit fears and uncertainty (MSCI UK: -1.8%). This is starkly illustrated by Howden Joinery which retreated 14% in the quarter and which, despite solid fundamentals, is now trading close to its panic-driven rating low in the immediate post-Brexit period of late 2016.

Based on current consensus expectations the fund offers a more attractive valuation than the overall market (forward PE: 12.9x vs. 15.5x and dividend yield: 2.6% vs. 2.3%), while producing a better return (ROE: 23% vs. 18%) and better profitability (operating margin: 23% vs. 19%). The fund has an active share of 88%.