Wednesday, November 28th, 2018
1. Ten years after the GFC what is your view of the outlook for European equity markets? Is there any compelling value in the European market after the recent pullback in equity prices? Any sectors of interest?
The chart below illustrates that only 23% of global assets had positive returns in 2018 up to the end of October when measured in US$. The collection of asset classes included equities, commodities, foreign exchange and credit instruments and illustrates that, apart from 2008, the negative returns experienced so far this year are among the worst experienced over the last 30 years. Europe is no exception with the equity markets down 13% on average (in US$) and the Italian equity market down 20% (in US$).
Our short explanation for the negative return environment this year is that investors are looking ahead to a reversal of the rosy global economic conditions which led to a synchronised economic recovery over the last 18 months. Elevated equity valuations in early 2018 also set up the market for disappointment.
Deutsche Bank has released the graph below which illustrates that the percentage of asset classes with negative returns measured in US$ could be as high as 89%.
Equity markets are discounting mechanisms for future prospects of economic growth and company earnings that flow from that. Could it be that the equity market is warning investors that we are facing a slowdown in economic activity globally, with Europe the canary in the coal mine?
Recent releases of economic data from Germany make for sober reading. Germany’s third-quarter economic growth showed a drop of 0.2% which partly reflected temporary factors but surprised to the downside nonetheless. Europe’s biggest economy recorded its first negative quarter of economic growth since early 2015 (worse than the consensus forecast of a 0.1% dip) and followed a healthy 0.5% rise in the second quarter. This grim statistic will serve as a warning to the European Central Bank to act slowly on interest rate policy normalisation.
Our exposure to European equity markets remains relatively modest as we believe that those companies offering defensive earnings streams are too pricey. A few examples of companies we follow in Europe and don’t own include L’Oréal, Nestle, Coloplast, Novo Nordisk, Essilor, Amadeus IT and Pernod Ricard. We would like to own these businesses (and have owned some of them over the last 5 years) but will only invest at more attractive valuations.
2. How do you think the unwinding of QE and the lifting of cash rates by the European Central Bank (the ECB) will proceed? Does this concern you or is it priced into markets?
We believe that the ECB is backed into a corner and unable to raise rates from negative levels in the short term due to slow economic activity. European financials continue to be an area we avoid, even as valuations flash false buying signals when measured as having low price-to-book levels. Instead, we focus our research efforts on companies with competitive moats which operate globally, wherever they may be listed in the world, including Europe.
In Europe, the threat of a trade war has had a more severe impact on the wider economy than the threat of interest rate increases. While expected weakness in car production has had a disproportionate impact on Germany, it is noticeable that there is a wider slowdown in economic activity across Europe and equity markets have not responded well to this.
The European car sector may already have discounted an “Armageddon scenario,” looking at multi-year low valuation levels. We are not tempted as the car industry in Europe faces more than just the threat of a trade war; it also faces serious disruption as electric vehicles become more mainstream over time.
In summary, cyclical sectors within Europe have discounted a fair amount of bad news but our investment process typically precludes us from investing in capital intensive industries like car manufacturers. Consumer-related industries like luxury good companies are too expensive.
European automakers 12-month forward price-earnings ratio
Looking at the Clime International Fund on a revenue basis illustrates that our emerging market exposure is larger than Europe (including the UK), a phenomenon discussed in more detail below.
3. Emerging markets have been battered in 2018. Why is that? Has it been overdone and is value appearing?
This year the valuation levels of most asset classes have improved. The valuations of emerging market equities have fallen a long way and are now much lower than those of equities in the developed world. The graph below shows that bond yields have backed up, implying higher future returns for bondholders from a very low base. Equity markets have pulled back while earnings growth has been strong, resulting in more attractive earnings yields compared with the beginning of the year.
Asset yield comparison, January vs September 2018
In our view, investors are starting to discount the ability of companies to continue to grow strongly as has been the case over the last 12 months when the global economy experienced a synchronised growth phase.
More attractive equity valuations versus the beginning of the year reflect investors’ fears that operating margins might be at peak levels at this advanced stage of the economic cycle. We question whether earnings levels will hold up from here if economic headwinds increase – which will almost certainly be the case during 2019 and 2020 as interest rates rise. We, therefore, assess company fundamentals against “normalised” operating margins and not the unsustainably high margins being enjoyed by many cyclical industries at present.
Although the MSCI Emerging Markets Index has recovered a little from the lows in late October, it is still 20% below its peak in late January. Earnings growth in emerging markets is closely related to changes in the exports of its largest members. As China’s economy loses momentum, we are concerned that export growth for the most significant emerging markets will slow in the coming quarters.
The two major emerging markets (China and India) have had disappointing returns over long time periods notwithstanding the rhetoric about strong economic growth. Hong Kong is back at the same level of 7 years ago and India has moved sideways for the last 5 years when measured in US$. The only return investors have enjoyed is if one includes the impact of dividends – which pushes annualised returns to 3-4% in US$.
We believe investors are better served accessing emerging market exposure through multinational companies which operate in both developed markets and emerging markets. The details below illustrate why we are long-term investors in Diageo, one of our top positions (recently trimmed after a period of strong performance).
Over decades, Diageo has demonstrated organic growth rates averaging close to 5% with the occasional slow-down depending on industry dynamics. Few businesses can lay claim to such impressive growth rates over many decades, harvesting both developed market and emerging market growth opportunities.
Looking at the US market, where Diageo has built up critical mass through decades of investing, illustrates that the operating margins of 45% translate into prolific cash generation in its most profitable region globally.
Diageo made a major investment in its Indian subsidiary, United Spirits, a few years ago. Through continuous reinvestment in its Indian operations, Diageo will improve operating margins over time whilst growing organically by at least 7% per annum for many years to come.
In summary, we access emerging market growth opportunities by investing in developed market companies with sizeable operations in emerging markets.
We used the recent equity market correction to add to positions in Fresenius, Yum China, Tencent, Sage (new position) and Facebook (new position), and reduced holdings in Medtronic and Microsoft after strong outperformance. Yum China and Tencent operate exclusively in Asia, while Facebook is exploring significant growth opportunities in Asia.
4. How is the trade war between the US and China being reported in London? Is there real concern that this could escalate, and what effect would this have on Europe?
The slowdown in the German economy needs to be analysed further to determine if this is a harbinger of things to come in Asia. The bottom line is that the decline in GDP was mainly due to foreign trade, with exports falling. This is indicative of an overall slowdown in global trade and the trade wars clearly had a negative impact.
In Germany, consumer spending fell, while investment increased. Both exports and consumer spending could rebound in the coming quarters as car producers make up for lost time and spending increases accordingly. It now looks likely that the Germany economy will grow by about 1.5% this year.
The US-China trade war will continue to rear its ugly head and put pressure on emerging markets due to their export-led economies. EM export growth has a fairly close relationship with earnings growth and any slowdown will drag earnings growth down.
EM central banks have generally tightened monetary policy and are more likely to raise than lower their policy rates in coming quarters.
It feels to us that European companies, in particular, will experience a slowing down towards year-end and we remain cautious.
5. The USD has been strong over 2018. Why is that, and what is your outlook for the USD in 2019?
We remain constructive on the US$. The Euro and Sterling are trapped in low interest rate environments, whereas the US tax breaks are adding impetus to US economic growth. The pressure for higher rates in the US should help the US$, with at least 3 more interest rate increases on the cards over the next 12 months. We will continue to monitor data and assess our views.
6. During the recent reporting season for your major Clime International Fund holdings, did any companies stand out? Any trends worth commenting upon?
The Clime International Fund’s top positions are shown below:
Clime International fund top positions ROE** P/E ***
Roche Holding AG 40.8% 14.0
Booking Holdings Inc 42.3% 19.1
Microsoft Corp 36.9% 22.9
Alphabet Inc 16.4% 18.3
Reckitt Benckiser Group PLC 16.4% 18.3
Oracle Corp 35.3% 14.1
Medtronic PLC 12.7% 17.2
Cognizant Technology Solutions 20.9% 14.0
Unilever PLC 55.0% 19.5
Yum China Holdings Inc 19.0% 22.2
Diageo PLC 32.8% 21.1
**ROE – return on equity P/E, *** price earnings ratio (2019)
It is noticeable how attractive the average return on equity is for the top positions in the Clime International Fund. Recent results for all our businesses have been impressive, with revenue and earnings growth for Microsoft, Alphabet and Booking Holdings recording double-digit gains year on year.
These 3 businesses alone had over $150bn in cash on their balance sheets as they continued to invest in their respective businesses at high returns on equity.
Analysing some of the names in our portfolio, we notice the large discrepancy in performances from the peak to the trough in equity markets below. This illustrates how volatile share prices can be on an individual basis, even within a short time frame.
COMPANY – returns since 26/1/18 to 26/10/18 in US$
MOVE US$ %
|Sabre Corp (sold)||
|American Express Co (sold)||
|Yum! Brands Inc||
|Samsung Electronics Co Ltd (not owned throughout)||
|Facebook Inc (not owned throughout)||
|Fresenius Medical Care||
|Yum China Holdings||
|Sage Group PLC (not owned throughout)||
|Tencent Holdings (not owned throughout)||
7. By mid-2019, how do you think the Clime International Fund will be positioned compared to today’s portfolio (including cash allocation and currency exposures)?
Even though many investors expected the Fed’s interest rate hikes (and developed market monetary policy normalization more generally) as having an eventual negative impact on all assets classes, most investors are only now coming to terms with the fact that positive returns going forward will be harder to eke out.
At the moment, our exposure to information technology and healthcare stocks are at a healthy margin above the relevant index, as valuations are still attractive and secular tailwinds of growth remain in place. The argument that higher bond yields are indicative of renewed strength in the global economy and thus beneficial to financials and materials is not convincing, as during the pull-back in October these sectors were hit disproportionately hard (whereas utility stocks, information technology stocks and health care stocks fared relatively well). In the Clime International Fund, we have zero exposure to mining and financial stocks.
We will use equity market weakness to invest in our preferred high-quality businesses, but at present, we are comfortable with 30% cash levels. We trimmed many long-term winners like Microsoft, Google, Oracle and Diageo before the October correction.
In retail, we fear a secular threat from disruption and cheap valuations might lead to value traps in this sector. The luxury retail sector has held up surprisingly well and has evolved significantly over time to combat disruption, but valuations are stretched on a normalised earnings basis.
Areas of long-term potential include fast food businesses (YUM China), testing and inspection companies (Intertek, SGS) and industrial consumer stocks with rock-solid balance sheets (like 3M).
Europe has structural problems including:
- A weak financial sector; and
- Heavy weightings to industrials and energy.
In the US, the valuation premium versus the rest of the world has expanded as investors want to own global technology names perceived to be long-term winners. We own a selection of these businesses but shy away from companies with lofty valuations like Amazon and Netflix.
The trade wars will lead to negative consequences including:
- Currency devaluation,
- Inflationary impact,
- Supply-side impact,
- Lack of capital investment due to uncertainty.
In summary, an extended economic cycle and higher than average equity valuations mean that we will be patient in deploying cash going into 2019, and will adhere to our sell disciplines.