View from the Road – June 2018

Over the past few weeks, we have been hitting the road and spending some time with investors…

Over the past few weeks, we have been hitting the road and spending some time with investors.  It is always insightful to hear how our clients view life and markets; and as usual some interesting perspectives emerged:

  1. Given the performance of the technology sector and its current elevated percentage of global indices, a number of clients asked about the fund’s exposure to technology.
  2. There was a noticeable lack of interest about investing in Europe – especially versus the US.
  3. It was noteworthy that very few investors now disagree with our view on consumer staples companies.
  4. Younger members of the investment community are only interested in secular growth stocks!

1. Technology

We are increasingly asked about our exposure to technology in SGIG.  This might well relate to the fact that technology has performed so strongly in recent years and now makes up such a large part of global equity indices.

Whilst we have been finding value in some of the US “old tech” names, we observe an increasing number of red flags for investing in the sector.

The continued shift to passive investing and increasing prevalence of the use of ETF’s is creating a virtuous circle for the so-called “FAANG” stocks which make up the largest part of the US equity market.  Investing through Passive/ETF vehicles involves buying shares without any regard to valuation – which is a difficult concept for us with our strict valuation framework!  The growth in passive investing and particularly ETF’s is a relatively recent phenomenon that has undoubtedly worked well for both investors and the FAANG stocks during the elongated bull market.  This may unwind rapidly if/when markets turn.

In addition, it is becoming apparent to us that some investors are now taking a top-down view on the sector and targeting a specific weighting in the sector irrespective of the valuation of the underlying stocks.

This suspension of investment process is very apparent in both UK and European markets where there is a scarcity of tech and investors are having to pay very full multiples to gain exposure.  We have seen this through our recent disposal of Amadeus IT, which is listed in Spain.  We first bought Amadeus IT in 2014 when the shares were trading on 16X Year 1 PER, 10X Year 5 PER and yielded 3%.  Today the shares now trade on 28X Year 1 PER, 17x Year 5 PER and yield 1.7%.  We recently sold the shares on valuation grounds.  We continue to think that Amadeus is a great company but no longer think that it is a good investment.  We are not sure how much of the re-rating over the last 4 years is due to Amadeus’s flawless execution of strategy, investors willingness to pay up for growth, or simply that Amadeus is a tech stock.

We don’t believe that we have any ability to time markets (nor do we think that anyone else can either) but just because we find a stock expensive and sell it, doesn’t mean that the share price will fall.  Our investment process tends to result in us being early into stocks and early out of stocks. Indeed, Amadeus shares have continued to rise since we sold it.

The most important piece of any investment process is valuation.  We like to buy great companies at cheap prices, hold them for many years and then sell them when the shares are expensive.  Having a strong Balance Sheet and attractive dividend yield are also important. We don’t believe in the “buying a great business at any price” philosophy.

As the table below highlights, the US “FAANG” stocks and their Chinese equivalents – “BAT” – are expensive on our strict PER metrics and have no dividend yield support.  Indeed some of these stocks don’t generate any Free Cash Flow.

We remain staggered by the market capitalisation of these relatively young companies which are disrupting many aspects of business and consumers every day lives.  We suspect that at some point Governments across the world will have a look the regulation and taxation of these companies.

We are unable to categorically state that any of these businesses are overvalued.  However, investors have priced in bold assumptions on the future rate of growth, any technological change and challenges to their market positions both from new entrants or regulatory challenges.  These multiples leave little room for error.

“FAANG and BAT stocks”

  PER FY1 Dividend Yield FY1 Market Capitalisation
“FAANG”      
Facebook 24X 0% $564bn
Amazon 107X 0% $830bn
Apple 16X 1.6% $924bn
Netflix 107X 0% $169bn
Google – aka Alphabet 25X 0% $801bn
       
“BAT”      
Baidu 24X 0% $95bn
Alibaba 30X 0% $530bn
Tencent 33X 0% $494bn

We detail our technology holdings in SGIG below.  Whilst we are very interested in the growth drivers that are helping the sector currently (e.g. shift to cloud, artificial intelligence), we have found that the “older” US tech stocks are much cheaper ways of playing these trends.

Microsoft has been in the fund since launch in June 2011.  At the time, Microsoft was a “hated” stock as it was on a Year 1 PER of 9X, Year 5 PER of 7X, yielded 3% and had over 20% of its market capitalisation in cash.  The low valuation was due to investors being concerned about the longevity of its office and windows products.  Over the last 7 years, Microsoft has transformed itself from a value to growth stock and re-rated on a significantly higher earnings number.  We have been reducing our position as it is nearing the top-end of our “hold” rating.

Cisco, IBM and Intel all have the value characteristics that we look for in any investment.  They are lowly valued because they are not pure plays on the new growth drivers, however they are all investing massively in next generation technology.  It has been interesting that both Intel and Cisco have started to re-rate on higher earnings numbers over the last 9 months since both businesses started to grow again.

SGIG current holdings:

  PER FY1 Dividend Yield FY1 Market Capitalisation
Cisco 15X 3.1% $207bn
IBM 14X 4.3% $132bn
Intel 14X 2.2% $256bn
Microsoft 25X 1.8% $766bn

2. Europe versus US

We encountered many questions around our US/Europe positioning.  With most investors struggling to see what will bring an end to the outperformance of the US market.

US outperformance against Europe is now at a 2-standard deviation event which according to statisticians is very significant i.e. it approximately equates to a 5% likelihood of occurrence.

 

As a reminder, we are completely agnostic to country of listing and much more interested in where companies generate their sales.

Catalysts are only obvious in hindsight but our research has identified some high quality low valued global businesses that happen to be listed in Europe.  We expect these shares to re-rate on higher earnings numbers.

3. Consumer staples

Over the last couple of years, we have been a relatively lone voice speaking about the impact that low bond yields were having on valuation in the consumer staples sector.  We were frequently asked why we were selling our “expensive defensives”!

It is noticeable that this is now a much more consensual view.  Many investors now view them as ex-growth companies and fully valued.

It is interesting to note that post the significant de-rating in recent months, these shares are re- appearing on our weekly screen as the dividend yield has moved above 3% in many cases.  We are now busy dusting down our templates in the sector to see if there is any value to be found.

4. Market Participants

Given the elongated nature of the bull market, there are many younger market participants who have yet to see a full cycle, inflation or a normal yield curve.  We hear lots of comments from more experienced members of the investment community that their younger colleagues are only interested in growth and momentum stocks.  They have no interest in buying value stocks no matter how cheap they may look.  Hopefully this is providing an opportunity for those of us with a longer-term and more value orientated perspective!!

 

Many thanks for your continued support,

David Keir

Graham Campbell

Co-Managers, TB Saracen Global Income & Growth Fund

 

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