GROWTH AND QUALITY CLEARLY OUTPERFORMED VALUE AND THE MARKET
Style preferences since beginning of the year have not changed compared to last year: growth and quality styles were in the lead, offering more attractive returns as compared to value stocks.
FIg.1 1H 2018 Total return by regions and styles
(MSCI Regional, Style, Size indices (Gross TR), USA – in USD, EU – in EUR, CH – in CHF, World – in EUR, EM – in USD);
* – Hérens Quality Composite; Source: Herens Quality AM, Reuters, MSCI
The first half of 2018 brought quite different flavor to the bullish narrative we have been so accustomed to over the last few years. The year started wild: the markets surged on the backdrop of strong global growth momentum that was evident by looking through the lens of recent purchasing manufacturing indices, especially in the Euro Area, where recovery was more pronounced. The additional stimulus of U.S. tax cuts, while anticipated, also gave way to another round of optimism and hope that this year could deliver same returns as 2017 did. However, the positive mood was interrupted by fears of a trade war and anxiety over a synchronized global slowdown. These factors, coupled with further interest rate hikes and political events, such as the elections in Italy, led to increased volatility and uncertainty.
The greatest pressure on equity markets was seen in emerging countries, where international geopolitical tensions, such as North Korean sabre-rattling and U.S.-China trade war threats, and specific country issues, like delayed economic recovery in Brazil and currency weakness in Indonesia hurt investor confidence. It all resulted in the signficant underperfofrmance of emerging markets as compared to developed peers, sending the valuations down.
Style preferences since the beginning of the year have not changed compared to last year: growth and quality styles were in the lead offering more attractive returns as compared to value stocks. The major driver behind growth stocks was the Information Technology sector, which can also boast of good fundamental quality. In addition, high allocation to high-tech companies has contributed to their returns thanks to the market-disruptive effect of passive investments. Quality stocks continue to enjoy positive tailwinds thanks to the systematic underweight of the weak financial sector as well as overweight in the market favourite IT sector.
PORTFOLIO BUY AND SELL DECISIONS
Below we would like to provide some insight into the few of Quality portfolios’ buys and sells in 1H 2018, sharing our experience.
We started the year with an expansion of our European quality portfolio by adding Beiersdorf, a global cosmetics group with a sharp focus on skin care. Beiersdorf became our investment target after the valuation levels declined in the beginning of the year and the stock became attractively valued in our view. The company has a number of competitive advantages that also make it an attractive investment opportunity from the fundamental side. Heritage, unmatched leadership in skin care through Nivea brand, and differentiation have provided immediate advantages over its competitors in the industry. Beiersdorf, competing with such cosmetics majors as Unilever, L’Oreal, P&G, Avon, and Estee Lauder, attempts to maintain a technological superiority through innovations (€143M spent in R&D in 2017) and their highly successful soft-sell techniques (Nivea is among TOP100 Global most valuable brands). The global market for personal care products is expected to increase 3.5% – 4.5% over the next years, with a total market value of US$500 billion by 2020. Also, the company is increasing direct interaction and reinforcing brand loyalty with its consumers through a wide range of digital initiatives. With the addition of a blue chip company like Beiersdorf to our European portfolio, we reduced cyclicality without sacrificing exposure to a growing sector (personal care). In such volatile market conditions, as seen in the first half of 2018, Beiersdorf delivered 6.2% outperformance and continues to report sound financial results (e.g. 1Q sales were up 6.5% y/y).
In March we decided to sell GEA Group from the European portfolio. GEA, one of the largest suppliers of process technology for the food and beverage industry that had been in the portfolio since December 2016. At that time the company was bought on the conviction of its cost saving opportunities and delivery of the greater operational synergies. Additionally, the company enjoyed favourable trends from urbanization and increasing food safety regulations. However, after rather disappointing FY 2017 results and a colorless outlook for 2018, we made the decision to sell the company. Strong currency headwinds, in particular in the second half of the 2017, as well as sustained weakness in dairy processing, resulted in only a 2.5% growth in revenues and reduced profitability. In our view, the Company’s moderate outlook was further challenged by poor market conditions in some consumer sectors and structural problems such as cost overruns on new projects and inefficiencies. Company continued to disappoint investors also in 1Q with orders falling 4% (in a quarter where majority of Industrials have still seen good order growth). We closed out position with 14% underperformance vs. Stoxx 600 and, since our sell decision in March, the stock continued to falter, underperforming market by 21% as of June 2018. However, if management successfully solves structural problems, we believe the company can improve its profitability levels in the long term, and in combination with attractive valuation can be on our radar again.
Momo Inc. is a fast-growing Chinabased Internet technology company that was added to the portfolio in January 2018. After pivoting in 2013 and developing a live-streaming mobile application (which accounts for 85% of the company’s revenues) with social media and messaging features, Momo has almost doubled the number of monthly active users (MAU) using its services to over 100 million in 4 years. Momo’s live-streaming platform enables users to connect to nearby or popular streamers and interact by sending messages or virtual gifts and has proven to have a high level of user stickiness. Due to the strong performance of this live-streaming business, the company has experienced double-digit growth in revenues and net income over the past couple of years, and its position as one of the top players has allowed it to take advantage of the ongoing consolidation in the live-streaming industry in China. The company has also made a recent acquisition of online dating application Tantan, allowing it to capitalize on the exploding demand for online dating services in China.
Momo is a high-quality company with outstanding debt-free balance sheet (equity ratio 80%), high capital profitability (RoE 40%) and strong free cash flow generation (FCF yield 8% as of 2017). We added Momo to our quality portfolio when it came on our radar in January on the basis that, despite its stellar growth and innovative business model, the company was undervalued compared to its peers, having experienced a downward correction through the second half of last year.
In addition to their low valuation, we believed that the pace of growth over the last few years could continue, having a high conviction that the industry would continue to expand. With 45% of China’s 724 million online users accessing live-streaming platforms, total industry revenue is expected to reach $4.4 billion in 2018, up 86% from 2016. Since adding the company to our portfolio, it has significantly outperformed the benchmark index and was our best-performing holding in the first half of 2018. We sold our position in June for an absolute return of 94% and a relative return of 100%, as valuation was pushing 9-month highs and we wanted to limit our exposure to the live-streaming industry, where we also have a position in YY Inc, another Chinese company in this business. Since selling, Momo has experienced a correction, and we continue to monitor this stock for another attractive entry point opportunity, as we believe the company can still grow and create value.
QUALITY STOCKS – PROVEN SHELTER IN AN INCREASING RISK ENVIRONMENT
Quality at attractive valuation is less than 10% of the market
About 77% of the market can be classified as non-Quality (based on S&P 500 and Stoxx 600 universes), while another 13-16%, though Quality, trade at inflated prices relative to earning power. Only a tiny portion of the investment universe is considered fairly valued Quality stock of the companies with excellent financials, well-structured corporate governance, enjoying global trends in the niches they operate. During a stable low interest rate environment and calm geopolitical situation, one could ignore the non-Quality tilt of the market and a passive strategy could be a viable option. However, these conditions are no longer valid making passive investments too risky. Investors should take two major issues into serious consideration when constructing an investment portfolio.
Increasing debt levels
First, the era of low interest rate has come to an end in both the US and Europe. However, we see that the capital structure management is not biased towards debt reduction yet, but rather the opposite. The TSR decomposition charts above show that companies started to increase debt levets in mid-2017, exposing their balance sheets to higher risk. Perhaps this was done on a wave of positive feelings thanks to strong fundamentals (cash return in the case of US companies; marginal profitability improvement) and good earnings forecasts. However, the general market now exhibits lots of risk, which should be acknowledged.
FIg.2 Total Shareholder Return
Source: Hérens Quality AM, MSCI, Reuters
Fig.3. Volatility and US Quality/Non-Quality Performance
* Performances of Quality and Non-Quality segments are based on our CE Corporate Quality Index® USA methodology. The performance does not include any dividends, transaction costs or other costs like management fees.
Source: Hérens Quality AM, Reuters
Volatility caused by US-Chinese trade sanctions
Second, geopolitical instability tends to cause a fever on the stock market, increasing volatility as we recently saw when the VIX hit 30% in the first half of February. In these periods of uncertainty, Quality stocks, as indicated on the chart below, tend to outperform their Non-Quality peers and are regarded by many as a shelter. Blackrock Investment Insitute has acknowledged1 that investors have given
preference to Quality stocks which have performed very well since US-Chinese trade tensions have escalated.
Fig. 4. Source: Hérens Quality AM, Reuters
1Global Investment Outlook 2018 midyear by Blackrock Investment Institute