Rootstock SCI Worldwide Flex comment - Jun 19
How quickly a decade has flown by. At the end of June 2019, the Rootstock Fund celebrated its tenth anniversary! The Rootstock team has much to be proud of. We are most pleased with the Fund's top quartile performance. For the ten years ending 30 June 2019, we have achieved a compounded annual return of 15%.
There is a lot of noise in global markets. The US-Sino trade war rages on. In the latest development, the US has flexed its muscles on claimed intellectual property abuses, restricting several international companies, most notably China behemoth Huawei, access to US-developed technology. Worryingly, long-time US allies are becoming ever more entangled in growth-stifling tariff antagonism. Trade disputes may be a longer-term phenomenon.
The regulatory scrutiny on big tobacco lingers, with market commentators speculating over an impending ban of tobacco products in the US. Opinions, based on few hard facts, range from substantial product-specific bans to total embargos. The large global technology companies have also come under regulatory scrutiny, primarily concerning antitrust. In macro news, the US Fed has indicated, conspicuously, a muted outlook for interest rates. Most interestingly, the Fed has not lowered rates since the Global Financial Crisis of 2008. The present interest rate regime, a gradual rise in rates since late 2015, is likely to change. Rate cuts, in the short term, may aid equity returns. For reference, Goldman Sachs Global Investment Research demonstrates that the historical median S&P 500 twelve-month return subsequent to the US Fed changing its interest rate regime (read: an initial cut in rates), has been 14%. In this scenario, so called bond proxies, including Healthcare and Consumer Staples, have tended to outperform the S&P 500 index, while highly-rated sectors, including Communication Services and Technology, have underperformed.
Locally, politics continue to dominate headlines. The national election, marked by a tellingly-low turnout, has come and gone. The size of the cabinet has been slightly reduced and some rotten wood has been cleared. Heartening speeches have been made. Unfortunately, the endemic structural inefficiencies suffocating the beleaguered economy are no closer to remedy. Instead, intensifying political infighting and a lack of accountability frame the narrative. Years of mismanagement and institutional decay are borne out in the latest GDP growth figures, with the economy contracting by 3.2% for the first quarter of 2019.
In South Africa, there are no winners. The no-growth environment will continue to squeeze company margins. Consumers remain unable to bear the pass-through of rising input prices. The costs of persistent economic attrition continue to weigh on local shareholders. Despite some optically attractive ratings, South African market valuations do not reflect the dismal economic outlook. Although we continue to monitor several best-in-class local businesses that fit our investment philosophy, our focus is on international markets.
In all the turmoil, Rootstock's focus on high-quality companies at attractive valuations endures. We own businesses that are likely to grow profits regardless of trade wars or regulatory scrutiny. We are however cognisant of undesirable short-term news flow, especially regarding regulation, and the potentially depressive effect such attention may have on valuation multiples.
The Fund's equity exposure rose from 77% at the end of March 2019 to 80% at the end of June 2019 as several new opportunities were added to the Fund. Foreign-equity exposure, measured as a percentage of our total-equity holding, is 96%. New additions to the portfolio during the quarter include Inditex, Monster Energy, S&P Global and the Walt Disney Company. Inditex is the owner of fast-fashion retailing-pioneer Zara. It is a best-in-class operator with an unmatched supply chain and attractive growth prospects. Monster Energy is a global energy drinks manufacturer and distributor. The energy drinks category is one of the fastest growing beverage categories globally, with Monster and Red Bull increasingly dominating the global market. Smaller regional players are unable to match the bottling and distribution network that Monster's largest shareholder, Coca Cola, gives it access to.
S&P Global, a diversified financial services provider, has a durable moat and is attractively valued relative to peers. During the past decade, non-core assets were sold, creating a focussed financial services business. S&P Global's four main businesses include its Ratings Agency, providing assessments of corporate and government debt, Indices, selling S&P500 and Dow Jones indices to tracking funds and other market participants, Platts, the leading oil-and-general commodity pricing and index service provider, and Market Intelligence, a financial data-terminal provider similar to Bloomberg. The businesses are all highly profitable with commanding market positions and growth prospects.
Lastly, we also took a small stake in the Walt Disney Company due to its newly-launched video-on-demand streaming service. The attractive new model provides hitherto incomparable access to a peerless content library. The launch of the services will have a negative impact on short-term profitability but should handsomely reward investors in the future.
Following the re-entry of Amadeus IT Holdings to the portfolio in Q1 2019, we increased its portfolio weight from roughly 3% to 5%.
We reduced British American Tobacco's (BATS) portfolio weight from 7.5% to below 5%. The growth path for the large tobacco companies, Next Generation Products (NGPs, the collective term for vapor and heat-not-burn tobacco delivery systems) has dimmed under regulatory uncertainty and weightier competitive forces. While still a small part of the industry, NGPs are its growth engine, yet have proved less predictable than the traditional combustible business. The extensive regulatory scrutiny, abetted by adverse media attention, has further-eroded investor sentiment. We are comfortable with BATS' ability to grow revenue and profits over time but acknowledge that the path may be bumpy. To manage this likely volatility, we have reduced the Fund's exposure.
We sold Coronation Fund Managers, realising a reasonable return over a short period of time. Although the business is easy to understand and highly profitable, Coronation's high market share and poor short-term client returns, reflected in a lackluster half-year result, furnished us with sufficient evidence that asset flows would remain weak. Clientèle Limited, a long-term holding in the Fund, was sold. This decision was not taken lightly. Clientèle is well managed and highly-profitable. Its dividend yield alone is attractive. Unfortunately, Clientèle's operating environment continues to deteriorate rapidly. Policy holder disposable income is under significant strain, with policy lapses on the rise. Moreover, the competitive landscape has changed considerably. The balance of distribution power has shifted to the primary-bank account providers, Capitec and FNB. Both have entered the funeral cover market with near zero-cost distribution through an unmatched branch footprint and frictionless app-based delivery. Capitec concluded in excess of 500,000 policies in its first nine-months of operation. Clientèle, for reference, has approximately 900,000 in-force policies, the product of decades' work.
The team has done a wonderful job identifying exciting investment prospects that are consistent with our investment philosophy. Pleasingly, the quality and diversity of the portfolio continues to improve. The Fund owns high-quality businesses that, irrespective of short-term macroeconomic events, will reward investors, on balance, over longer periods of time. The past ten years have been most rewarding. The team has gained much experience that will stand us in good stead. May the next decade bring us all continued prosperity.
The portfolio may invest in global and local securities, government, corporate and inflation linked bonds, debentures, non-equity securities, property shares, property related securities, preference shares, money market instruments and asset in liquid form.
The portfolio may also invest in participatory interests and other forms of participation in portfolios of collective investment schemes or other similar schemes operated in territories with a regulatory environment which is to the satisfaction of the manager and trustee of a sufficient standard to provide investor protection at least equivalent to that in South Africa and which is consistent with the portfolio's primary objective.
The manager may make active use of listed and unlisted financial instruments to reduce the risk that a general decline in the value of equity, property and bond markets may have on the value of the portfolio. The manager shall have the maximum flexibility to vary assets between the various markets, asset classes and countries to reflect the changing economic and market conditions.
Nothing in this supplemental deed shall preclude the manager from varying the ratios of securities or assets in liquid form in changing economic environment or market conditions, or to meet the requirements in terms of legislation and from retaining cash or placing cash on deposit in terms of the deed and this supplemental deed.
The Manager will be permitted to invest on behalf of the portfolio in offshore investments as legislation permits.