Rootstock SCI Worldwide Flex comment - Dec 19
Global equity markets got off to a good start in 2019. This stands in stark contrast to the dismal performance during 2018. The US market fell a stomach-churning 9% in December 2018, the singleworst month on record since the early 1930s. The ricochet off this low base resulted in a one-year US dollar return of 31.5% for 2019, the best for the S&P500 since 2013. With this in mind, the Rootstock Fund maintained its top-quartile performance, returning 20.8% in rand for the year, while the CPI + 5% benchmark grew 8.8%. Dollar weakness neutralised the fund’s rand-based return in the fourth quarter of 2019. For reference, in the last quarter, the rand strengthened 8.7% against the US dollar, translating into a fund return of 1.0%.
We believe 2018’s capricious equity markets were a function of, inter alia, the US Federal Reserve’s (the Fed) tightening of monetary supply, the escalation of the US-Sino trade war and the associated deterioration in global growth, along with a marked increase in policy uncertainty across the globe. Although these issues persisted into 2019, equity markets were far less turbulent, at least on the downside, than 2018. Our high-level postmortem of the equity markets in 2019 revealed a number of contributing factors. Principally, the Fed’s monetary tightening stance was short lived, with US interest rates cut three times in the year. In addition, the US and China loosened their respective purse strings, providing welcome fiscal stimulus to offset trade conflict-induced economic softness. The latter half of the year saw “this is not QE” monetary easing from the Fed, aimed at relieving some short-term liquidity issues in the overnight repo market, along with China reducing the Reserve Requirement for its banking system. In sum, despite the global slowdown in industrial and manufacturing activity, global growth remained steady. The IMF’s initial global growth figures for 2019 indicate GDP expansion of approximately 3%, notably the slowest expansion since the Global Financial Crisis. Forward-looking estimates suggest improved global growth prospects for 2020, roughly 3.4%, premised on improved expectations for large emerging markets and a moderating US-Sino trade war.
If history is a guide, the near-record market returns of 2019 are unlikely to be repeated in 2020. Nothing suggests that equity markets will fall over, and we remain cautiously optimistic. Equity valuations are elevated by historic measures, particularly in the US. Notwithstanding, we fail to find any other liquid, investable, growth-asset alternatives for global investors. The world is awash in negative yielding sovereign debt, some $11 trillion; equity is the only alternative. The negative/low interest rate regime, supported by expansionary monetary policy, endures. Companies have unfettered access to balance-sheet-altering amounts of ultra-cheap funding. Although, low rates have largely had a positive economic effect, sustaining growth in both global GDP and asset prices, there can be no doubt that quite a number of industries and zombie businesses owe their existence to an abundance of discounted debt. Too much of a good thing can become problematic. For reference, in the US, the debt on the balance sheets of investment-grade issuers (read: companies viewed as financially durable) is at levels last seen in the late 1990s, roughly two-times Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA). This ratio, a measure of balance sheet health, compares to a low of one-times EBITDA in 2011. Despite elevated debt-to-EBITDA levels, low interest rates make debt service manageable. We foresee no immediate catastrophes, but maintain vigilance on the debt levels of our portfolio companies.
Investor concern with company indebtedness shows up in equity valuations. The distinction between ‘Quality’ companies, narrowly-defined as those with limited debt, and ‘Value’ companies, employing balance sheet leverage, is often not a useful lens for examining equity markets. However, it bears consideration in the present valuation climate. Research by Goldman Sachs has shown that Quality stocks, despite being approximately twice as expensive as Value stocks, nevertheless outperformed the latter in 2019 by roughly ten percentage points. For context, in the late 1990’s the valuation gap between Quality stocks and Value stocks reached a high of 2.5 times. The valuation differential between
Quality stocks and better-run Value stocks cannot indefinitely rise. Invariably, stretched valuations do revert to trend and the exhilarating period of Quality outperformance may be followed by a period of disappointing underperformance. Owning high-quality companies (broadly defined by us on account of their competitive position, inherent profitability, growth prospects, quality of balance sheets and management) is one pillar of our investment philosophy. The other pillar is valuation. We aim to buy companies at an appropriate valuation so as to protect our investors from the myriad of risks surrounding business and financial markets. Entry price as a departure point, rather than an afterthought, serves as an important safeguard against paying inflated prices for assets. Even the best business in the world would be a poor investment at too high a price. Regardless of any market-defined Quality or Value bias, our research shows that businesses with superior returns on invested capital and the opportunity to deploy retained earnings at similar-or-better levels of return, purchased at reasonable valuations, on balance outperform the broader market over the longer term. This is the portfolio of companies that we endeavor to build and own.
Another noteworthy investment trend, presently at fever-pitch, is the scrutiny on Environmental, Social and Governance (ESG) factors. Globally, an estimated $31 trillion of assets are allocated to responsible-investment strategies, approaching 30% of global assets under management. In 2006, this figure was roughly $3 trillion of assets, an approximate 6% of global managed assets. One would be foolhardy not to take note of this astounding shift. ESG investment strategies take various forms, broadly separated into three buckets, viz. Exclusion, Screening and Social Entrepreneurship. Exclusion strategies identify specific sectors and companies that are entirely excluded from the investment universe. The usual suspects are defense, tobacco, gambling and pornography stocks. Screening involves the over- and under-weighting of a company on the basis of its relative ESG ranking. Social Entrepreneurship involves investing primarily for the investor-defined ‘social good’, where profits are a secondary consideration.
Regardless of the wisdom of such seemingly arbitrary-defined investment decision-making criteria, the increased awareness of environmental issues around global warming, single-use plastic pollution, social inequalities and corruption is driving a groundswell in responsible investing. Quite clearly, businesses falling foul of the ESG lobby do attract lower valuation multiples over time. Notwithstanding, we make no moral judgement when assessing our investable universe, but rather scrutinise the sustainability credentials of individual investment opportunities. We believe that any negative externalities or unsustainable practices should be correctly priced (read: regulated and taxed) by local authorities and ultimately by markets. Invariably, high-quality businesses (the ones that we are interested in) concern themselves with all pertinent ESG matters in a manner that ensures the long-term sustainability of their businesses and growth of equity-holder value.
Consistent with our sanguine market view, the Fund’s equity exposure sequentially increased from 78% to 84% during the fourth quarter. Foreign equity exposure as a percentage of our total equity holdings is unchanged at approximately 99%.
We made several adjustments to the portfolio’s composition. We disposed of our holding in AB InBev. Any positive market sentiment from the listing of its Asia Pacific business, Budweiser Brewing APAC Limited, was quickly quelled by AB InBev’s disappointing third quarter sales update, registering growth of a mere 2.7% year-on-year. The beer majors are already highly efficient operators. Along with an apparent lack of long-term revenue growth prospects, they will struggle to improve profitability. We see better opportunities elsewhere.
Speaking of better opportunities, we added Amazon.com to the portfolio during the quarter. Amazon, a household name for online retailing, also owns the largest IT cloud-services business globally. The cloud stands at an inflection point for broad-scale enterprise adoption, while in Amazon’s retailing arm, its scale advantage in digital foot-traffic and physical infrastructure continues to entrench the business. Historically, Amazon’s online store was the largest contributor to sales but produced limited profitability. Presently, the fastest growing parts of Amazon, the highly profitable third-party marketplace named Fulfilled by Amazon, its Amazon Web Services cloud division, and its advertising business contribute almost 40% of sales. They are growing at roughly twice the rate of Amazon’s mainstay online store. Moreover, these segments have significantly higher margins than Amazon’s own e-commerce operation. The strong expected sales growth and improving profitability from Amazon’s service-related businesses place the daunting historic earnings multiple in context. We are of the opinion that despite the optically-high valuation, the business may, in fact, be under-priced.
Other notable portfolio changes include increased allocations, measured as a percentage of total portfolio value, to Microsoft from 3.0% to 5.3%, S&P Global from 2.4% to 4.9% and Ulta Beauty from 1.6% to 4.9% of the portfolio.
Microsoft’s cloud business continues to grow at a rapid rate, and along with the software-as-a-service delivery model, should see improved business profitability over time. The business’ hybrid cloud and top-down approach place it in prime position to benefit as enterprises begin a meaningful cloud transformation.
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. These businesses are highly profitable with commanding market positions and growth prospects. Ulta Beauty is a Specialist Beauty retailer operating exclusively in the United States. The Beauty category, aided by the Millennial demographic’s tireless use of social media and rising purchasing power, is growing strongly. In addition, Specialist Beauty retailers, a category which Ulta dominates, are taking significant market share from Drug, Grocery and Department stores. Ulta has an excellent omni-channel strategy and well-curated, contemporary product range. A recent fall in the share price has provided an opportunity to buy a quality, growing business at an attractive valuation.
Global growth forecasts for 2020 appear robust. Monetary and fiscal easing over the next few quarters should provide some relief to the injured global economy. The ostensibly deescalating USSino trade war may reassure capital markets, businesses and other global decision makers. Notwithstanding, these are uncertain times. Our structured and disciplined investment process stands us in good stead to face the ambiguity. We will stay true to our philosophy of investing in high-quality, growing companies that produce high returns on invested capital. Our investment process will ensure we do not overpay for assets. We wish all our clients, friends and family a prosperous 2020. We stand ready to assist, and as ever, we strive to grow your, and our, capital as best we can. We thank you for your continued support.
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.